Sven Steck

Gian Carlo de la Paz

IFRS 7: Disclosure of Financial Instruments

Do European banks comply with the new
standard in terms of credit risk and risk
management?

Business Administration
Master’s Thesis
15 ECTS

Term: Spring 2011

Supervisor: Hans Lindkvist
Acknowledgement
The authors wish to express genuine appreciation to people who got involved and
devoted their time to assist in the conduct of this thesis. The accomplishment of
this thesis would not have been easy without the help extended by many people.
The authors would like to thank the thesis supervisor Hans Lindkvist for being
accommodating and for always offering his assistance. Special mention is given
to Karlstad University for the relevant learning and for the potent source of
reference material for this thesis.The authors wish to thank their family and
friends for the encouragement and unwavering show of support.
Abstract
With the increasing complexity of banking operations, the demand for extensive
disclosure has advanced over the years. In 2007, the International Accounting
Standards Board (IASB) has consolidated and expanded disclosure requirements
related to financial instruments in IFRS7. Arguably, the adoption of IFRS7 in
Europe was met with substantial differences in implementation among countries.
Moreover, IFRS7 was launched a few months before the global financial crisis hit
Europe.

This study examines the level of disclosure according to IFRS7 of 12 banks

spread across Europe using their annual accounts from 2007-2010. The banks
were chosen on the basis of their market capitalization by the end of 2007. A
disclosure index based on IFRS7 was created for this study to evaluate the level of
disclosure of the banks. After examining the disclosure level, this paper analyzes
if there is a correlation between compliance on disclosure index and bank
performance as measured by the Total Shareholder Return. This study aims to
find out if a high compliance significantly affects performance in terms of TSR
and if it helped banks weather the global financial crisis.

The background part provides a broad perspective on disclosure, financial

reporting, accounting standards, and IFRS7. It also provides a situation on bank
run, and on the recent financial crisis. With the use of secondary data from
published accounts of banks, the empirical study presents the disclosure level of
banks and TSR performance. The findings suggest that most banks have a
selective compliance and moderate fulfillment on disclosure obligations.
Inadequacy is particularly seen in areas where additional disclosure is required by
using the implementation guidance of IFRS7. The correlation between
compliance and performance is seen to be very minimal which suggests that a
high disclosure during a financial crisis does not help prevent huge financial
losses.

Keywords: Disclosure, Financial Reporting, IFRS7, Investor Confidence, Total

Shareholder Return
 TABLE OF CONTENTS
1. INTRODUCTION ................................................................................................................. 1
2. THEORETICAL FRAMEWORK ........................................................................................ 2
2.1 Disclosure ............................................................................................................................................ 2
2.2 Financial Reporting .......................................................................................................................... 2
2.3 Accounting Standards ...................................................................................................................... 4
2.4 IFRS Adoption ................................................................................................................................... 4
2.5 Establishment of IFRS 7 ................................................................................................................. 6
2.6 Banking Regulations Issued by the Basel Committee on Banking Supervision ........... 7
2.7 Financial Crisis .................................................................................................................................. 9
2.8 Investor Confidence, Market Discipline, Risks .................................................................... 10
2.9 Bank Run .......................................................................................................................................... 11
3. EMPIRICAL STUDY ......................................................................................................... 14
3.1 Disclosure Requirements According to IFRS 7 ................................................................... 14
3.2 Scope and Definitions................................................................................................................... 14
3.3 Objective of IFRS 7....................................................................................................................... 15
3.4 Disclosure Requirements in the Balance Sheet and Income Statement ........................ 15
3.5 Risk Reporting According to IFRS 7 ....................................................................................... 17
3.5.1Basics ................................................................................................................................................. 17
3.5.2Disclosure Requirements in terms of Credit Risk and Risk Management ................... 18
3.6 Empirical Evidence about the Disclosure of Information in terms of Credit Risk .... 21
4. RESEARCH METHODOLOGY ....................................................................................... 23
4.1 Data Basis and Research Design ............................................................................................... 23
4.2 Reliability and Validity of the Research Methods ............................................................... 27
5. FINDINGS OF THE EMPIRICAL STUDY..................................................................... 30
6. EVALUATION AND ANALYSIS ..................................................................................... 34
6.1 Evaluation of the Empirical Findings ...................................................................................... 34
6.2 Correlation of Disclosure and Firm Performance ................................................................ 35
7. CONCLUSION .................................................................................................................... 40
References .................................................................................................................................................. 42
Appendix .................................................................................................................................................... 47
 1. INTRODUCTION
A significant development in the conduct of monetary policy over recent years has
been the shift to more transparency through disclosure by different banks. As time
passed, financial reporting has evolved with many changes introduced since the
first financial statements were published in 1930’s (Ramanathan 2009). It has now
become a practice by many companies to secure information related to
performances, bank objectives, operating procedures, and decision making
processes. For Healy and Palepu (2001), the popularity of disclosure on the
performance of entities has grown in recent years although Thomas et. al (2006)
thinks that it remains elusive and that progress has been slow in some countries.
According to Kieso et. al (2003), a full disclosure principle requires financial
reporting of information that is deemed useful for the judgment of informed users.
It makes important data on financial matters available to academics and policy
makers (Thomas et. al 2006). James and Lawler (2010) echo this view that an
increased transparency is likely to be beneficial. Over the years, disclosure has
become an indispensable part of the financial statements and the requirements
continue to increase. It could be seen that much of European Financial Regulation
is based on the disclosure model.

The launch of IFRS7 in Europe has significantly expanded the disclosure of

entities; particularly users of financial instruments. Bischof (2009) supported this
view in his research on the first time adoption of IFRS7 in Europe. Many
academics like Tang (2010) Thomas et. al (2006), and Bischof (2009) agree that
IFRS7 is a logical step towards increased transparency in the banking industry.
With this, it is interesting to pursue a study on the performance of banks in
achieving this objective. Using published reports from financial years 2007 to
2010, this paper will examine the disclosure quality of 12 selected banks in
Europe using established criteria.

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 2. THEORETICAL FRAMEWORK
2.1 Disclosure
It could be seen that requirements in disclosing information has increased over the
years. According to Kieso et. al (2003), the reasons for this increase in disclosure
requirements are varied. It includes complexity of business environment.
Increasing complexity of operations resulted to an increase in reliance on financial
statements to explain transactions and its effects. Another reason presented by
Kieso et. al (2003) is the necessity for timely information. They argued that users
of financial information demands more current and predictive information.
Another reason presented is to increase control and monitoring of company
activities. Kieso et. al (2003) shared two problems though in implementing a full
disclosure principle. One is cost of disclosure and another is information overload.
For instance, an increase in disclosure could result to an increase in accounting
staff for some companies. In addition, some disclosure requirements could be very
detailed to the point that users have difficulty processing the information (Kieso
et. al 2003).

The process of continuously increasing the disclosure requirements has been

never-ending as evidenced by the launches of new financial reporting standards
by the International Accounting Standards Board (IASB). The IASB was said to
be patterned after the US GAAP but has even went further with their requirements
(Elliot et. al 2006).

2.2 Financial Reporting

Despite the existence of different financial reporting models for communicating
the performance of a company, it was deemed inadequate in terms of its capability
to meet the growing information needs of users. In addition, there were perceived
differences in the financial reporting of different countries which made it difficult
to compare reports internationally. History attests that establishing a financial
reporting standard for Europe was difficult because of the different accounting
philosophies existing within member states (EUCE 2009). Previous research
conducted by Tang (2010) revealed that different banks have varying levels of
disclosure. Tang (2010) argues that better-performing banks are less likely to
disclose accurate information because a detailed disclosure could be used against
them by their industry counterparts or competitors.

According to Elliot et. all (2006), the reasons for the differences in financial
reporting include:
Character of the national legal system
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 Way of industry financing
Relationship between the tax and reporting systems
Influence and status of accounting profession
Magnitude to which accounting theory is developed
Accidents of history
Language

Elliot et. al (2006) argues that national legal system could contribute to the
differences in the regulation of financial reporting due to the level of flexibility it
allows in reporting. Those legal systems based on Roman law for instance tend to
be less flexible than that of those based on common law. This makes countries
vary in terms of compliance and completeness of information. The way the
industry is financed is one of the considerations according to Elliot et. al (2006)
because the information needs of the financier varies. For instance, the
information needs of equity investors vary from that of loan creditors. The
financial reporting therefore could vary in terms of how most companies
operating in a country are funded. Although Ketz (2008) thinks that information
that is crucial to capital providers may also be useful to other users of financial
reporting, Elliot et. al (2006) believes that the predominant provider of capital in a
country influences the financial reporting of a country. Relationship between the
tax and reporting systems could also influence the differences in financial
reporting because of the differences in rules for computing for tax and computing
for profit for financial reporting systems (Jenkins 2011). In UK and Netherlands
for instance, legislation for tax purposes is usually more prescriptive but their
financial reporting environment is less prescriptive (Elliot et. al 2006). The
advancement of accounting profession who produces relevant and reliable reports
has also influenced the development of accounting regulations and reporting of a
country. Many countries require companies to prepare annual accounts while in
some countries where the level of need for market-sensitive information is lower,
accountants usually just perform bookkeeping tasks. According to Russell (2011),
accounting theory creates a framework for accounting practices. Elliot et. al
(2006) supports this by arguing that accounting theory has an influence on
accounting practice. The extent to which accounting theory is developed is one of
the reasons identified why there are differences in financial reporting. Some
theories that are the basis of accounting practices were developed at academic
level while the others at professional level. History of failures has also contributed
to the differences in financial reporting of countries. Following the global
financial crisis that broke in 2007, many countries adopted new rules to disclose
information (Bentley 2010). Certain scandals that broke from company failures
affected financial reporting in some countries (Elliot et. al 2006). According to
Bentley (2010), after what happened to the US for instance, the Security and
Exchange Commission wants to have additional transparency among companies
so that investors could make more informed decisions. A popular cause of
difference among countries is language. Some countries are known for
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exclusively using their own language, which has prevented them from gaining
from the wisdom of other countries (Elliot et. al 2006)

2.3 Accounting Standards

Triggered by the economic consequences of having different accounting practices
(Elliot et. al 2006), many academics and professionals were aligned calling for the
regulation and increase in consistency of financial reporting. In addition, there
were also recommendations to widen the scope of reporting as opposed to just
increasing the frequency of the reporting. In early 2000, the European
Commission moved to propose the creation of unified international accounting
standards for companies in EU to harmonize financial reporting (EUCE 2009).

Elliot et al (2006) outlined the arguments in favor of having a single set of

standards for companies. It was summarized into four arguments namely:
comparability, credibility, influence, and discipline. First, it argued that to allow
users of financial statements make a legitimate comparison of performance,
relevant and reliable data must be standardized. It is deemed useless to make
comparisons if companies were allowed to select accounting policies that are
convenient or favorable for them, with the purpose of disguising or withholding
performance news. Second, this selection of accounting policies could result to a
lost of credibility. Elliot et. al (2006) expounded that if companies under similar
situations disclose significantly different reports as a result of their freedom to
choose accounting policies, credibility of reports will be lost. Elliot et. al (2006)
added that having a uniform standard is essential if financial reports will disclose
an accurate view. Third, the establishment of standards has promoted an
evaluation of proposed policies for individual reporting problems and stimulated
accounting thought and development of a conceptual framework. Fourth, Elliot
et. al (2006) assumes that even in the absence of standards, companies will
eventually be disciplined by the financial market. Imposing a mandatory standard
therefore could promote an active regulation that could prevent a major loss to a
company and to other investment decision makers.

2.4 IFRS Adoption

The first time adoption of IFRS entailed major changes in accounting policy and
disclosures. With this, many companies had to transition their financial
statements from GAAP to IFRS and this required the restatement of accounts
(Elliot et. al 2006). Coming with this transition is a disclosure requirement on the
effect of the transition on the company’s cash flow, financial performance, and

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financial position (Elliot et. al 2006). Starting 2005, listed companies in countries
belonging to the European Union were required to report consolidated financial
statements that follows the provisions of IFRS (Ball 2006). The adoption of IFRS
in many countries, including all of Europe, is deemed helpful for investors and
users of financial statements because it improves the quality of information and
reduces the cost of comparing different investments.

Ball (2006) outlined the advantages of IFRS for investors in his report on IFRS
Pros and Cons.
It is also helpful for companies as investors, provided with a more accurate,
comprehensive, and timely financial statement information, could lower the
risk involved with a more-informed valuation in the equity markets.
For small investors, IFRS provides a better playing field against big
investors as they get the same financial statement information. IFRS
reduces the risk that small investors take when they are dealing with more-
informed professionals.
By standardizing reporting formats and accounting standards, IFRS
eliminated many international differences. This has resulted to a decrease in
cost of processing financial information.
As a result of the reduced cost, there is an increase in efficiency with which
the stock market incorporates. An increase in market efficiency is expected
to benefit most investors.
To some extent, the decrease in differences in accounting standards among
countries helps in removing barriers to cross-border acquisitions and
divestitures. Investors therefore are expected to enjoy better takeover
premiums.

Ball (2006) further adds that IFRS brings about other indirect advantages for the
investors. He argued that an increased in transparency for instance makes
managers uphold the interest of shareholders. For example, a timely recognition
of loss in the financial statement increases the incentives of managers to focus on
loss-contributing investments and engage in fewer new investments with negative
net present value. Ball (2006) therefore concludes that having a better
transparency and loss recognition increases efficiency between firms and their
managers and improves corporate governance.

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 2.5 Establishment of IFRS 7
In an attempt to constantly improve standards, the IASB has integrated existing
and new disclosure requirements related to financial instruments in IFRS7. The
new requirements are meant to improve the information on financial instruments
that is provided in company’s financial statements (IASB 2005). In its press
release in 2005, IASB announced that IFRS 7 is replacing IAS32 Disclosures in
the Financial Statements of Banks and Similar Financial Institutions and some of
the requirements in IAS 32 Financial Instruments: Disclosure and Presentation.
According to Tweetdie (2005), IASB Chairman, “IFRS7 leads to greater
transparency about the risks that entities run and provides better information for
investors and other users of financial statements to make informed decisions about
risks and returns.”

For perspective, IFRS7, described by PWC (2007) as an expanded replacement of

IAS32, complements the principles for recognizing, measuring and presenting
financial assets and financial liabilities in IAS 32 Financial Instruments:
Presentation and IAS 39 Financial Instruments: Recognition and Measurement
(IASC 2009). It consolidates and expands several disclosure requirements and
introduced new disclosures that are deemed as both significant and challenging
(PWC 2007). In general, the level of disclosure required by IFRS7 is higher than
preceding standards. This explains why a number of requirements of IFRS7 are
similar to IAS32. The quantitative and qualitative market risk disclosures are just
some of the new addition to the new disclosure standard that is IFRS7. According
to Epstein and Jermakowicz (2008), the qualitative disclosures details the
management’s objectives, policies and processes for managing risks while the
quantitative disclosures describe the scope to which the entity is exposed to risk,
based on the information it provides internally to the entity's key management
personnel. When combined, both disclosures provide an overview of the entity's
use of financial instruments and the exposures to risks they create (Epstein and
Jermakowicz, 2008). The addition of more disclosure requirements in IFRS7 is
part of IASB’s long term project with regard to financial instruments (Bischof
2009).

IFRS7 was implemented for financial years beginning after December 31, 2006
(PWC 2007). Unlike IAS 30, IFRS7, as a regulation, is not limited to banks,
instead it is for use by all entities using financial instruments. While it required all
companies engaged in financial instruments to follow (IASC 2010), the new
standard has a particularly strong effect on the banking industry, where financial
instruments significantly account for its total assets and liabilities.

In his report on the effect of IFRS7 on bank disclosure on Europe, Bischof (2009)
distinguished the two different types of disclosure in IFRS 7:

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 The standard demands for the disclosure of the significance of measurement
categories used in compliance with IAS 32 and of governing accounting
policies. For example, assumptions made in determining values.
It is required to disclose both qualitative and quantitative information about
credit risk exposures, market risk exposures, and liquidity risks exposures.
Credit risk is said to be a function of customer’s credit quality because it is
the risk of defaults in payments to be given to customers. A maturity gap in
a company’s asset and liability management that arises when obligations to
be serviced exceed the entity’s current liquidity results to a liquidity risk.
An entity’s exposure to fluctuations in market prices gives rise to market
risks.

With the implementation of IFRS7, there has been cross country differences in the
change of disclosure quality. Ball et. al (2003) argued that institutional
environment that rewards preparers with incentives for disclosure rather than
content of accounting standards, influenced accounting quality. Bischof (2009)
added that since bank supervision is not yet fully harmonized in Europe,
supervising authorities is responsible for creating the imperative features of the
accounting environment at the local level. Bischof (2009) believes that these
differences in accounting environment per country could partially explain the
heterogeneity in the compliance of IFRS7.

2.6 Banking Regulations Issued by the Basel

Committee on Banking Supervision

With the resolution of the financial crisis, there was a wide range of proposals
aimed at addressing the various regulatory shortcomings that have allowed banks
to take excessive risk taking. MAS (2006) argued that financial institutions such
as banks should regulate the level of credit risk that it can bear and that it should
establish a strategy for risk management that is aligned with its credit risk
tolerance. It further adds that credit risk management should be part of an
integrated approach to the management of all financial risks. This involves having
a framework that adequately identifies, measures, monitors and controls credit
risk. The Enhancing Bank Transparency Report (1998) of Bank for International
Settlements communicated the importance of transparency in banking activities
and in the risks inherent in those activities such as credit risk. Having more
transparency through an improvement in public disclosure of banks strengthens
the safety and soundness of the banking system.

Several bank failures manifested in the 1980’s, a period usually called as a loan
and savings crisis period (Zaher 2006). During this period, banks granted loans

7
extensively while the external indebtedness of countries was burgeoning to an
unsustainable level. A bankruptcy scenario of major bank players grew as an
aftermath of low security. In order to prevent the looming bankruptcy, the Basel
Committee on Banking Supervision drafted a standard called Basel 1 Capital
Accord that sets the minimum amount of capital that banks should hold (Zaher
2006). This standard was also called the minimum-risk based capital adequacy. It
was aimed at assessing capital in relation to credit risk, or the risk that a loss will
be experienced if one of the parties fails to fulfill its obligations (IFRS 2008). The
purpose was to promote the stability of the international banking system and to set
up a fair system that will minimize the competitive inequality among banks. Basel
2, an extension of Basel 1 and implemented in 2007, is a comprehensive
framework that determines regulatory capital requirements and measures risk
(BIS 2011). While the Basel Committee does not possess an authority to enforce
regulations, most member countries usually implement the committee’s
agreements.

The beginning of the financial crisis which occurred in 2007-2009 was a credit
boom that transpired in extremely indebted economies with investors having a
high appetite for risks (Zaher 2006). During the crisis, there was a major
confidence loss in bank’s capital standards. The fallout of the crisis led to calls for
more reforms in regulation. As a result, the Basel Committee formed a new
regulatory standard on bank capital management and liquidity. The new global
standard called Basel 3 was developed because the recent financial crisis revealed
deficiencies in financial regulation and existing standards (BIS 2010). Aside from
strengthening bank capital requirements, Basel 3 integrates new regulatory
requirements on bank liquidity and leverage. In response to the financial crisis, the
Basel Committee wants to promote a more resilient banking sector by improving
the banking sector’s ability to handle financial and economic shocks (BIS 2009).
Basel 3 was drafted to prevent the financial system from suffering from the same
type of meltdown and economic slowdown which occurred between 2007 and
2009. Hirtle (2011) argues that one way to prevent a bank failure is to require
banks to hold more capital. The new standard now includes having capital buffer
requirements and having a higher quality of capital than what Basel 2 requires
(Moody’s 2011). This buffer will help banks to maintain capital levels during a
major downturn and that they will have fewer concerns in exhausting capital
buffers by way of dividend payments. Hirtle (2011) narrates that the financial
crisis, the current and historical ones includes, has provided information to help
determine the capital conservation buffer since we can measure how the capital
positions of banks were affected during the period of turbulence.

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 2.7 Financial Crisis
The financial crisis came on the heels of the implementation of an expanded
disclosure standard known as IFRS7 in Europe. IFRS7 was launched a few
months before the financial crisis. The European economy was plagued by a
series of financial crisis that broke in the late summer of 2007 (Nemeth 2010).
Similar to previous financial crisis in other markets, the recent financial crisis in
Europe was preceded by a long period of rapid credit growth, abundant
availability of liquidity, rising asset prices, low risk premiums, strong leveraging
and development of bubbles in the real estate sector (EU Commission 2009).
During the financial crisis, many investors withdrew from securities markets and
placed their funds on safer assets. The financial crisis had a pervasive impact on
European banks and its operations. Banks were the focal point of the financial
crisis in 2007-2009. The financial crisis revealed several loopholes in the banking
industry. According to EU Commission (2009), when the crisis started to surface,
banks became dubious about the credit worthiness of their counterparts as heavy
investments were made on various financial products that are deemed as highly
complex and overpriced. This has resulted to the closure of interbank market and
skyrocketing of risk premiums on interbank loans. In addition, banks had to deal
with serious liquidity problems which came as a result of their failure to rollover
short-term debts. The financial system meltdown grew in scope, with banks
restraining and cutting down credit, sudden drop of economic activity, and
deterioration of loan books. The threat made investors, as described by EU
commission (2009), rush for the few safe havens that were remaining such as
sovereign bonds. It could be seen that financial instability may decrease investor
confidence and could prolong recovery following a crisis.

Mora (2010) compared the financial crisis of 2007-2009 with previous financial
crises. She argued that the 2007-2009 crisis had a similarity in terms of the need
for liquidity by businesses and households and this was unmet by market-based
sources of funding. It was difficult or even impossible to borrow in securities
market. The difference is that the banking system was significantly affected by
credit losses and uncertainty surrounding the losses compared to previous crises.
Mora (2010) added that beliefs about risks or uncertainty in the economy may have
influenced the investors who supplied market funds. This resulted to a shift of
funds to low risk assets.

Freixas (2010) argues that the financial crisis that started in 2007 has affected the
banking industry and banking regulations. The financial crisis almost spared no
banks but some banks have been more vulnerable than others, showing major
differences in financial positions and shareholder value. This paper is therefore
seeking to find out the correlation between the level of bank disclosure and
movement of shareholder value.

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 2.8 Investor Confidence, Market Discipline, Risks

According to Elliot et. al (2006), the dynamism of international financial markets

brought the influx of different kinds of financial instruments and these could
potentially contribute to the risks that an entity faces. There are many kinds of
instruments that are considered versatile and it is this versatility that could cause
problems due to the risks it entail (Hull 2007) The operation of many European
banks have become increasingly intricate and this has resulted to a difficulty in
managing their risk controlling behaviors. Hull (2007) argues that operations of
banks are prone to many risks and that trading operation gives rise to these risks.
For Masschelein and De Ceuster (2003), the risk sharing and monitoring services
that banks make, paves the way for distinct contract situations. For this reason,
international agreements on how banks should be regulated have now been
established. Although there are existing regulations for corporations, Masschelein
and De Ceuster (2003) argued that special regulations for bank failures are
justified due to the unique nature of banks. Banks and financial institutions in
many countries are regulated to check and control their liquidity and risks. Banks
are now required to sustain for the risks they are holding and that this does not
significantly vary from other regions. As an example of the requirements,
regulators are tasked to ensure that the total capital of a bank is sufficiently high
that the probability of a bank failure is kept low (Hull 2007). There are many
countries now the implemented a guaranty program to protect small depositors
from losing in the incidence of bank failures (Hull 2007).

The Bank for International Settlements (2001) recognizes that market discipline
has the capacity to strengthen capital regulation and supervisory tasks aimed at
promoting safety and soundness in banks and financial systems. It further adds
that market discipline offers strong incentives for banks to operate in a safe, sound
and efficient manner. Notwithstanding the incentives, there could be different
reasons why a growing reliance on bank supervision on market discipline through
disclosure standards such as IFRS7, could run against the objective of enhancing
competitive image (BIS 2001).

On investor confidence, the premise was investors could make optimal decisions
in relation to resource allocations, and wealth maximization if they are provided
with sufficient information which could be found in financial disclosures.
Executives and academics from different fields support this view. Cohen and
Hathaway (2003) share the view that financial disclosure is the beginning of a
decision and for investors to make good decisions, they have to gain access to
truth. NEF (2006) supports this by saying that transparency is a starting point of
greater openness and shared information that can promote working partnerships
among banks, lenders, and investors. Garton (2003) believes that the integrity of
the society is weakened if the disclosure is not accurate or is misrepresented;
otherwise, there could be a non-functioning market. Mora (2010) explained that
10
banks suffered during a financial crisis due to the panic arising from the lack of
information and loss of confidence. Uncertainty of exposures made it difficult for
counter-parties to gauge each other’s soundness. Having no access to information
could make policies and programs implemented from partial studies and
incomplete analyses. Norris (2003) thinks that bad financial disclosure has risen
over the years due to the desire of companies to get stock prices up. This is
supported by a study conducted by Kothari et. al (2005) on the timeliness of
public disclosure of good news and bad news. The study revealed that if
companies leak and reveal good news to investors but delays and accumulates
disclosure of bad news, the impact of the negative stock price reaction to the
accumulated negative news is bigger than the impact of the positive stock price
reaction to the positive news.

According to Elliot (2006), for financial information to be useful, it has to be

relevant and reliable. To help investors secure markets, information from financial
instruments should enter public domain in any given area of financial market
activity. With the aid of available information, market actors would customize
strategies and investment decisions to what the information is telling thereby
resulting to monitoring bank’s risk profiles and influencing bank’s management
decisions.

2.9 Bank Run

The theoretical issue behind this standard is built upon the premise that there is a
confidence problem existing between investors and banks. Having a legal
authority and duty to make financial decisions, institutional investors carry both a
fiduciary responsibility and an economic interest in ensuring that the management
goals of an entity are fully synchronized with their interests. Diamond and Dybvig
(1983) share the view that even banks that are considered healthy could also fail
and cause the recall of loans and cancellation of investments. According to Ng
(2009), previous research conducted by MIT Sloan School of Management
supports the view that investors do not easily believe the values being reported by
financial institutions. In addition, even if banks claim that it is performing
relatively well, investors continue to cast doubts about it. Kothari et. al (2005)
added that in an efficient market, investors know that only parts of good news are
disclosed to the public and that they normally supplement the remaining good
news from the disclosed portion.

To amplify, this paper will discuss the models of Diamond/Dybvig (1983) and
Calomiris/Kahn (1991) which have analyzed a possible consequence of the
confidence problem, the bank run, and which also point out instruments to prevent
it.

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Financial intermediaries such as banks are commissioned to create liquid deposits.
It is also engaged in monitoring borrowers and enforcing loan covenants. The
model of Diamond/Dybvig (1983) which has been used to understand bank runs,
analyzes the demand for banks´ liquidity and transformation performances. They
outline the pivotal role of the banks in providing liquidity for consumers and in
transforming short-term borrowed capital of depositors in long-term loans for
companies. They regard the deposit guarantee by the state as the optimal solution
to prevent a bank run.

Diamond and Dybvig (1983) first argued that banks should be able to create
liquidity via offering deposits that are more liquid than assets being held by
entities. There is an investors’ demand for liquidity because the need to consume
could be unpredictable. Because of this, investors prefer to know the value of
liquidating their assets at several periodic dates as opposed to a having a single
date (Diamond & Dybvig 1983). Having deposits that are more liquid than the
assets being held by banks could be interpreted as a guarantee set up that puts
depositors at a risk of liquidating an asset at a loss. Offering these demand
deposits makes the banks more vulnerable to bank runs if many depositors decide
to pull out. Diamond and Dybvig (1983) argued that a loss of confidence in the
banking system could lead to depositors demanding withdrawal of their funds.
The financial crisis that broke in the late summer of 2007 saw sporadic bank runs
crippling different parts of the world. According to Diamond and Dybvig (1983),
bank runs occur as a result of depositors withdrawing money due to fear of a bank
failure. The abrupt withdrawals pressures the banks to liquidate many of its assets
regardless of its value or even if it is at a loss. Diamond and Dybvig (1983)
further adds that these bank failures cause a disruption in the monetary system and
reduction in production. Reduction in production happens during a bank run
because banks are pressured to call in loans early.

Having a diversified source of funding could help protect the bank from runs if
diversified means that there is no single source of information observable to a
large number of depositors. When there is a bank run, it is important that banks
are able to convince depositors that it is going to stop soon. Having no dominant
news or information shared by depositors makes panic and bank runs baseless.

The model of Calomiris/Kahn (1991) focuses on the moral hazard that exists
between the bank and investors. They assume that the banks have the incentives
to take high risk without paying attention whether they can pay off their
depositors. In doing so, they regard the possibility of investors to demand their
deposits back in the short-term as a mean to prevent the management of the bank
to take inappropriate risks. Regarding to their opinion, this measure may prevent a
bank run finally. Moreover, we will discuss other possible solutions in respect to
the confidence problem, namely the self-regulation and the co-regulation. In this
context, self-regulation means that the state delegates the authority to the private
sector which has to develop appropriate risk management strategies and to
12
monitor their compliance and finally to improve them. In doing so it is assumed
that the banks know the danger of a possible bank run and therefore, they try to
solve the confidence problem independently. Another possible way to increase the
disclosure of decision-relevant information is the co-regulation which is also
called “mandated self-regulation”. It means that a private-sector organization is
appointed by the state to formulate and enforce rules on self-regulation within a
legal framework.

The International Accounting Standards Board dealing with the European

accounting also pursues this approach of a co-regulation. The IASB is entitled by
the European Union to develop international accounting standards (IFRS) which
are finally enforced by the EU.

13
 3. EMPIRICAL STUDY
3.1 Disclosure Requirements According to IFRS 7
In the following chapter, the disclosure requirements for financial instruments
according to IFRS 7 are described. After giving a short insight into the scope, the
objectives and the disclosure obligations on the balance sheet and in the income
statement the analysis is concentrating on the risk reporting according to IFRS 7.
In doing so, the focus is on the disclosure requirements in terms of the credit risk
and the risk management as the following empirical examination is concentrating
on both these areas.

The reporting obligations of financial instruments have been bundled into one
standard since the establishment of IFRS 7. This standard which was passed by
the IASB on 18.8.2005 supersedes the bank-specific standard IAS 30 (IFRS 7.45)
and the disclosure requirements according to IAS 32.54-95. It is mandatory to
apply IFRS 7 to annual periods beginning on or after 1.1.2007, but an earlier
application is encouraged (IFRS 7.43). The standard contains the paragraphs 1 to
45 and the appendixes A and B. Appendix A includes definitions of terms which
are used within the standard, such as “credit risk”, “market risk” and “liquidity
risk”. Appendix B provides explanatory information about the interpretation of the
single paragraphs. Additionally, the Implementation Guidance (IFRS 7.IG) and
the Basis for conclusions (IFRS 7.BC) can be used; however these explanations
do not have to be applied on a mandatory basis.

3.2 Scope and Definitions

The definition of a financial instrument is adopted from IAS 32. A financial
instrument is according to IAS 32.11 “any contract that gives rise to a financial
asset of one entity and a financial liability or equity instrument of another entity”.
Based on this definition IFRS 7 shall be applied to all kinds of financial
instruments by all companies. This means that the companies are required to
provide detailed information about on- and off-balance sheet financial instruments
(IFRS 7.4). Thus, the scope of IFRS 7 is more encompassing than IAS 39 (PwC;
2008). However, the following financial instruments are excluded from the
application of IFRS 7:

interests in subsidiaries and joint ventures (IAS 27),

interests in associates (IAS 28),
assets and liabilities from employee benefit plans (IAS 19),
insurance contracts (IFRS 4),
financial instruments having a share-based payment (IFRS 2),
14
 contracts of the acquirer for contingent consideration in a business
combination (IFRS 3) (IFRS 7.3).

3.3 Objective of IFRS 7

The objective of IFRS 7 can be divided in two parts. On the one hand IFRS 7
obliges companies to disclose detailed statements about the possessed financial
instruments in order to provide the users of financial reports with appropriate
information with which they are capable to estimate the importance of financial
instruments for the financial situation and the performance of the company (IFRS
7.1.(a)).

On the other hand the provided information shall enable the users to evaluate “the
nature and extent of risks arising from financial instruments to which the entity is
exposed during the period and at the reporting date” (IFRS 7.1(b)). Additionally, it
is mentioned that this objective complement the principles of IAS 32 and IAS 39
(IFRS 7.2). This goal setting documents the purpose of the IASB to create a
framework resulting in an efficiently operating market discipline.

3.4 Disclosure Requirements in the Balance Sheet and

Income Statement

At different places within IFRS 7 the standard requires companies to disclose

information about previously classified categories of financial instruments.
According to IFRS 7.6 financial instruments shall be split up into categories,
however, the nature of the allocation is mainly left to the company itself. Only the
distinction between financial instruments measured at amortized cost and those
measured at fair value is mandatory (IFRS 7.B2).

The balance sheet related disclosure requirements are covered by IFRS 7.8-19.
According to IFRS 7.8 the carrying amounts of each category of financial
instruments, as defined in IAS 39.9, “shall be disclosed either on the face of the
balance sheet or in the notes”. Furthermore, IFRS 7.9-11 rules the disclosure
requirements of financial assets and liabilities at fair value through profit or loss.
Moreover, IFRS 7.12 contains the reclassification of financial instruments in other
categories during the reporting period and prescribes that the amount reclassified
and the reason for this reclassification shall be disclosed. IFRS 7.13 rules the
cases where a financial asset is transferred in such a way that the criteria of
derecognition are not completely fulfilled according to IAS 39.15-37 and
therefore, the company bears part of the risks and rewards of the ownership
15
anymore. Furthermore, IFRS 7.14-15 requires the disclosure of the carrying
amounts of the provided collateral. In case of a sale of the collateral, without the
default by the owner of the collateral, the fair value of the collateral held, the fair
value of the sold or repledged collateral and the contract conditions shall be
disclosed. When financial assets of the company are reduced by credit losses and
records this impairment in a separate account, instead of reducing directly the
carrying amount of the asset, the company has to disclose the reconciliation of the
changes according to IFRS 7.16. Besides, IFRS 7.17 is concerned with the
disclosure requirements of issued financial instruments containing a liability as
well as an equity component with multiple embedded derivatives. IFRS 7.18-19
requires companies to provide detailed information about financial instruments
with defaults or breaches of loan agreement terms.

The disclosure requirements in the income statement are bundled in IFRS 7.20.
The following items can be shown either on the face of the income statement or in
the notes. According to IFRS 7.20 (a) net gains or net losses shall be disclosed on

financial assets or financial liabilities at fair value through profit or

loss;
available-for-sale financial assets;
held-to-maturity investments;
loans and receivables;
financial liabilities measured at amortized cost;

Furthermore, information in terms of the total interest income and total interest
expense (IFRS 7.20 (b)), fee income and expense (IFRS 7.20 (c)), interest income
on impaired financial assets (IFRS 7.20 (d)) and about the amount of any
impairment loss for each class of financial asset (IFRS 7.20 (e)). These presented
disclosure requirements were valid at the balance sheet date 31.12.2007. In the
course of financial market crisis and the establishment of the IFRS 9 there were
modifications within this standard in terms of the disclosure requirements in the
balance sheet and of the liquidity risk. However, the thesis is not affected by these
changes and therefore, these modifications are not taken into account.

The paragraphs IFRS 7.21 to 7.30 cover further disclosure requirements, such as a
description of accounting policies of financial instruments or annotations about
hedge accounting. However, these disclosure obligations are not analyzed
anymore as the focus of this thesis is only on the credit risk.

16
 3.5 Risk Reporting According to IFRS 7
3.5.1 Basics
IFRS 7.31-42 prescribes a detailed risk reporting of financial instruments. This
shall enable the users of financial statements “to evaluate the nature and extent of
risks arising from financial instruments to which the entity is exposed at the
reporting date” (IFRS 7.31). The scope and the level of detail of the risk reporting
shall be oriented on the company´s use of financial instruments (IASCF (2009):
IFRS 7.BC40 (b)). Thus, a bank - due to its intensive use of financial instruments
– has the highest disclosure requirements. In doing so, the transmitted data shall
originate directly from the internal risk management (“Management Approach”)
(PwC; 2008). The information can be shown either in the IFRS financial
statement or by the means of a cross-reference in another report, however, a
summarized presentation is recommended, for instance a description in the risk
report (IFRS 7.B6).
The risk reporting in IFRS 7 is divided into qualitative and quantitative disclosure
requirements. The qualitative disclosure obligations are composed of three items
which shall be disclosed for each type of risk including the credit risk (The credit
risk is defined in IFRS 7.A as “the risk that one party to a financial instrument
will cause a financial loss for the other party by failing to discharge an
obligation”.), the market risk (The market risk is regarded in IFRS 7.A as the risk
that “the fair value or future cash flows of a financial instrument will fluctuate
because of changes in market prices“.) and the liquidity risk (The liquidity risk is
defined in IFRS 7.A as “the risk that an entity will encounter difficulty in meeting
obligations associated with financial liabilities”.). In particular:

First, a description of the exposures to risk and how they arise has to be made for
each risk type. Secondly, it is required to make a statement about the objectives,
policies and processes of the risk management and about the methods used to
measure the risk. This area of the qualitative disclosure requirements will be
presented more in detail in the next chapter under the heading “risk management”.
Thirdly, any changes in terms of the risk extent, risk management and risk
measurement compared with the previous period shall be disclosed (IFRS 7.33).

The quantitative disclosure requirements require according to IFRS 7.34 (a) a

summarizing quantitative presentation of the risks assumed for each individual
risk type. Additionally, further disclosures in terms of the credit, market and
liquidity risk have to be made in compliance with IFRS 7.36-42 unless these
disclosures are already made according to IFRS 7.34 (a) (IFRS 7.34 (b)). If there
are further concentrations of risk which do not arise from the disclosures
requirements of IFRS 7.34 (a) and (b), further statements about the risk
concentration are required (IFRS 7.34 (c)). Apart from the supplementary

17
information about the credit risk which is explained in detail in the following
chapter information about the market and liquidity risk are required.

In terms of the market risk IFRS 7 requires a sensitivity analysis for each type of
market risk (IFRS 7.40 (a)). The standard divides the market risk in the currency
risk, interest rate risk and other price risks (IFRS 7.Appendix A). In addition to
the sensitivity analysis IFRS 7.40 (b) and (c) require the company to disclose “the
methods and assumptions used in preparing the sensitivity analysis” and the
corporation shall inform the users of the financial statements if the assumptions
and methods were changed compared to the previous period. Instead of a
sensitivity analysis a value-at-risk analysis can be carried out alternatively. For an
alternative application the following conditions have to be met: First, the method
with which the value-at-risk analysis is performed has to be explained and the
main parameters and assumptions underlying the data provided have to be
described (IFRS 7.41 (a)). Secondly, the objectives of the applied method and its
possible limitations in terms of the reproduction of the fair value of the financial
assets and liabilities involved have to be disclosed (IFRS 7.41 (b)).

In terms of the liquidity risk the company preparing the financial statements has to
disclose a maturity analysis about the remaining lives of all financial liabilities
and all derivative financial instruments (IFRS 7.39 (a)-(b)). The standard suggests
as possible time bands “up to one month”, “one to three months”, “later than three
months and not later than one year” and “between one and five years”, however,
the corporation uses its judgment to determine an appropriate number of time
periods (IFRS 7.B11 (a)-(d)). Furthermore, the company has to describe with
which methods they manage their liquidity risks.

However, the Master´s Thesis is focused on the analysis of the quantity in terms
of the disclosures about the credit risk and the risk management. In the following,
therefore, the disclosure requirements in terms of these items are presented in
more detail as the empirical analysis in chapter 4 refers to the year 2007 and the
regulations according to IFRS 7 which have been effective since 2007.

3.5.2 Disclosure Requirements in terms of Credit Risk

and Risk Management

The disclosure requirements about the credit risk are ruled in IFRS 7.36-38 and
are supported by the “Basis for Conclusions” (IFRS 7.BC 49-50) and by the
“Implementation Guidance” (IFRS 7.IG.21-29). Hence, the “Basis for
Conclusions” and the “Implementation Guidance” are recommendations for the
implementation of the regulations in IFRS 7.36-38, however, it is not mandatory
to apply these supporting guidelines. The minimum disclosures of the credit risk

18
in IFRS 7 are divided into the categories “financial instruments which are neither
in default (past due) nor impaired”, “financial instruments which are in default
(past due)” and “impaired financial instruments”.

The following illustration presents the minimum disclosures for these categories:

Illustration 1: Minimum disclosure in terms of the credit risk (PwC; 2008)

As illustration 1 shows the company is required to disclose the maximum

exposure of risk for each class of financial instruments according to IFRS 7.36
(a). This exposure includes the gross carrying amount less the netting out in
accordance with IAS 32 and less previous impairment losses in accordance with
IAS 39 (IFRS 7.B9).

Furthermore, IFRS 7.36 (b) requires the company to publish statements about
those financial instruments which are held as collateral for financial instruments
being afflicted with default. This information shall include different aspects. At
first, a description of the methods and processes for the evaluation and
management of securities held as collateral has to be made and the most important
kinds of collateral received have to be shown. Moreover, the most important
counterparties providing the collateral shall be mentioned in the financial
statements in combination with their respective creditworthiness. Finally, the

19
company shall provide information about the risk concentration which arises from
the collateral received (IASCF (2009): IFRS 7.IG22).

For financial instruments which are neither in default (past due) nor impaired the
creditworthiness of the contracting partners of each class of financial assets has to
be shown according to IFRS 7.36 (c). A possible implementation of this disclosure
requirement is explained in IFRS 7.IG23-25. IFRS 7.IG23 suggests splitting the
credit risks into different credit rating classes by the use of internal or external
ratings. Moreover, this presentation shall include information about the nature of
the counterparties and their historical default rates. Finally, the company shall
disclose any other information which could be helpful to assess the
creditworthiness of the contracting partners (IASCF (2009): IFRS 7.IG23).

Furthermore, the “Implementation Guidance” recommends specific statements in

terms of the external and internal ratings. If an external rating is applied, the
maximum risk exposure of each rating class shall be stated. Furthermore, the
corresponding rating agency, whose data are used by the company, shall be named
according to IFRS 7.IG24. Besides that, respectively the ratio between financial
instruments with and without rating and the relation between internal and external
rating shall be disclosed (IASCF (2009): IFRS 7.IG24). In case of using an
internal rating, IFRS 7.IG25 advises to publish information about the internal
rating process, about the amount of the risk exposure of each credit rating class
and in terms of the relation between external and internal ratings.

Furthermore, according to IFRS 7.36 (d) “the carrying amount of financial assets
that would otherwise be past due or impaired whose terms have been
renegotiated” shall be disclosed.

For financial instruments which are classified as past due (according to IFRS 7.A
a financial instrument is regarded as past due „when a counterparty has failed to
make a payment when contractually due”), but not impaired, an analysis of the
age of the financial assets has to be carried out according to IFRS 7.37 (a). Here, a
maturity analysis means the information on how long a financial instrument has
already been in default (PwC; 2008). The possible time bands of delay which are
proposed by the IASCF are “less than 3 months”, “3 to 6 months”, “6 to 12
months” and “more than 12 months”(IASCF (2009): IFRS 7.IG28).

Moreover, according to IFRS 7.37 (b) an analysis of the impaired financial

instruments shall be carried out, however, this is not put in concrete terms within
the standard. Therefore, you should refer to the explanation of IFRS 7.IG29. Here,
the comment suggests disclosing the carrying amount before allowance, the nature
and the amount of impairment and the fair value of the collateral held for this kind
of financial instruments (IASCF (2009): IFRS 7.IG29).

20
To enable the user of financial statements to assess the risks resulting from
financial instruments which are past due or impaired, IFRS 7.37 (c) requires a
description of the collateral held by the company which are related to just
depicted financial instruments. Furthermore, the fair values of the collateral shall
be assessed if possible and the estimated amounts shall be disclosed (IFRS 7.37
(c)).

If a company takes possession of financial and non-financial assets within the

realization of the collateral and these can be recognized as assets according to
IFRS, the nature and carrying amount of these assets obtained have to be
disclosed according to IFRS 7.38 (a). In case the assets cannot be sold
immediately IFRS 7.38 (b) requires the company to describe in which way the
company plans to dispose of the assets or how the securities can be possibly used
in the company´s operation.

In terms of risk management the company is basically required to disclose its

objectives and policies as well as processes with which the risks are measured and
managed according to IFRS 7.33 (b). Additionally, the guidelines of IFRS 7.IG15
(b) can be used in terms of strategies and processes for identification,
measurement and management of risks. Here, the risk management´s structure and
the organization shall be shown and the area of application and the nature of the
risk reporting shall be described in more detail. Furthermore, the methods for
hedging and reducing of risks shall be explained and the processes which are
employed for the supervision of the effectiveness of the applied methods shall be
stated (IASCF (2009): IFRS 7.IG15 (b)).

3.6 Empirical Evidence about the Disclosure of

Information in terms of Credit Risk

Until now, only a few studies have dealt with the disclosure of information in
terms of credit risk. These have examined the statements about the credit risk
primarily as part of the risk reporting (Bischof (2009): IFRS 7 Adoption and
Linsley et al. (2006): Risk disclosure).

One of these studies was carried out by Bischof (2009). Thereby, he analyzed the
effect of the implementation of IFRS 7 on the quality of the disclosure in the
balance sheet and the risk report of European banks. In one section of his analysis
he elaborated on the quantity and the quality of the published information about
the credit risk. In doing so, he considered the number of published pages as an
indicator for the shift in the quantity of disclosed information. Bischof has
detected that the number of pages about the credit risk within the examined annual
reports has increased significantly from 2006 to 2007 by the adoption of IFRS 7,
21
namely from 4.6 to 8.3 pages. Moreover, according to the author, the quality of
the published information about the credit risk has also enhanced as after the
enforcement of IFRS 7 considerably more banks have released information about
ratings and financial assets which are past due. Finally, Bischof also states that as
a result of the adoption of IFRS 7 now the emphasis is more on the information
about credit risks and the previously preferred market risk attracts less attention in
terms of the disclosed information than before.

A study with a similar approach was carried out by Linsley et al. (2006). The
authors analyzed the degree of disclosure of information about the risk reporting
of banks from Great Britain and Canada by counting those sentences in the annual
reports whose content was concerned with the areas “risk” and “risk
management”. These sentences were initially grouped by risk types, such as
“credit risk”, and then divided into different categories. Each class includes
combinations of the following characteristics: quantitative/qualitative information,
good/poor information and information from the past or the future. The authors
found that first, most sentences were placed in the area “credit risk” and secondly,
the counted sentences contained rather qualitative information and statements
from the past.

However, both research methods can be considered as questionable. Although,

page numbers can be regarded definitely as an indicator for the quantity of
disclosed information within an annual report, however, such a number does not
reveal anything about the quality of the disclosed statements. This also includes
the counting of sentences and their later classification in certain risk categories as
just the allocation of sentences to the defined categories requires subjective
assessments which can vary among the testing persons.

This short literature overview shows that the disclosure of information about the
credit risk was analyzed only marginally and not enough in detail so far.
Therefore, the following examination chooses another approach. It shall be
explored to which extent European banks have fulfilled the current disclosure
requirements in terms of credit risk and risk management after the implementation
of IFRS 7. This fulfillment is of great importance against the background of a
sufficient information provision ensuring an efficient market disciplining as
market participants can evaluate the risk positions of banks reasonably and
demand adequate risk premiums only if they have enough information about the
banks´ risk structure available.

22
 4. RESEARCH METHODOLOGY
The following empirical examination shall answer the question to which extent
European banks have fulfilled the disclosure requirements for the credit risk and
risk management after commencement of IFRS 7 to determine whether banks
which complied better with the standard in 2007 were also coping better with the
recent financial crisis. If this is the case you can state that the appropriate
prerequisites are created to ensure an efficiently operating market discipline. In
doing so, it is also examined in which areas of these disclosure obligations the
analyzed banks have concentrated during the financial year, 2007. Both of these
aspects are of great importance as in a case of optimal information provision for
the market players, the created efficient market discipline could reduce the
confidence problem between investors and bank.

To answer this research question, first, the annual reports of 12 European banks
are analyzed for the financial year 2007 by the means of a designed disclosure
index and the quantity of the disclosed information it detected. This disclosure
index is based on the disclosure obligations of IFRS 7 for the credit risk and the
risk management so that an assessment in terms of the fulfillment of the
disclosure requirements can be made.

4.1 Data Basis and Research Design

For the empirical analysis of this Master´s Thesis, first, the 9 most important
countries in the banking sector within the EU11 plus Suisse are selected. These
are: Great Britain, France, Germany, Spain, Suisse, Italy, Belgium, Netherlands
and Sweden. This broad inclusion of European banks shall prevent a bias towards
the larger countries with their bigger banks. However, to take the relative
importance of countries and their banking sector into account two banks of the
three most important countries Great Britain, France and Germany and only one
bank from the remaining countries are included in the data basis.
In doing so, the biggest banks of each country are selected on the basis of the
market capitalization in the end of 2007 before the financial crisis had started. To
ensure unbiased results the chosen banks have to meet the following two criteria.
First, the annual reports of the financial year 2007 have to be prepared according
to IFRS and secondly, the corresponding annual report has to be available online.
These criteria were checked for each bank according its amount of market
capitalization. The 12 banks listed below fulfilled these conditions and therefore
were included in the sample.

To be able to quantify the individual degree of disclosure of information about the

credit risk and risk management a disclosure index for the financial year 2007 was
23
designed based on the requirements of IFRS 7. A disclosure index created on the
basis of certain criteria within the IFRS 7 enable the user to quantify the extent of
disclosure of picked issues by the allocation of points. In doing so, in the
following it is assumed that the requirements of IFRS 7 guarantee the information
the market player needs to evaluate the risk position of banks.

The methodology to determine the quantity of information by the means of a

disclosure index is popular in the English technical literature (Perignon/Smith
(2010); Lopes/Rodrigues (2007); Chalmers/Godfrey (2004) and Bryant/Street
(2000)) so that this method can be applied in the following analysis, too. In the
following, the preparation of the disclosure index 2007 is described.

The requirements of IFRS 7.36-38 and the Implementation Guidance IFRS 7.IG
22-25 and IG.28-29 are taken as a basis for the disclosure index in terms of the
credit risk. Furthermore, the disclosure requirements of IFRS 7.33 (b) about the
risk management were taken into account and these were complemented by the
guidelines of IFRS IG.15 (b). Thus, in the following, it is assumed that the
guidelines of the Implementation Guidance recommended by the IASB shall be
used for an optimal fulfillment of the disclosure requirements of IFRS 7. The
criteria of IFRS 7.38 (b) were not included in the index as a description about the
use of the assets taken possession with the realization that collateral has just to be
made if these assets were not sold immediately.
Altogether, the disclosure index comprises nine criteria which correspond with the
partial disclosure obligations of the single paragraphs. The criteria are:

1. maximum credit exposure ( 1 point )

2. collateral ( 4 points )
3. creditworthiness of the counterparty ( 7 points )
4. renegotiation of the payment terms ( 1 point )
5. financial instruments being in default ( 1 point )
6. impaired financial instruments ( 3 points )
7. collateral for financial instruments from the classes (5) and (6) ( 2 points )
8. assets taken possession within the realization of the collateral ( 2 points )
9. risk management ( 7 points )

24
25
 Illustration 2: Constructed disclosure index based on the requirements in IFRS 7

Illustration 2 shows the constructed disclosure index 2007. By the means of this
index the annual reports of the 12 selected banks were analyzed and the degree of
the quantity of the disclosure in terms of the credit risk and the risk management
of each bank were determined. When the bank disclosed information about the
issues depicted in the index then one point was awarded for each fulfilled
requirement. A special case is the category “creditworthiness of the counterparty”.
In this case the IASB gives the companies the choice to publish information about
internal or external ratings for this kind of financial instruments. Therefore, within
the evaluation of the annual reports, points were just awarded for supplement
information either about an internal or an external rating. Furthermore, the
obligation to disclose the amount of the credit risk divided in financial
instruments which have a rating and which do not have one were not taken into
consideration preparing the index to ensure that in both cases a maximum of 3
points can be reached. Thus, no bank is discriminated against. In case a bank has
disclosed information about internal as well as external ratings the highest score
of the both criteria were counted for the index score. Totally, a maximum of 28

26
points could be achieved. Moreover, the index was standardized at 100 so that the
index figure is calculated as follows:

with = achieved score, = maximum score and = index score.

With this, the results of the disclosure index reflect the percentage fulfillment of
the disclosure requirements of IFRS 7.

4.2 Reliability and Validity of the Research Methods

To evaluate the measure of the compliance with IFRS 7 by a disclosure index the
scientific terms reliability and validity have to be considered.

According to Bryman and Bell (2007) “reliability refers to the consistency of the
measure of a concept”. Whether or not a measure is reliable can be answered by
the following three factors. First, the measure is supposed to be stable over time
which means that the results gained today from a specific sample are supposed to
be the same as the results which can be obtained from the same sample some time
later. This prerequisite is fulfilled by the disclosure index as the specific criteria in
the disclosure index and the used annual reports do not vary over the time.
Secondly, the internal reliability is dealing with the question whether or not the
indicators which constitute the index are consistent. Thereby, it is asked whether
the single indicators are related to each other and are able to explain the
characteristic of the index. This requirement is also met as the main items in the
disclosure index come from an accounting book (PwC; 2008) specialized on this
issue and the designed sub-criteria are based on the standard IFRS 7 and the
corresponding “Implementation Guidance”.
Thirdly, the inter-observer consistency is threatened when a bunch of subjective
judgments are involved in the measure process, for instance the recording of
observations or the translation of data into categories. If the results of this
measure vary between the researchers there will be a lack of consistency and
hence, the study cannot be replicated by other researchers. This condition might
represent a problem as a few subjective assessments have to be made while
checking whether the specific requirements of the disclosure index are met by the
present information from the annual reports.

In terms of the validity there are two main characteristics according to Bryman
and Bell (2007). First, the measurement validity refers to the issue of whether or
not an indicator that is devised to gauge a concept really measures that concept.
This covers the face validity which is supposed to ensure that the measure reflects
27
the content of the research question and also the question of possible errors in the
implementation of the measure. The latter shall ensure that the researcher follows
exactly the instructions whilst carrying out the research method over the entire
evaluation period. Both prerequisites are met while constructing the disclosure
index and analyzing the annual reports as it is paid attention that the analytical
process is in all cases the same and when designing the disclosure index it was
referred to a professional accounting book (PwC; 2008).
Secondly, there is also the external validity which describes the degree of
generalization of the findings. External validity represents a problem for this
carried out research study as the size of the sample might be not big enough to
generate valid statements about the disclosure of banks in terms of the analyzed
aspects.

The reliability and validity in terms of the correlation between the compliance
with the disclosure index and the firm performance is solved by a statistical
program. First, this program calculates the Pearson´s correlation coefficient which
can be applied to examine the relationship between two interval variables
(Bryman and Bell (2007)). The coefficient can lie between 0 (no relationship
between the two variables) and 1 (a perfect relationship) which means that the
figures indicates the strength of the relationship. Besides, the coefficient can be
either positive or negative which indicates the direction of the relationship.

Secondly, the statistical program calculates the statistical significance and this is
concerned with the question whether or not the findings will be generalizable to
the population from which the sample was drawn (Bryman and Bell (2007)). If
there are any sampling errors the sample will be unrepresentative of the wider
population and therefore the empirical results will be invalid. With regard to the
relationship between two variables the statistical significance makes a statement
about the risk of concluding that there is a relationship in the population when in
fact no such relationship exists (Bryman and Bell (2007)).
To test the significance of the findings, first, a null hypothesis is set up. This
claims that the two variables are not related in the population. Secondly, an
acceptable level of statistical significance is established. This is a measure of the
degree of risk that the null hypothesis is rejected implying that there is a
relationship in the population when the null hypothesis should be supported
implying that there is no relationship in the population (Bryman and Bell (2007)).
Among business researchers the convention is that a level of statistical
significance of 5 percent is acceptable. After determining the statistical
significance of the findings, then the researcher is able to make a reliable and
valid statement about the calculated correlation coefficient by either confirming or
rejecting the null hypothesis.

28
To carry out these calculations SPSS is applied as it automatically produces
information regarding statistical significance when the correlation coefficient is
calculated.

29
 5. FINDINGS OF THE EMPIRICAL STUDY
In the following, the annual reports of the 12 selected banks are examined
according the constructed disclosure index for the financial year 2007. The results
of this analysis for all the banks are summarized and shown in the illustration 3.

In the further course of this work the individual examination results of the
observed banks are compared in more detail.
First, it has to be mentioned that UBS achieved the best result among the selected
banks and fulfilled 78 percent of the analyzed requirements. In doing so, this bank
even kept predominantly to the designation of the IFRS 7 standard which
facilitates the user of the financial report to recognize the required disclosures.
This was the reason why this bank was taken to illustrate the procedure and the
findings of one example which is shown in the appendix. Additionally, UBS met 5
out of 9 criteria completely and this bank also disclosed the most information in
terms of the criteria “creditworthiness of the contractual partner” and “risk
management”. Finally, UBS was one of the few banks which published
information about financial assets which have been taken possession within the
realization of the collateral. UBS failed to make a disclosure only in the area
“renegotiation of the conditions of payment to defer the default in payment of
these financial instruments”. In contrast, Banco Santander met the fewest
requirements with a quote of 21 percent.

The amount of the maximum credit exposure by class of financial instruments

was released by 11 out of the 12 selected banks. Only the ING Group did not
publish this figure.

In terms of the disclosure requirements about the collateral which reduce the
exposure to credit risk the examined banks have had difficulties to comply with
these. Therefore, in the best case just half of the disclosure obligations were met.
In case information was available mainly the most important types of securities
held as collateral were described. For instance, Barclays disclosed the used
collateral for each sector where a credit risk exists. Just in very few cases the
nature of the counterparties providing the collateral and the information about the
risk concentration were published. A description of the methods and processes for
the evaluation and management of the collateral received were just given by UBS
and Barclays. Therefore, in these areas there is also a potential for improvement.

Deutsche Bank and UBS fulfilled with 71 percent the most requirements in terms
of the disclosure of the creditworthiness of counterparties. These banks
distinguish themselves by dividing the credit risks arisen from financial
instruments in rating categories as well as by disclosing the nature and the
historical default rates of the contractual partners. Furthermore, they published
information about the internal rating process and about the exposure to credit risk
for each individual internal rating class. The other banks often met these
30
disclosure obligations in terms of the nature of the counterparties just by showing
a sector overview of the contractual partners. Moreover, in many cases they
provided detailed information about the internal rating process. However, weak
points were also detected, especially the disclosure of additional information for
assessing the creditworthiness and the release about the relation between internal
and external ratings.

The carrying amount of the financial assets whose terms were renegotiated was
disclosed only by four banks. Therefore, you can see that there are still a lot of
accumulated needs in this field.

However, a mature analysis for financial instruments being past due was
presented by the majority of the banks. Thereby, the used time bands about the
default of the financial assets differ significantly yet. So, for instance, the time
periods of default applied by Barclays are “up to one month”, “one to two
months”, “two to three months”, “three to six months” and “more than six
months”. However, BNP Paribas discloses time bands with “up to 90 days”,
“between 90 and 180 days”, “between 180 days and 1 year” and “more than one
year”.

The disclosure requirements in terms of impaired financial instruments were

completely fulfilled only by UBS, Barclays, Deutsche Bank and Royal Bank of
Scotland. These banks have stood out from the others also by a detailed
description of the factors the bank considered in determining that the financial
instruments are impaired. Furthermore, these banks also published the carrying
amount and the amount of the allowance in terms of impaired financial
instruments. In contrast, 6 banks did not provide any disclosure about impaired
financial instruments. Thus, there is still a need for improvement in terms of this.

31
Illustration 3: Evaluation of the disclosure index 2007

32
Also the disclosure requirements about collateral held for financial instruments
being past due or impaired were neglected completely by almost the half of the
observed banks. Only 7 banks published information about these securities at all,
whereby UBS and Dexia were the only ones which provided a description of their
collateral held and also disclosed their corresponding fair value.

The picture was still worse in case of the disclosure about financial assets which
were taken possession within the realization of the collateral. Only UBS,
Deutsche Bank and Nordea Bank made a statement about this. But these three
banks even completely met the requirements by disclosing the nature and the
carrying amount of the financial assets. In the case of UBS real estate is such a
kind of asset.

However, the disclosure obligations in terms of the risk management were

fulfilled frequently. Thereby, again UBS made the most disclosures with 86
percent in terms of the requirements of this category. It could fulfill all the
requirements except the mentioning of the processes which shall check the
continuous effectiveness of the methods applied to hedge and reduce the risks. In
contrast, Dexia, Banco Santander and BNP Paribas could only meet 29 and 34
percent respectively of the disclosures. The results of the analysis in terms of the
risk management show that the statement about the policies and processes of the
risk management is a standard disclosure in most cases. This is also true when it
comes to structure and the organization of the risk management and to the
methods for hedging and reducing of risks. To achieve a better general result in
this field the banks should disclose more information about the risk management´s
objectives, the risk measurement methods and about the processes which
supervise the effectiveness of the methods applied to hedge and reduce the risks.

In summary, it can be stated that the disclosure requirements about the maximum
credit exposure, financial instruments being past due and about the risk
management were fulfilled in an above-average degree. Regarding the other
criteria it has become clear that there is partly significant need for improvement at
the selected banks. Only UBS, Deutsche Bank and Barclays fulfilled the
requirements satisfactorily.

33
 6. EVALUATION AND ANALYSIS
6.1 Evaluation of the Empirical Findings
The findings of the analysis of the disclosure index have shown that the disclosure
obligations of financial instruments according to IFRS 7 were fulfilled by the
observed banks only to a moderate extent in the year 2007. In the following, the
findings are assessed and it is tried to make a judgment about the impact of these
results for the market participants.

The outcomes point out that the European banks have had difficulties with the
implementation of the IFRS 7 standard in the first year after the establishment as
on average the banks have achieved a level of compliance in terms of the criteria
of the disclosure index of just 46 percent which is actually too little. However, it
has to be taken into account that the mandatory regulations about the disclosure in
terms of the credit risk according to IFRS 7.36-38 are devised in a less detailed
manner. Just by using the Implementation Guidance (IFRS 7.IG) the disclosure
obligations become more concrete and more decision-relevant information for the
user of financial statements has to be provided. However, these implementation
directives are not obligatory. Therefore, when banks just refer to the IFRS 7
standard as a guideline for their disclosure obligations it is within the law, but at
the same time it opens many possible implementation strategies. This fact might
be the reason why the observed banks have not disclosed that much information in
terms of the criteria “collateral”, “creditworthiness of the counterparty”,
“collateral held for financial instruments being impaired or past due” and “assets
taken possession within the realization of the collateral”. Especially in the area
“collateral”, the banks should not only publish which types of collateral (for
instance, credit derivatives or guarantees) they hold but also which contractual
partners providing them and information about their specific creditworthiness.
This information is of great importance for the user of the annual report as
provided collateral cannot meet its aim if the collateral provider is not able to
compensate the capital losses in case of a credit default because of its low
solvency.

Also, there is still potential for improvement in terms of the disclosure about the
creditworthiness of counterparties. The historical default rates of the contractual
partners and the maximum exposure to credit risk by rating class were published
by an insufficient number of banks. But just the historical default rates of the
counterparties are very important for the investors as this information enables
them to make a first impression about their solvency. Moreover, the disclosure
about the maximum exposure to credit risk each credit rating class provides an
overview of the profile of the contractual partners.

However, the high level of disclosure about the maximum exposure to credit risk
each class of financial instruments has to be positively evaluated. As already
34
mentioned this information might be of great importance for investors as it
provides an adequate overview about the credit risk. But this high degree of
compliance is not surprising as this information already had to be disclosed in
2006 according to IAS 32. Another positive outcome is that more than half of the
examined banks have carried out a mature analysis of their financial instruments
being past due. This finding is particular to stress as the information about a
maturity analysis represents a new disclosure requirement. By means of such a
mature analysis about the default of financial instruments an investor is able to
evaluate which part of the financial instruments being past due could result in a
capital loss in the future.

Likewise, the disclosure requirements about the risk management were met on
average in satisfactory degree. However, it has to be mentioned that the disclosure
obligations were only analyzed on quantitative terms within this thesis and
qualitative aspects were not taken into account. However, it has to be mentioned
that the information about the risk management was rather general and these
disclosures hardly reveal an insight in the internal risk management.
Hence, it can be stated that the observed banks could fulfill the disclosure
requirements according to IFRS 7 in terms of the credit risk and risk management
only to a moderate proportion. Therefore, the new endorsed standard IFRS 7 has
not been able to create the prerequisites for a better disciplining of the banks by
market participants.

6.2 Correlation of Disclosure and Firm Performance

In the following, the total shareholder return (TSR) is used as the measure of the
firm performance. The TSR is comprised of the capital gain based on the annual
stock development and the dividend the bank distributes within one year.

This measure is used more and more by investors because this figure is an
objective indicator about the success of the company which is not vulnerable for
earning distortion by the management accounting. The importance of the total
shareholder return for the evaluation of company success is emphasized by the
fact that the US supervisory authority Securities and Exchange Commission
(SEC) has obliged the publicly traded companies in the US to include the TSR in
their 10K-filings (Edwards; 1994). According to the SEC´s directives the total
shareholder return is defined as follows:

“Total shareholder return on a class of common stock (...) as measured by dividing

(i) the sum of (A) the cumulative amount of dividends for the measurement
period, assuming dividend reinvestment, and (B) the difference between the
registrant´s share price at the end and the beginning of the measurement period;

35
by (ii) share price at the beginning of the measurement period (…)” (Securities
and Exchange Commission (SEC); 2011).

This market driven measure of firm performance is used particularly because the
new IFRS 7 standard is essentially a means for the banks providing their investors
with relevant information about their current risk exposure and introduced risk
management in terms of their financial instruments. These disclosures are mainly
aimed at investors who are usually just looking for the highest yields on their
investments. Moreover, a good compliance with a disclosure index might be
reflected more in current market-based performance measures such as TSR ratio
than in accounting-based measures for two reasons. First, investors will demand a
lower risk premium if they get enough decision-relevant information about the
bank´s risk position to reduce the uncertainty resulting from the bank´s business
practices. This diminished uncertainty leads to a rising share price of the bank.
Secondly, it is assumed that the bank performs a more adequate and reasonable
risk management and takes lower risks which results in higher earnings on
average, at least in the long run. As a result of this investors get higher annual
dividend payments and besides, investors like payouts which are not subject to
high fluctuations and thus, are easy to anticipate which, in turns, leads to a higher
share price.

Due to these reasons the TSR measure was applied to evaluate the firm
performance. In doing so, the total shareholder return was calculated for each
bank over the time period ranging from the 31.12.2006 to the 31.12.2010. The
data for the calculation came from Bloomberg´s database.

starting date: 31.12.2006

TSR in 2007 TSR in 2008 TSR in 2009 TSR in 2010 average yearly TSR
ending date: 31.12.2010
Royal Bank of Scotland -18,22% -86,43% -37,25% 46,88% -43,45%
Barclays -32,18% -70,96% 91,67% 8,05% -20,08%
Société Générale -19,83% -63,83% 43,68% -15,55% -22,98%
BNP Paribas -6,14% -56,08% 92,61% -10,30% -8,14%
Deutsche Bank -7,84% -63,84% 79,37% -19,36% -16,67%
Commerzbank -6,38% -70,91% -11,75% -5,29% -30,92%
UBS -27,44% -67,52% 9,23% 14,95% -26,25%
Banco Santander 8,96% -50,38% 86,24% -26,71% -7,32%
UniCredit -9,85% -62,97% 114,05% -29,61% -15,79%
Nordea -2,36% -48,47% 40,31% 16,88% -4,69%
Dexia -9,82% -77,53% 50,85% -41,18% -34,88%
ING Group -16,25% -67,91% -1,56% 4,91% -27,42%

Illustration 4: Results of the TSR calculation

As can be seen from illustration 4 the yearly average TSR of each bank during the
time period ranging from 31.12.2006 to 31.12.2010 has been substantially
negative. There are only three banks which had a higher average return than
minus ten percent on an annual basis. Royal Bank of Scotland has achieved the
worst firm performance over this period and its investors would have sustained a
loss of more than 43 percent each year from its investment if they had invested in
the bank at the end of 2006 and held this investment until the end of 2010.
36
Obviously, the recent financial crisis hit all the banks in a high degree. But this
tremendous downturn in the financial markets in 2007 and especially in 2008 after
the collapse of Lehman Brothers also resulted in very differing TSRs over the
period 2007-2010. In 2007, only Banco Santander achieved a positive TSR and
the in 2008 the bank´s TSR scores ranged from minus 48 percent to minus 86
percent. In the following year, in contrast, the most of the banks have performed
very well with exceptional high returns except of three banks still providing
negative returns. These calculated figures reflect the substantial recovery of the
markets in the year 2009 leading to a substantial rise in the TSR for this year. In
2010, the TSR values vary strongly. Some banks achieved positive returns and
some banks provided negative results which seem to be normal, however the
variance of these returns were extraordinarily high.

In order to make a statement about the correlation between the compliance with
the disclosure index and the total shareholder return, the statistical program SPSS
was applied. The output below shows that there is a negative but highly
insignificant correlation between the degree of disclosure and the TSR. The 2-
tailed significance level α is 0.66 which means that the probability of error, that
the null hypothesis (H0: correlation = 0) is rejected although it is in fact true, is
about 66 percent. Usually, the significance level is chosen to be 0.05 (or
equivalently, 5%), therefore it is not possible to make a robust statement about the
Pearson correlation coefficient.

There might be two reasons for this highly insignificant value. First, probably the
sample of 12 observed banks is not big enough to provide valid and reliable
results. However, within this thesis a more extensive examination of the bank´s
financial reports was not possible. Secondly, obviously the recent financial crisis
occurred during this period has had a huge impact on the TSR of all banks. It
seems as if investors punished all banks by selling their shares and did not pay
that much attention to the individual performance of each bank. But these are just
guesses and however, it is also possible that there is no correlation even in normal
financial times.

TSR disclosure
TSR Pearson Correlation 1 -,141
Sig. (2-tailed) ,661
N 12 12
disclosure Pearson Correlation -,141 1
Sig. (2-tailed) ,661
N 12 12
SPSS output: Correlation

As there is no significant correlation between the high of the index score and the
TSR in terms of our data sample a linear regression model is carried out with four

37
other variables which may affect firm performance. The data on these variables
have been obtained from the annual statements of the financial year 2006 as the
measurement period of the TSR begun on the 31.12.2006.

market debt to equity

data refer to the financial market to book
capitalisation in price earnings ratio (market value)
year 2006 (equity) ratio
million Euro ratio
UBS 91.989 11,9 16,41 3,14
Deutsche Bank 53.183 7,6 20,50 1,62
Barclays 71.885 10,1 19,83 2,41
Dexia 23.090 8,1 23,75 1,25
Société Générale 59.797 10,4 15,44 2,04
UniCredit 68.574 12,5 11,54 2,46
BNP Paribas 77.232 10,3 18,00 1,55
ING Group 74.220 9,4 16,03 1,94
Royal Bank of Scotland 93.445 10,2 13,08 1,56
Nordea 30.703 9,7 10,80 2,00
Commerzbank 18.960 11,9 31,33 1,33
Banco Santander 85.867 11,7 9,20 2,11
Illustration 5: Calculation of investment ratios

With these obtained data a linear regression model was carried out by means of
SPSS. In doing so, it is assumed that the total shareholder return is the dependent
variable which will be influenced by the other four exogenous variables.

The findings below show that all coefficients have very high significance levels
which means that the null hypothesis, beta coefficient = 0, could not be rejected.
Hence, the result of our sample states that none of the six regressors is able to
explain or predict the value of the TSR. This outcome is also confirmed by the
coefficient of determination (R2) of the linear regression model which lies about
31 percent.

Unstandardized Standardized
Coefficients Coefficients

Model B Std. Error Beta t Sig.

1 (Constant) ,036 ,380 ,095 ,928
disclosure -,002 ,005 -,270 -,351 ,738
market_cap -1,83E-006 ,000 -,405 -,874 ,416
P_to_E_ratio -,011 ,052 -,146 -,216 ,836
leverage -,008 ,012 -,420 -,641 ,545
market_book_ratio ,103 ,201 ,476 ,511 ,627
a Dependent Variable: TSR
SPSS output: Linear Regression

These four exogenous variables were selected as Fama/French (1993) have

detected a significant relation between these financial ratios and the average
return in univariate tests over an observation period of 50 years. The main
38
findings of their scientific paper which attracted a lot of attention in the scientific
world were the following:

The market capitalization shows a negative relation which means the

higher the market capitalization the lower the return is. The result of the 12
observed banks also indicates a negative relation, but with a probability of
error of 41 percent. In the scientific world an error probability of 5 percent
is usually accepted and hence, this correlation is very insignificant.

The market-to-book ratio of the equity indicates also a negative relation

which means the higher the equity is traded at the stock exchange the
lower the yield is in the future. In contrast, the SPSS output shows a
positive relation, but also highly insignificant.

The price-to-earnings ratio also shows a negative relation which means the
more it is paid for current corporate earnings at the stock exchange the
lower the future average return is. Likewise, the outcome of the selected
sample indicates this negative correlation, but highly insignificant again.

The leverage at market value indicates a positive relation which means the
higher the debt compared to the equity of a company is the higher the
expected future return is. The findings form the sample in terms of the
impact of leverage on the TSR are not confirmed by the outcomes of
Fama/French in their study as the SPSS output shows a negative relation,
however with a high probability of error.

All these findings show that the sample of the selected 12 banks is not able to
generate meaningful statements about the impact of the four exogenous on the
endogenous variable TSR. First, in all cases insignificant results were produced
and secondly, the determined trend of the influence is also just partly confirmed
by the previous research results by Fama/French.

Consequently, and that is the interesting fact, the size of the sample and the
selected time period seems not to be able to provide any meaningful information
about the relation between the compliance with the disclosure index and the total
shareholder return. Therefore, a detected result of a negative and insignificant
influence might change by increasing the size of the sample to a more appropriate
scale and expanding the examined time period.

39
 7. CONCLUSION
Against the background of an optimal information provision for disciplining
market players, the main goal of this present thesis was to analysis to which extent
European banks have fulfilled the disclosure requirements in terms of the credit
risk and risk management of financial instruments after the endorsement of IFRS
7. Additionally, the work tried to examine whether there is a correlation between
the compliance with the disclosure index and the firm performance measured by
the total shareholder return (TSR). For this purpose, a disclosure index based on
the requirements of IFRS 7 were constructed and the annual report for the
financial year 2007 of twelve big European banks were evaluated by means of this
index.

Generally, it can be stated that the requirement of the created disclosure index was
fulfilled only on a small scale by the analyzed banks. This implies that market
participants had too little information available to evaluate the risk exposure of the
examined banks and as a result of this the efficient disciplining of banks by the
market is threatened.
However, there were also positive outcomes. The disclosure by class of financial
instruments about the maximum exposure to credit risk was made by all examined
banks with one exception. This disclosure is very important because this
information facilitates the investors to make an assessment about the overall credit
exposure and which classes bear the most risks. This should be maintained in the
future.

The most deficits were detected in those areas where additional disclosure
information was required by using the Implementation Guidance of IFRS 7, for
instance “collateral” or “creditworthiness of the counterparties”. Although, the
banks are not obliged to apply the Implementation Guidance, the disclosure
requirements of IFRS 7 provide just sufficient decision-relevant information if
they are supplemented by the disclosure obligations of the Implementation
Guidance. Therefore, in the future a more extensive application of the
Implementation Guidance should be demanded to ensure a better information
provision for investors. Here, UBS could be considered as an example for other
European banks as it have fulfilled the implementation directives best.

By the means of the carried out statistical analysis a significant correlation

between the degree of compliance with the constructed disclosure index and the
total shareholder return could not be detected. But this finding does not state that
there is no possible relationship because it is to assume that the size of the sample
and the selected time period is not appropriate to generate valid and reliable
predictions. In particular, the financial crisis occurred during the observed time
period suggest that investors perceived the performance of all banks a kind of the
same and did not pay that much attention on different performances among the
banks.
40
However, this detected negative relation, although highly insignificant, could
indicate that even an appropriate risk disclosure and risk management is not able
to prevent huge financial losses if the overall market is in a big turmoil as seen in
the recent years.

41
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Appendix

The list below is an example how the analysis of the disclosure index was carried out in case of UBS
which had the highest compliance with the criteria in the disclosure index.
However, it has to be mentioned that this list does not reflect all the disclosures the bank made in
terms of the criteria, but it shall provide a general insight in the empirical study.

Criteria:
Credit risk:
1. Disclosure by class of financial instruments about the maximum exposure to credit risk
Disclosure of
gross value less allowance and netting out ( 1 point )

2. Collaterals which reduce the exposure to credit risk

description of the methods and processes for the evaluation and management of the collaterals
received and other risk mitigating arrangements ( 1 point )
and
description of the most important types of securities held as collateral ( 1 point )

47
48
49
50
disclosure of the most important counterparties providing the collaterals and an assessment of
the creditworthiness of the collateral provider ( 1 point )
No disclosure

information about concentration of risk which are associated with collaterals held or credit
enhancements ( 1 point )
No disclosure

51
3. Credit quality of financial assets which are neither past due nor impaired
graphical representation of the division of the credit risks in credit rating classes by using of an
internal or external rating ( 1 point )

information about the counterparties ( 1 point )

52
information about historical default rates of the contractual partners ( 1 point )
No disclosure

additional information for assessing the creditworthiness ( 1 point )

No disclosure

53
in case of an internal rating:
information about the internal rating process ( 1 point )

54
the amount of risk exposure for each internal rating class ( 1 point )

55
 the transition of internal and external ratings ( 1 point )

4. Financial instruments whose terms have been renegotiated and thereby the default in payment
could be deferred
disclosure of the carrying amounts by class ( 1 point )
No disclosure

56
5. Financial instruments which are in default (past due)
presentation of a mature analysis by class
classification in several time bands (for instance, up to 3 months, 3 to 6 months, 6 to 12 months,
more than 12 months to default) ( 1 point )

6. Individually impaired financial instruments

carrying amount before allowance ( 1 point )
and
amount of the allowance ( 1 point )

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58
 description of the factors the bank considered in determining that the financial instruments are
impaired ( 1 point )

7. Collateral held for the financial instruments from category (5) and (6)
description of the collateral which are held for the financial instruments of the categories (5)
and (6) ( 1 point )
and
estimate of the fair values ( 1 point )

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60
8. Assets taken possession within the realization of the collateral
Disclosure about
nature of the assets obtained (properties, buildings etc.) ( 1 point )
and
carrying amount of the assets obtained ( 1 point )

61
Risk management:
9. Disclosure in terms of
objectives ( 1 point )

policies ( 1 point )

62
 processes ( 1 point )

for managing the risk.

63
A verbal description should be carried out in terms of the following aspects:

structure and organization of the risk management with reference to its independence and
responsibility ( 1 point )

area of application and nature of the risk reporting or of the methods of risk measurement
( 1 point )

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methods for hedging and reducing of risks including the regulations and procedures in
terms of the inclusion of collaterals ( 1 point )

processes which are used for supervising the continuous effectiveness of the methods which
are responsible for hedging and reducing of risks ( 1 point )
No disclosure

65