Banks have completed their first round of viability statement reporting. Vincent Papa reviews the reports of five big firms.
Encouraging transparent and robust risk communication by financial services firms is the holy grail for financial reporting authorities and investors. Mandated viability statements are the latest tool aimed at improving risk disclosures, but the jury is still out over how much impact they will have.
As was evident during the financial crisis, clearer risk reporting by banks could have helped to provide an early warning system of their financial health and enabled investors to exercise market discipline. As noted in the 2012 Enhanced Disclosure Task Force report, there is a risk premium associated with the lack of transparent risk reporting.
In this vein, the objective of the UK Financial Reporting Council’s (FRC) mandated viability statement within corporate governance, effective from 2015, is laudable. It requires the management of reporting companies to re-orient their focus towards communicating longer-term principal risks and the impact of these on the viability of the reporting company. If firms follow this spirit, rather than doing the minimum required, then it could be a step in the right direction.
The first iteration of viability reports (within the 2015 annual reports) are typically fairly abbreviated (half-page to one page). In that space, they give the executive management team’s aggregate judgement on the business viability for the next three years. But there are limits to how much new information can be provided about long-term risks within this time horizon and firms are reluctant to look any further into the future.
Instead, the viability report usually cross references the relevant related sections (regulatory risk reports, principal risks and uncertainties). In effect, the viability statement is only as useful as its underlying sections and the extent to which these provide high-quality risk communication. A review of the viability statements of the five biggest UK banks (HSBC, Barclays, RBS, Lloyds and Standard Chartered) paints a rather mixed picture of how useful this new reporting requirement has been at providing fresh insight. Below are some observations from a review of the five largest UK banks’ 2015 financial statements.
RBS, HSBC and Lloyds signposted their viability statements clearly. RBS also had a reader-friendly presentation of the ‘package of viability and related risk information’ – where the viability statement was immediately preceded by a risk overview report outlining key risk metrics and principal risks. In contrast, some banks could improve their signposting. The reader should not, for example, have to use a word search function in the pdf to locate the viability statement. This was necessary in one case, even knowing that the viability statement was somewhere within the corporate governance reporting section.
Cross references are useful (all the banks reviewed provide this) but related information on risks should be presented in a more connected, less disparate manner. It is not unusual to see a reporting structure along the following lines: summary of top and emerging risks on page 30, detailed description of top emerging risks on page 60, risk management on page 90 and regulatory reporting of some of these risks on page 285.
When related information is dispersed throughout the report it just makes it harder for a reader to view all the information at one go and to identify any inconsistencies within the information.
Some banks are better than others in how effectively they communicate about and prioritise their principal risks. RBS’s overview of top and emerging principal risks included an entity-specific description of risks and a selection of changes in key risk metrics (for example, a decrease in risk-weighted assets, increase in capital and changes in risk elements in lending).
HSBC and Lloyds also provide an executive summary and a detailed description of their top and emerging risks. HSBC’s executive summary of top and emerging risks highlighted the trending patterns of different risk categories (increasing or unchanged).
HSBC also flagged a section titled “areas of special interest” that included: financial crime and compliance; status of the US official monitor and the deferred prosecution arrangement with the Department of Justice; regulatory stress tests; oil and gas prices; metals and mining; and mainland China exposures. This latter section is helpful in identifying the most critical risks.
In my opinion, this process-heavy communication is not informative. In addition, banks typically provide highly detailed and granular risk reports with a plethora of measures and key risk metrics. What is often lacking is a coherent picture of the aggregate impacts of key risk categories. Put simply, banks need to convey how the detailed risk information aligns with the principal or top and emerging risks that are identified.
The five banks reviewed all applied a three-year period for the viability statement even though they regularly think longer term, for example, when making lending and funding decisions. Some banks asserted that this time frame was selected to align with their regulatory stress test horizons, and others just stated that any forecasting longer than three years would be riddled with uncertainty. It is difficult to gauge whether firms are simply focusing on three years in order to minimise their viability reporting requirements. However there needs to be greater connectivity in the overall communication about strategy, business model and risk. For instance, banks should convey how their strategic planning horizons coincide or differ from the analytical horizon for the viability statement.
Regardless of it being part of the corporate governance reporting requirements, the viability statement ought to be positioned and given prominence as part of a firm’s overall risk communication. It should be an informative summary of management’s judgement of what the principal risks are, any key choices to manage these risks, and how the sum of these risks affects the prospects of the reporting entity.
The FRC needs to look carefully at the quality of viability statements and ensure that they don’t simply become a compliance exercise – a quite bland paragraph within the corporate governance reporting section. This would be a wasted opportunity and firms should not be surprised if it is ignored by most investors.