Do Large European Banks Differ in their Derivative Disclosure Practices? A Cross‐Country Empirical Study

• Author: Salvatore Polizzi,Enzo Scannella
• DOI: http://doi.org/10.1002/jcaf.22373
• Date: 01 January 2019
• Published date: 01 January 2019

Do Large European Banks

Differ in their Derivative

Disclosure Practices? A

Cross-Country Empirical Study

Enzo Scannella and Salvatore Polizzi

INTRODUCTION

The use of

derivative instruments

is widespread among

banks and other

financial institutions.

Potentially, it is a sig-

nificant source of sys-

temicriskinthe

financial system. This

increases the impor-

tance of an accurate

derivative disclo sure

in banking, particu-

larly with respect to

the ongoing turmoil

in the banking and

financial systems.

Derivative disclosure

is essential for banks’

stakeholders to evalu-

ate the bank’srisk

exposures and to

make decisions. It is

crucial for stake-

holders that an

adequate amount of

information about

banks’derivative

exposures does not

remain within the

boundaries of

the bank.

Risk disclosure in

banking contributes

to reduce asymmetric

information among

stakeholders (Akerlof,

1970; Leland & Pyle,

1977) and agency

problems (Fama,

1970, 1980; Fama &

Jensen, 1983; Jensen &

Meckling, 1976) that

arisebecauseofdiffer-

ent interests between

a principal and an

agent in the economics

and management of

banks. In this perspec-

tive, risk disclosure in

banking is an incentive

device (Armstrong,

Risk disclosure has stra tegic importance for the

efficiency of financial markets and overall finan-

cial stability. It plays a pivotal role in strengthen-

ing market discipline and b uilding trust to

improve relationships with stakeholders in bank-

ing. Risk reporting has taken a growing impor-

tance in banking over the last years. The topic of

this article is derivative reporting in banking. The

authors employ content analysis to conduct an

empirical study on a sample of large European

banks. The authors propose a hybrid scoring

model for the assessment of derivative disclo-

sure in banking institutions. The methodology

employed in this research is able to capture a

considerable amount of information because it

combines the characteri stics of a quantitative

and qualitative analysis. This article provides evi-

dences that banks differ in their derivative

reporting, although they are subject to similar

regulatory requirements and accounting stan-

dards. This empirical an alysis shows that there

is room to improve various aspects of derivatives

disclosure in banking and poses some questions

Refereed (Double-Blind

Peer Reviewed)

© 2019 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22373

14

Guay, & Weber,

2010; Dobler, 2008) to

align divergent inter-

ests, and offers an

opportunity to

improve the functions

of screening, selection,

and monitoring

(Diamond, 1984) per-

formed by depositors, investors,

and other stakeholders. In addi-

tion, risk disclosure performs a

signaling function for the market

(Foster, 1980; Leland & Pyle,

1977; Ross, 1977).

Risk disclosure, and deriva-

tive disclosure particularly, is

also connected to the cost of

capital of the bank. There is a

substantial relationship

between risk disclosure and

cost of capital. Risk disclosure

might result in reduced costs

of capital (Botosan, 1997;

Botosan & Plumlee, 2002;

Healy & Palepu, 2001; Leuz &

Verrecchia, 2000). Derivative

disclosure in banking is also

central to the efficacy of mar-

ket discipline and nonmarket

mechanisms in limiting banks’

development of debt and in

mitigating the adverse conse-

quences for the stability of the

financial system (Acharya &

Richardson, 2009; Acharya &

Ryan, 2016; Core, 2001;

Crockett, 2002; Financial

Stability Board, 2012; Freixas &

Laux, 2012; Malinconico,

2007; Nier & Baumann, 2006).

A better knowledge of deriva-

tives in banking should

enhance both transparency and

stability in the financial mar-

kets. Moreover, although sev-

eral studies already shed light

on the importance that disclo-

sure has for several kinds of

risk in banking industry

(Beattie & Liao, 2014; Beattie

et al, 2004; Beretta &

Bozzolan, 2008; Dowd,

Humphrey, & Woods, 2008;

Jorion, 2002; Linsley &

Shrives, 2005), it is crucial to

recognize that derivative expo-

sures might lead to serious

losses for banks, if this kind of

financial instruments are not

managed properly. Hence, the

analysis and the methodology

proposed in this article might

contribute in closing the loop on

this field of study, because a

complete and clear disclosure on

market, credit, and other kind of

risks would be almost useless if

banks do not provide an ade-

quate amount of information

about their derivative exposures.

Derivative instruments are an

enormous potential source of

risk for banks; therefore, a satis-

factory disclosure on other kind

of risks might be completely

spoiled by an inadequate

reporting on derivative exposure.

Furthermore, derivative disclo-

sure is notably affected by finan-

cial innovation and financial

engineering, which is a never-

ending process. Thus, since the

contributions on this topic are

not very recent (Chalmers &

Godfrey, 2000; Venkatachalam,

1996; Wang et al, 2005; Woods

& Marginson, 2004), it is

straightforward to understand

the importance of the topic of

this research article.

In this article, we make an

empirical study on derivative

disclosure on a sample of large

European banks. Hence, this

article investigates the quality of

derivative disclosure in banking

with reference to the Interna-

tional Accounting Standards

IAS/IFRS, the Pillar

3 disclosure require-

ments of the New

Basel Capital Accord,

and the national regu-

latory framework for

banks’annual finan-

cial statements.

In this article, we employ a

content analysis to evaluate the

quality and quantity of deriva-

tive disclosure in banking.

Content analysis is a methodol-

ogy that has been used by sev-

eral researchers to examine and

evaluate risk reporting in

annual reports, as a “research

technique for making replicable

and valid inferences from texts

to the contexts of their use”

(Krippendorff, 2004), and as

“a research technique for the

objective, systematic and quan-

titative description of the mani-

fest content of communication”

(Berelson, 1952). Over the

years, content analysis has been

applied to a variety of scopes

(Holsti, 1969; Weber, 1990).

By using a scoring model

based on key disclosure param-

eters, this article provides evi-

dences that banks differ in their

derivative reporting, even

though they are subject to simi-

lar regulatory requirements and

accounting standards. Our

research also shows that there

is room to improve various

aspects of derivative disclosure,

discusses some policy and theo-

retical implications, and pro-

vides some useful insights for

further research.

The structure of this article

is as follows. Section 2 intro-

duces derivative disclosure in

banking. It aims to frame the

specific nature of derivatives,

and provide a regulatory and

accounting perspective of

derivative disclosure in bank-

ing. Section 3 proposes a

hybrid-scoring model based on

that researchers may develop with further empir-

ical analysis. This article also discusses the

potential policy implications of the research find-

ings for practitioners, bank regulators, and

accounting standard setters. © 2019 Wiley Period icals, Inc.

The Journal of Corporate Accounting & Finance January 2019 15

© 2019 Wiley Periodicals, Inc. DOI 10.1002jcaf