Effective Financial Risk Communication Beneficial for Investors

April 1, 2012

This article was originally published in Arab Times


Risk disclosures can convey to investors the nature and magnitude of significant financial risks and how well these risks are being managed. Following an earlier article in the Financial Times (FTfm supplement) Vincent Papa, director of financial reporting policy at CFA Institute, and Mandagolathur Raghu, President of CFA Kuwait, argue the recent crisis have heightened the importance of the quality of corporate communications about financial risk exposures and risk management. This is just as important in the GCC as elsewhere, as the region has battled a series of corporate failures due to the financial crisis.

 

 Where do the largest financial risks to companies arise?

 

Financial risk exposures arise from a number of factors including volatile currency exchange rates, interest rates and commodity prices. They also arise from complex financial instruments such as derivatives instruments and from debt instruments used in the capital structure. Different business models dictate a businesses susceptibility to different types of risk.  For example, Airline companies contend with jet fuel price uncertainty while mining companies have to contend with fluctuating commodity prices. Companies with global operations will likely face foreign currency risk. Banks are susceptible to credit risk during all phases of the economic cycle and credit risk primarily arises due to the possibility of borrowers failing to fulfill their obligations to banks.

 

Why are financial risks currently so high? 

 

For both financial and non-financial companies, financial risks are influenced by the economic cycle. For example, credit risk related losses typically materialise during strained economic environments when borrower firms and individuals are likely to be financially distressed. Credit risk can in turn exacerbate the funding risks faced by banks and cause problems refinancing the debt portion of the capital structure. For example, during the ongoing European sovereign debt crisis, European banks have suffered a significant reduction in the levels of wholesale funding available, especially short-term funding from US money market funds.  The recent crises also highlighted counterparty risk. Significant losses could occur during stressed market environments for the financial institutions that are net sellers of credit protection via credit default swap contracts (CDS). Another facet of counterparty risk is “wrong-way risk” where counterparties who have provided credit risk insurance cannot fulfill all their insurance obligations due to being financially distressed.

 

 How well do companies communicate about financial risk management?

 

Financial risk management can occur through many enterprise choices. For example, banks hold liquid assets to mitigate the risk that customers will withdraw their deposits. Banks can hold greater equity capital buffers to absorb unexpected losses. Additionally, risk management entails hedging activities that are undertaken to mitigate particular risks faced by companies. Hedging occurs through financial instruments such as derivatives and through economic hedges such as foreign currency revenue receipts being hedged by foreign currency borrowings. But companies are typically opaque about specific hedging strategies and this can result in investors only becoming aware of ineffective hedging strategies belatedly when losses are incurred.  This is especially true in relation to complex and synthetic hedging strategies.

 

 Are there specific financial risks that the GCC region is exposed to?

 

Since most of the GCC countries are pegged to the US dollar, currency risk is the predominant issue. While the much talked about GCC monetary union aspires to bring about a unified currency (along the lines of the Euro), it is still unlikely to mitigate the currency risk. Also, the GCC region comprises a number of major conglomerates that are predominantly family businesses. While in the past they carried enormous goodwill , popularizing the concept of “name lending”, the financial crisis has created some large scale corporate defaults drawing attention to this increased level of risk in the region. Lack of transparency and communication also exacerbates the problem in GCC. However, the non-development of a derivatives market may reduce this impact albeit marginally.

 

How can risk communication be improved through financial reports?

 

CFA Institute conducted a study on risk disclosures under international financial reporting standards (IFRS). The study made several recommendations for improving risk disclosures to convey useful and understandable information for investors. One of the key recommendations is that executive summaries should be provided for all key risk categories that any company bears. These summaries should be succinct and portray an entity-wide picture of key risk exposures and the effectiveness of risk management.

 

Another recommendation is that there should be an integrated presentation of related risk information. Such integration is particularly necessary for banks, where Basel III disclosures are often reported in a disparate fashion relative to the IFRS requirements. We also recommend sufficient breakdown of information, clear presentation of all quantitative details and significant improvement of qualitative disclosures, focusing on adequately communicating the company’s specific risk management strategies.

 

Regardless of the arsenal of choices employed to manage financial risk, high quality risk disclosures are required to allow investors to make a more informed evaluation of the effectiveness of risk management strategies. To this end, risk disclosures need to communicate sufficient detail about the nature of applied risk management strategies. 

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