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.
