Qualitative Disclosure in Bank Financial Statements

Scott Liao^†, Helen Zhang^#, and Jacob Ott^#

^† Rotman School of Management, University of Toronto, Toronto, ON

^# Carson School of Management, University of Minnesota, Minneapolis, MN

This study examines the effect of bank transparency in disclosure on systemic risk, the risk that “the capacity of the entire financial system is impaired, with potentially adverse consequences for the real economy” (Adrian and Brunnermeier, 2016). We focus on the quality of disclosure of the unobservable inputs in the level 3 fair value measurements that FASB requires firms to disclose based on ASU 2011-4, and study whether the quality of such disclosure affects bank systemic risk.

This paper is motived by the Dodd-Frank Act that requires the Federal Reserve to monitor bank risk taking from the macro-prudential perspective. Specifically, the Federal Reserve uses the FR Y-15 data starting from 2016 to monitor the systemic risk profile of systemically important banks. Among many items that banks need to disclose, the Federal Reserve posits that level 3 fair value assets contribute to systemic risk because level 3 fair value assets are measured using management judgment and unobservable inputs, which are opaque by nature. The lack of transparency of level 3 assets may deter market discipline and regulators’ monitoring. This may result in unmonitored bank risk taking and externality to the whole financial system. To examine whether the increased disclosure requirement alleviates this consequence on systemic risk. We examine whether banks’ contribution to system risk declines after year 2012 and whether the decline in systemic risk depends on the quality of their disclosure of observable inputs in level 3 valuation. Our initial analyses show that the association of level 3 assets and the three different systemic risk measures we use declines after 2012. We are also in the process of collecting the disclosure of unobservable inputs using innovative approaches such as textual analyses. So far, we observe heterogeneity of banks’ disclosure, which provides us with variation in analyzing this research question. For example, while some banks are very specific about the valuation models, the range and the weighted average of their assumptions of valuation inputs, others provide very opaque information. We believe this study has a potential to broaden our understanding of the role of accounting disclosure and transparency in curbing systemic failures.