Impact of Risk-Related Disclosure on the Risk-Taking Behavior of Commercial Banks in Pakistan

Abstract

Information asymmetry leads to moral hazard in commercial banks, as evidenced in the 2008 crisis. This study aims at analyzing the implications of risk disclosure practices of commercial banks on their risk-taking behavior in Pakistan. It also attempts at assessing the level of compliance for commercial banks with the specifications of Basel accord II under Pillar 3. For measuring disclosure level, a risk disclosure index is devised. The dependent variable i.e. risk-taking behavior is operationalized through portfolio risk. The analysis employed panel data techniques of Ordinary Least Squares (OLS). The relationship of risk disclosure index with risk-taking behavior, as expected, is found to be significantly negative; in line with information asymmetry and moral hazard hypotheses. These discoveries are consistent with the essence of market discipline that greater disclosure enables stockholders to more closely monitor and scrutinize, resulting in contrived and sensible risk taking. The results of the study provide evidence on the current state of market discipline and the vital part it plays in the risk-taking behavior of Pakistani commercial bank. This study is also significant for the regulators, and financial managers, that need adequate information for making informed decisions. As the results empirically confirm the issue of non-disclosures with an intent to take higher risks, in commercial banks of Pakistan. In the light of this study, the policy makers can strengthen regulations that govern risk disclosure practices, in order to uphold market discipline, realizing the ultimate objective of State Bank of Pakistan and Basel Committee for Banking Supervision.

Bank Risk Appetite Communication and Risk Taking: The Key Role of Integrated Reports

“…Thanks to a GSEM approach, the study extends risk science by complementing the literature stream on banks' accounting discretion (Bushman & William, 2012) and risk disclosure (Del Gaudio et al, 2020;Naz & Ayub, 2017), supporting the impact of market discipline in promoting new forms of corporate reporting (especially IR) to achieve substantive disclosure "keeping corporate stakeholders better informed about banks' management, and inducing banks to reduce their RT" (Srairi, 2019). This study contributes to emphasize the prominent role of IR in assessing risk metrics, which are strategically important to incorporating prospective events, and in favoring a holistic approach to reporting (Cohen et al, 2017), which also leads to better internal decision making (Barth et al, 2017).…”

“…Regarding this conclusion, the prior literature is divided. On the one hand, many contributions emphasize the positive effects of such induced transparency in facilitating banks’ monitoring, reducing moral hazard, fostering accountability, and enhancing efficiency and integrity of the market (González, 2005; Naz & Ayub, 2017). Banks’ disclosure about their risk exposure enables reasonable financial risk analysis and an effective market discipline practice, which has a direct effect on bank asset risk (Ariffin, Archer, & Karim, 2007; Blum, 2002; Cordella & Yeyati, 1998; Greuning & Iqbal, 2008; Hall, 2006; Landskroner & Paroush, 2008; Stephanou, 2010).…”

“…Thus, accounting information plays a key role in increasing transparency, facilitating market discipline. In addition, financial reporting is the foundation of the information set available to external stakeholders and it represents the logical starting point for investigating properties of information important for addressing moral hazard problems at banks (Naz & Ayub, 2017). It is also plausible that the quality of banks’ financial accounting information is correlated with the quality of other bank disclosure.…”

“…Such flexible and vague normative constraints regard the volume and the quality of RA disclosure also in the ARs. These represent the most investigated type of document, including risk‐related information both in accounting terms within financial statements and through qualitative disclosure (Abraham & Cox, 2007; Abraham & Shrives, 2014; Aljughaiman & Salama, 2019; Beretta & Bozzolan, 2004; Buckby, Gallery, & Ma, 2015; Elshandidy, Fraser, & Hussainey, 2013; Elshandidy & Neri, 2015; Hassan, 2009; Linsley & Shrives, 2005; Linsley, Shrives, & Crumpton, 2006; Naz & Ayub, 2017).…”

Pillar 3: Does banking regulation support stakeholders’ interest in banks financial and risk profile?

“…Importantly, a balance in transparency should be held as the aggressive decrease in the risk-taking by increasing disclosures can hinder economic growth. This negative effect of market discipline implementation should be closely monitored, as a market discipline plays a vital part in risk-taking behaviour of commercial banks [ 18 ]. The role of market discipline is important in evading financial crisis and has come out even stronger in this endeavour because information asymmetry led to moral hazard in commercial banks.…”