The 2007 financial crisis arose, in part, from overleveraged banks and credit agencies underestimating market risk. Which begs the question: Is there a better way to communicate risk? If, for instance, companies had to disclose specific risks in corporate filings, would the market find this useful?
There is already a vehicle to do just that. Each year, corporations must fill out the Securities and Exchange Commission (SEC)-mandated 10-K form, which includes an open-ended section on qualitative risk. But firms are given broad latitude in terms of how much detail they present. Instead of simply reporting that sales are reliant upon a limited number of customers, for instance, a firm might offer the names of three specific corporate customers that together account for 40 percent of sales.
Since the financial crisis, the SEC has called for more specificity in these reports. Yet many analysts believe this sort of filing-based risk disclosure is of limited value.
So in recent research, Danqi Hu, an assistant professor of accounting management and information at the Kellogg School, set out to learn the extent to which the market values specificity. She teamed with coauthors Ole-Kristian Hope of University of Toronto and Hai Lu of University of Toronto.
The researchers uncovered a link between risk-related specificity in the 10-Ks and increased market activity such as trading volume, along with more reliable analyst forecasting.
“We believe specificity is important and valuable to the market,” Hu says.
Yet what is good for the market, which likes to see transparency in corporate decision-making, is not necessarily good for the corporation. While these findings show that investors and analysts may benefit from more specific risk reporting, executives need to consider the potential downsides of over-specifying risk, Hu says.
The Debate about Risk Reporting
While a great deal of attention is paid by the market and researchers to the financial-performance sections of the 10-K and similar filings—such as information related to earnings and assets—risk-related information tends to be less of a focus.
“There’s debate about whether the risk-reporting sections of some corporate filings are of any use at all,” Hu says. She notes that many analysts think it is “purely boilerplate” information.
“Financial performance is interesting, of course,” Hu says, “but we wanted to see what we could learn from risk information.”
“We believe specificity is important and valuable to the market.”
The researchers were especially interested in the level of detail provided in the 10-K on risks. How many details did firms offer, for example, about the nature and intensity of their competition, liquidity problems, potential technology disruptions, or the challenges of doing business in politically unstable parts of the world?
"Many financial managers do update the section with anything material," Hu says, "so it's not truly boilerplate."
Capturing Risk Specificity
To study the impact of risk specificity in corporate filings, the researchers analyzed nearly 15,000 10-Ks filed with the SEC from 2006 to 2011.
They defined specificity as using names (such as “Microsoft”), locations (“China”), numbers (“25 percent of revenues”), dates, and other information in the disclosure of qualitative risk. “The good examples we saw in filings used lots of specific information, such as competitors’ names and the percent of business exposed to the challenges of specific emerging markets,” Hu says.
The team used a computer algorithm to assess the specificity of the relevant section in the 10-K. Then they compared risk specificity with market activity, analyst forecasts and scenarios, and other measures.
It Is a Trade-off
As they had predicted, the researchers found that greater specificity in risk disclosure was related to increased market activity and analysts’ accuracy.
“The idea is that more specificity helps investors to incorporate a wider range of risk information in decision-making,” Hu says, resulting in a stronger short-term market reaction.
The findings represent an interesting trade-off for corporations, according to Hu. “From a company perspective, if you want your audience to understand more about the risk your business faces, be more specific,” she says.
But all firms may not want to emphasize such transparency.
“If the goal is not to promote understanding in the market, then firms are more likely to use boilerplate risk information,” Hu says.
For corporations, she points out the downside of over-specifying risk: “Information that’s too specific may signal something negative to competitors or investors. Investors might think you’re too risky or have too high a cost of capital or cost of equity.”
Thus, the research points to the need for a strategic approach to risk specificity on the part of executives. While presenting more specific information will benefit analysts and investors, senior managers should think carefully about their objectives when communicating risk, and potential downsides.
Exactly what goes into the risk sections of corporate filings may become even more critical because the SEC is considering reducing the length of corporate filings for simplicity.
“That means it will be even more important to provide the most specific, relevant information, depending on your goals,” Hu says.