|By Ahmad, Normah|
The East Asian financial crisis in 1997 and later the global financial crisis in 2007 and 2008 had a big impact on the corporate world as many companies and financial institutions collapsed during that period. Poor governance systems and lack of transparency in reporting including lack of risk reporting and disclosure were blamed as the roots of the problem. Conventional financial institutions have widely practiced risk management within their organization, but it is still under-developed in Islamic financial institutions due to new emerging market and unique business structures which are based on Shariah or Islamic law. Therefore, this study examined the risk management disclosure by all 17 Islamic financial institutions in
Keywords: Risk management; Islamic Financial Institutions (IFIs)
Corporate risk disclosure is a critical issue in corporate communication (Abraham & Cox, 2007) as the risk information disclosed in the financial statements will be closer to the decision models, as set out in financial theory (Cabedo & Tirado, 2004). The FASB (2001) Steering Committee demonstrated Ulis when it reported that the information that users are most looking for from the annual report includes (1) more disclosure of non-financial information, (2) more forward-looking information, and (3) more information about tangible assets. Husseiney (2004) considered forward-looking information to include risk and opportunities. In relation to risk information, the
disclose its principal risks and describe related risk management systems to enable MD&A report readers to understand and evaluate the company's risL· and its decisions regarding the management of such risks"(CCA, 2004, Para 360.2)
Thus, risk disclosure aims to enable users to evaluate the risk and risk management of a corporation.
During the first quarter of the 20th century, issues on corporate risk disclosure focused on the amount of risk information provided to shareholders and other stakeholders. In particular, with the advent of corporate collapses, a strong demand emerged for information on companies' exposure to risks. Various reports, such as those produced by
the failure or near failure of many financial institutions and corporations in the East Asian region resulted from a highly leveraged corporate sector, growing private sector reliance on foreign currency borrowing and the lack of transparency and accountability.... A crucial role was played by disclosure deficiencies. ..and the lack of appropriate disclosure requirements indirectly contributed to the deficient internal controls and imprudent risk management practices of the corporations and banks (IF A, 2003, p. 6).
Furthermore, die East Asian financial crisis in 1997 and die even worse global financial crisis driven by the US sub-prime debacle in 2007 and 2008 also contribute to me corporate collapses. The East Asian financial crisis occurred due to me devaluation in the
Both financial crises have significantly impacted the corporate world as many companies, including financial institutions, collapsed during me first decade of the 21st century. Otìier companies managed to survive tìianks to their strong financial management and prudent risk management. Dobler (2008) argued mat corporate disclosure including risk reports is important for managing the effects of risks on companies' future financial positions. Thus, it is imperative to employ good risk management to reduce potentially negative impacts on companies. Indeed, Foong (2009) pointed out mat poor corporate governance and a lack of transparency, especially in terms of risk management disclosure among major financial conglomerates, intensified the financial meltdown in the US sub-prime mortgage crisis. Therefore, financial institutions need to pay serious attention to Ulis area as risk management is a global problem. The availability of the Basel Accord (Pillar 3), requires a number of disclosure requirements in an effort to improve the market's ability to assess a bank's risk and value (Baumann & Nier, 2004). Thus, it is important for companies to practice risk management, especially financial institutions, which are more exposed to various types of risk due to me nature of their operations.
Risk management is widely practiced by conventional institutions, but it is still underdeveloped in Islamic financial institutions. Almough Islamic banks face the same risks as conventional banks, mey must also deal with "new and unique risks as a result of their unique asset and liability structures" (Kahf, 2006). This new type of risk is an immediate outcome of meir compliance with the Sharia requirement tìiat prohibits interest on all types of loans. As a result, Islamic banking is based on interest-free banking, meaning that investment account holders at Islamic banks share the risk of investment with mese banks.
All Islamic financial institutions in
Several studies have focused on risk management disclosure in financial institutions (Sundararajan & Errico, 2002). Mohd Ariffin, Archer, and
The organization of this paper is as follows. The next section provides the literature review, which is followed by the section outlining the research design used in this study. The results are summarized in the subsequent section. The final section provides a discussion and concludes this paper.
Islamic Financial Institutions
Islamic finance has grown tremendously since it first emerged in the 1970s. According to
The growth of the Islamic finance market resulted in the establishment of the international standard-setting organization called the Islamic Financial Services Board (IFSB) on
Risk Information and Its Importance
Fatemi and Glaum (2000) conducted a survey on non-financial German companies listed on the
In addition, by using risk management, a company can benefit in terms of lowering costs and enhancing communication across the company. By focusing on risk management disclosure, the company is better able to handle internal transactions and determine whether it has under- or overestimated the risk (Klefmer, Lee, & McGannon, 2003). Therefore, a company with a risk management strategy is able to manage its risk efficiently and have better communication among departments, ultimately avoiding huge losses.
Risk Management Disclosure Requirements in
Risk information in the corporate annual report can be quantitative or qualitative, financial or non-financial, and historical or forward-looking in nature (Beattie, Mclnnes & Fearnley, 2004). Risk disclosure is partly mandatory and partly voluntary. Mandatory disclosures include those specifically required under regulatory requirements of statutes or laws, professional regulations or accounting standards, and stock exchange listing requirements. Failing to disclose such information will result in a corporation being issued a qualified audit report or some other regulatory sanction. However, Al-Razeen and Karbhari (2004) contended that, in an environment where everything is equal and disclosure is made under the same regulatory requirements, corporate disclosure may be in full compliance, in partial compliance, or not at all in compliance with the regulatory requirements. In other words, full disclosure is not guaranteed. The inconsistencies of corporate disclosure in complying with regulatory requirements are due to ineffective enforcement measures and controls (Akhtaruddin, 2005). In addition, full voluntary disclosure rarely seems to be made in reality. Typically, corporations do not disclose more than the regulation requires despite the free choice and discretion in disclosing voluntary information. Thus, the levels of mandatory and voluntary corporate disclosure vary among countries. Although no correlation exists between voluntary disclosure and mandatory disclosure (Al-Razeen & Karbhari, 2004), Inchausti (1997) demonstrated that voluntary disclosure decreases when mandatory disclosure requirements increase, thereby influencing the quality of corporate disclosure.
Chavent, Ding, Stolowy, and Wang (2006) posited that no inherent characteristic exists for determining the quality of disclosure because disclosure is an abstract concept that is difficult to measure (Botosan, 2004). Nevertheless, the norms in corporate disclosure studies are to use quantities of corporate information disclosed as proxies for the levels and quality of corporate disclosure practices (Linsley & Shrives, 2005; 2006; Barako, Hancock, & Izan, 2006). The precarious assumption that quantity signifies quality was reportedly pioneered by
Requirements in Disclosing Risk Information
As disclosure of corporate risk is governed by statutes or laws, professional accounting regulations, or accounting standards and stock exchange listing requirements, corporate risk disclosure is considered mandatory disclosure. Only the thematic content of risk information normally discussed in management's explanatory materials or governance reports is voluntary. In
The Malaysian regulatory framework does not govern the overall information requirements for annual reports. The Financial Reporting Standards (FRS) only apply to financial statements, not other information presented in other documents as part of the annual report. Although FRS provides accounting policy choices, the disclosure of items in the financial statements is mandatory to the extent of the inclusion of a provision in the Ninth Schedule, CA 1965. Non-compliance with statutory requirements results in criminal sanctions or fines, imprisonment, or both. In terms of risk reporting, MASB issued the Financial Reporting Standard (FRS) 101: Presentation of Financial Statement and FRS 132: Financial Instruments: Disclosure and Presentation. Paragraph 105 (d) (ii) of FRS 101 specifies the need for a company to disclose notes to assist users in understanding the financial statement on non-financial disclosures such as the company's financial risk management objectives and policies. Paragraph 52 of FRS 132 requires a company to provide information to assist users of financial statements in assessing die extent of risk related to financial instruments.
According to the revised Bursa Malaysia Listing Requirements (2007), "a listed issuer must ensure that its board of directors includes in its annual report a statement about the state of internal control of the listed issuer as a group" (Part E, Para 15.27(b)). Bursa
Furthermore, Islamic financial institutions in
The importance of risk disclosure was again highlighted by die IFSB in its standards in IFSB1. IFSBl's "Guiding Principles of Risk Management for Institutions (Otiier Than Insurance Institutions)
The sample for this study includes all 17 Islamic financial institutions in
All data for this study were based on the annual reports available from BNM's website as well as from die individual financial institutions' websites. The 17 institutions' annual reports for a four-year period, from 2006 to 2009, were selected. Consistent with previous studies, content analysis was performed in collecting and analyzing the level of risk management disclosure in die annual reports (Lajili & Zeghal, 2005; Linsley & Shrives, 2006; Amran et al., 2009). Content analysis was chosen as it is a research metiiod that uses a set of procedures in making valid inferences from the text. This method is appropriate for examining die risk disclosure's qualitative terms as die analysis includes capturing die extent and volume of such disclosure (Lajili & Zeghal, 2005). A scored checklist was developed; scores were assigned based on die percentage of disclosure for each area, as disclosed by the Islamic financial institutions.
Risk Management Disclosure Checklist
The study developed a risk management scorecard based on me FRS, GP8-/, and "Guidelines on Corporate Governance for Licensed Islamic Banks" (GPl-i). In order to examine die effect of the financial crisis on disclosures, the study focused on a four-year period (i.e., 2006 to 2009).
Mandatory risk disclosure, as required by FRS 132, is divided into four main attributes:
* Market risk
* Credit risk
* Liquidity risk
* Interest rate risk
In addition, me voluntary disclosure scored checklist consists of seven main attributes, obtained from EFSB's "Guiding Principles of Risk Management" and Bursa Malaysia's "Statement on Internal Control: Guidance for Directors of Public Listed Companies (2000)." The following items are recommended for voluntary disclosure for bodi international and national bodies:
* Control environment
* Control activities
* Information and communication
* Sharia compliance risk
* Operational risks
Sharia compliance and operational risks are a unique risk faced by Islamic financial institutions as a result of complying with Sharia requirements.
Risk Management Disclosure Measurement
This study used a 3-point scale to determine the extent of risk management disclosure. This scale was used to provide more details on die extent of risk disclosure man a dichotomous measurement would have provided. Islamic financial institutions that disclosed all required details of risk management were awarded two points, those with at least one criterion of risk management disclosure from the checklist were awarded one point, and those with no risk management disclosure were awarded no (0) points. Eleven items were assessed on the disclosure checklist, resulting in a maximum possible score of 22 points (i.e., 100% disclosure) and a minimum of 0 points (0% disclosure).
Similar to the results in previous literature, the current study defined the level of disclosure according to the mean percentage score on the checklist as this figure shows the average percentage that would be obtained by the companies under observation (Ismail & Abdul Rahman, 2011;
Table 2 also indicates the overall maximum score of risk disclosure (96.67%) and minimum score (46.67%). Although the financial institutions did not achieve 100% risk disclosure, the maximum disclosure rate is promising and suggests that Islamic financial institutions are quite concerned about potential risks. Table 3 identified the companies with the highest risk disclosure based on the checklist. As expected, the two biggest banks in
Mandatory Risk Disclosure
Based on Table 2, the overall result for mandatory risk disclosure was 85.71%. Such a result is reasonably high due to the governing bodies' legal requirements; non-compliance with the legal requirements would have legal implications. Therefore, most companies have taken the initiative to disclose what is required by the standards. The highest mandatory disclosure is recorded at 100%, indicating that these companies have provided full disclosure as required by FRS 132.
Mandatory disclosure focusing on risk assessment includes four main types of risk, as required under FRS 132: market risk, credit risk, liquidity risk, and interest rate risk. As shown in Table 4, the highest overall mean score was 90.93%, which was for credit risk; this score was followed by market risk (87.75%), interest rate risk (77.21%), and finally liquidity risk (75.49%).
Credit risk's average mean score is highest likely due to the fact that credit risk is important for banking and financial institutions as their operations focus primarily on taking deposits and lending money. Indeed, Mohd Arriffin et al. (2009) found that Islamic bankers perceive credit risk to be very important; failing to focus on credit risk management practices and quality will lead to bank failures and banking crises worldwide, as suggested by the Basel Committee report.
The lowest mean score item disclosed was liquidity risk. Unlike normal business operations, banking and financial institutions do not face pressures in terms of liquidity because of the nature of their business, which is dealing with deposits from customers and businesses. According to
For voluntary disclosure, seven main attributes were examined in this study. The results shown in Table 5 highlight that the highest attribute disclosed was control activities (98.16%) followed closely by risk framework (96.08%), information and communication (96.32%), and control environment (95.59%).
The control activities consist of policies and procedures to ensure that risk action is carried out effectively. Most financial institutions have disclosed the policies and procedures that they adopt in their operations, as mese are part of the standard operating procedures that financial institutions should have in place. Previous studies (Ismail & Abdul Rahman, 201 1; Othman et al., 2009) similarly found that control activities are least reported by companies due to the unavailability of such policies and procedures in their companies. However, other studies, such as Ismail and Abdul Rahman (2011) and Othman et al. (2009), found contradictory results in their studies of non-financial institutions and financial and non-financial institutions, respectively.
The second highest disclosure was risk framework, which consists of the availability of frameworks; procedures for identifying, monitoring, and controlling various risks; and the availability of independent risk management and control functions. These results are consistent with the findings of Ismail and Abdul Rahman (2011), suggesting that most Islamic institutions have a framework in place due to pressure from regulatory bodies, especially BNM, which requires a strong framework for reporting in line with the Basel Pillar 3 requirements. Furthermore, the item for information and communication has been fairly disclosed by most Islamic financial institutions - likely because they have in place good policies and procedures, including the dissemination of information among management and employees.
Next, the control environment consisted of items such as overall attitude, awareness, and actions of directors and management as well as written communication systems that support the business objectives and risk management system. The results were expected, as most institutions have disclosure on the overall attitudes, awareness, and actions of directors and management - an area that focuses on disclosures related to the organizational structure, functions of the board of directors and its committees, and management's philosophy and operating style. These items are usually available in the annual reports of most corporations. Such results are consistent with those found by Ismail and Abdul Rahman (2011) and Othman et al. (2006) - namely, that these attributes are mostly disclosed in the annual reports of companies in
The lowest mean score, at 77.94%, was for Sharia compliance risks. This result is unexpected as Islamic financial institutions and banks are supposed to have detailed disclosure on Sharia compliance given that the main principles of Islamic institutions are based on Sharia. However, although Islamic banks were formed 30 years ago, the development of Islamic financial institutions has only attained significant importance in the last few years. Most Islamic financial institutions were first established as Islamic branches of conventional banks before being transformed to stand-alone Islamic banks. Indeed, further analysis revealed that most of the sample institutions did not disclose Sharia compliance risk in 2006 and 2007, but made full disclosure in 2008 and 2009, which was likely due to the lack of availability of a Sharia compliance risk committee in earlier years, when most of the financial institutions in this study still operated as Islamic branches of conventional banks. Thus, initially they did not have their own Sharia committee, but by 2008, these Islamic financial institutions had started to operate as standalone institutions.
The East Asian financial crisis in 1997 and the global financial crisis in 2007 and 2008 significantly impacted companies and financial institutions. Many companies collapsed during the first decade of the 21st century due to poor governance systems and the lack of transparency in reporting (Foong, 2009), including risk reporting disclosure - one of the most important types of disclosure as it affects companies' future financial positions (Muda & Yazid, 2006). Thus, it is critical that companies practice risk management, especially financial institutions, which are more exposed to various types of risk due to the nature of their operations, as evidenced during the US sub-prime crisis, which affected not only financial institutions, but all businesses around the world.
Conventional financial institutions have extensively practiced risk management; however, it is still underdeveloped in Islamic financial institutions due to the newly emerging market and unique business structure based on Sharia or Islamic law. Therefore, this study focused on risk management disclosure by all Islamic financial institutions in
This study analyzed the institutions' risk management disclosure using the regulatory requirements and guidelines of the relevant bodies. Thus, risk disclosure was divided into two main elements: (i) mandatory disclosure and (ii) voluntary disclosure. The descriptive results demonstrated that the overall mean score for risk management disclosure among Islamic financial institutions in
The overall result for mandatory risk disclosure shows more than 80% disclosure by these institutions. However, the results indicate that some companies did not comply with disclosure requirements even when mandated by regulatory bodies. Thus, a need exists for these regulatory bodies to identify the reasons for such noncompliance as risk disclosure is important for stakeholders.
Mandatory disclosure consists of four main areas of risk, as required by FRS 132: market risk, credit risk, liquidity risk, and interest rate risk. Credit risk was mostly disclosed by Islamic financial institutions with an overall mean score of approximately 90%, followed by market risk at almost 90% and interest rate risk at almost 80%. The least area of disclosure was liquidity risk, with an overall mean score of 75%.
Seven main attributes were examined for voluntary disclosure in this study. The results indicated that the highest attribute disclosed was control activities while the lowest disclosure was for Sharia compliance risks. Most financial institutions have disclosed control activities, which consist of policies and procedures they adopt in their operations because they are part of the standard operating procedures that financial institutions should have in place. Sharia compliance risk was found to be the item least disclosed by Islamic financial institutions, which is surprising given that Islamic financial institutions and banks are supposed to have detailed disclosure on Sharia compliance. This finding could be explained by the underdevelopment of the Islamic financial institutions as Islamic banking has only started to grow rapidly over the last 10 years.
The results of this study contribute to establishing a preliminary point for empirically examining the level of risk management disclosure. It is crucial to fully understand the factors that drive risk management disclosure in Islamic financial institutions. Such institutions should consistently follow requirements established by relevant authorities to ensure full compliance with risk disclosure.
In essence, future research can be conducted to study the relationship between the risk management disclosure level and corporate governance mechanisms, such as the board of directors, audit committee, and ownership structure. Such an approach would help regulators understand the most important factors that can influence the disclosure level in Islamic financial institutions. Future research should also compare the risk management disclosure level between Islamic financial institutions and conventional financial institutions to determine if any differences exist in the reporting style.
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Rosnadzirah Ismail, Universiti Teknologi MARA,
Rosnadzirah Ismail is a lecturer at
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