Does Operational Risk Disclosure Quality Increase Operating Cash Flows?
| Autor | Nobanee, Haitham |
| Cargo | Report |
Introduction
The banking system plays a dynamic role in every economy, has a central impact on overall economic performance, and had a major involvement in the extensive financial crisis (Kabir, Worthington, & Gupta, 2015). In effect, effective operational risk management helps banks in, among others, avoiding disastrous financial losses, accurately measuring performance, restructuring products and services, and ensuring persistence in case of takeovers. In addition, operational risk management is considered an important condition, among others, for enhancing the stability and ensuring the sustainability of the banking sector. After the recent financial crisis, operational risk management has gained attention from regulators requiring a better understanding of critical risks and more transparency in managing the operational risk with the objective to strengthen confidence in the banking system.
In the finance literature, there are many studies exploring the extent of the general risk disclosure but few exploring operational risk disclosure, including: Linsley and Shrives (2006) in UK and Canada; Helbok and Wagner (2006) in North America, Asia and Europe; Oliveira, Rodrigues and Craig (2011) in Portugal; Hemrit and Ben Arab (2011) in Tunisia; Haija and Hayek (2012) in Jordan; Barakat and Hussainey (2013) in Europe; Herghiligiu (2013) in Romania; and Barakat Chernobai and Wahrenburg (2014) in the USA.
In the particular context of the emerging market economy of the United Arab Emirates (UAE), there are only researches about general risk disclosure in annual reports and not specifically about operational risk, such as Hassan (2009) and Hassan (2014). Hassan (2009) examines the relationship between UAE corporations-specific characteristics (size, level of risk, industry type and reserves) and the level of corporate risk disclosure by using a sample of 49 companies for 2005. His empirical findings reveal that the extent of the risk disclosure is significantly affected by the level of risk and reserves. In the same context, Hassan (2014) explores the extent of the narrative risk disclosure in 23 annual reports of UAE financial institutions for 2008 and examines how societal expectations of the UAE stakeholders are related to risk disclosures. His results show that the UAE financial institutions use their risk disclosure to gain, maintain and restore their social legitimacy.
Although our paper has some similarities with the previous studies regarding the exploration of risk disclosure in annual reports, it goes further to examine the extent of the specific operational risk disclosure. In addition, our study analyses the impact of the operational risk disclosure on operating cash flow by differentiating between Islamic and conventional banks. This is a very attractive research opportunity because, in the UAE, there is an emphasis on forcing all listed banks to comply with the best practices of risk disclosure, on one side, and efficiently manage their cash flows, on the other.
Even though Islamic banks' products may be similar to conventional banks' products, the two banking systems differ significantly. The major difference between the two banking systems is that conventional banks make their money by charging interest and also by charging fees for services, while Islamic banks make their money by profit and loss sharing, trading, and leasing, in addition to charging fees for services and using other sharia-based contracts of exchange (Jamaldeen, n.d.). Islamic banking has achieved high growth rates in the past few years, the top 500 Islamic Financial Institution (TIFI) listing indicates that the 2012 total of Shariah-compliant assets grew by 29.7% over 2011 (Banker, 2013 as cited in Daly & Frikha, 2016). Islamic banks currently hold about $2.5 trillion of global bank assets (Daly & Frikha, 2016).
Against this background, we conduct this research with the following main questions. First, to what extent do the UAE listed banks disclose their operational risk in their annual reports? Second, is there any significant difference between Islamic and conventional banks in their risk disclosure? Third, is there any significant impact of the operational risk disclosure on the operating cash flow of the banks?
Our paper contributes to the existing literature on operational risk disclosure in two important ways. First, our study focuses not only on conventional banks but also on Islamic banks, whereas most of previous researches have focused on exploring the operational risk disclosure in conventional banks (Barakat & Hussainey, 2013; Helbok & Wagner, 2006; Herghiligiu, 2013; Oliveira, Rodrigues, & Craig, 2011). Hence, the operational risk disclosure of Islamic banks needs to be explored as well, since this type of banks is also concerned with operational risk management. Second, our study fills the gap in risk management literature concerning the possible association between the extent of operational risk disclosure and the operating cash flow generated by banks. In addition, our research will shed light on the operational risk disclosure areas that need further improvement, and recommend that UAE regulatory authorities implement more effective mechanisms to enhance compliance with the best practices of corporate disclosure. Our findings will help the central bank develop an operational credit risk framework and guideline to address areas of weaknesses in terms of operational risk management and exploit the sources of strength in terms of operating cash flow within the UAE banking system. To our knowledge, there is no single research conducted in the UAE about the extent of the operational risk disclosure in the annual reports of the banks, so our research will illuminate this topic.
The results of the content analysis show a low degree of operational risk disclosure index for both Islamic and conventional UAE banks. The effect of the degree of operational risk disclosure on operating cash flow is examined by applying the robust Generalized Method of Moment System Estimation (GMM) to dynamic panel data. The results of the GMM show that the higher the disclosure of the operational risk, the higher the operating cash flow for all UAE-listed banks.
These results contribute by providing a better knowledge about the level of the operational risk disclosure of the banks in the UAE as well as a deep understanding of the impact of the operational risk disclosure on the operating cash flow generated by the banks. This would help the banks to optimally disclose their risks, enhance the quality of their disclosure practices, improve the quality of their financial reports, and more efficiently manage their cash flows.
The remainder of the paper is organized as follows: Second section contains a literature review about the importance of operational risk disclosure in risk management. Third section focuses on data and the empirical methodology. Fourth section presents the empirical results and finally the conclusion is given in fifth section.
Literature Review
Operational risk is defined as "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events" (Bank for International Settlements, 2001, p. 2). In effect, operational risk is integral in all banking products, processes, and systems, and the effective management of operational risk is considered to be a fundamental element of a bank's risk management process (Bank for International Settlements, 2011). Therefore, banks should use their...
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