Did the banking sector foresee the financial crisis? Evidence from risk factor disclosures (original) (raw)

Review of Quantitative Finance and Accounting, 2019

Abstract

Beginning in December 2005, the SEC required registrants to discuss “ the most significant factors that make the company risky ” under the Risk Factors item (Item 1A) in annual reports. The objective of this research is to evaluate the informativeness and timeliness of Item 1A in the setting of the banking industry during the financial crisis of 2008, and to investigate the characteristics of banks that moved fastest in communicating information through Item 1A as the crisis developed. We first document that the average number of risks disclosed by the national banks increased significantly from 2008 to 2009 and the tone of Item 1A, based on a standard dictionary (Loughran and McDonald in J Finance 66(1):35–65, 2011), also became more negative over this period. By creating a dictionary of financial crisis related words in press articles using an application of Latent Dirichlet Allocation, we show that the appearance of those words also increased from 2008 to 2009. Overall, the results support a finding that the banking industry failed to disclose business risk on a timely basis in their item 1A disclosures even though the purpose of this item is to allow firms to communicate information about all eventualities including those that may not be realized. The results also provide some information about the characteristics of the banks that had better disclosures in anticipation of crisis. Our finding suggests that the firms that disclosed earlier did a better job in pro-actively managing their operations over the financial crisis period.

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