Core Path · L1.8.08

Reading an annual report

12 minDisclosurePillar 3Financial statements

By the end you will be able to

  1. 1Find the risk disclosures in a bank's annual report and in its Pillar 3 report.
  2. 2Describe what each main part of an annual report holds, for an IFRS bank and in a US Form 10-K.
  3. 3Use the standard Pillar 3 templates to find capital, risk-weighted assets, leverage and liquidity figures.
  4. 4Cross-check a figure between the statements, the notes and Pillar 3, and name the insurer's equivalent report.

Why it matters

A large bank's annual report can run to several hundred pages, with a Pillar 3 report of a hundred or more on top. Nobody reads them front to back. Risk analysts navigate them, and know which ten pages matter.

Core explanation

Two reports, one map

Everything in this module so far, the balance sheet, the income statement, capital and ratios, comes from two public documents. The annual report tells the year's story and contains the audited accounts. The Pillar 3 report sets out the bank's regulatory capital, risks and liquidity in standard tables, so banks can be compared. In the US, the annual report is filed with the SEC as the Form 10-K, and large US banks also publish Pillar 3-style regulatory capital disclosures.

The annual report. Most IFRS bank reports follow the same broad order: a strategic report, a risk report, governance, the auditor's report, the financial statements and their notes. The risk report is the heart of it for a risk manager. The notes are where the detail lives: how loans are split by credit quality, how much of the balance sheet is valued with models (the fair value hierarchy), and when assets and liabilities mature. Do not skip the auditor's key audit matters: they point to where the judgement is.

The Pillar 3 report. Here the order is set by the Basel Committee's standard templates, each with a short code. Once you know the codes, you can open any international bank's Pillar 3 report and find the same table in the same format. Ratios and definitions that a bank chooses itself, such as many of the ratios in L1.8.07, are alternative performance measures; the Pillar 3 numbers follow the rules.

Insurers: the SFCR

EU insurers publish a Solvency and Financial Condition Report each year under Solvency II. It follows a fixed structure: business and performance, system of governance, risk profile, valuation for solvency purposes, and capital management. Standard templates at the back show the Solvency II balance sheet, own funds and the SCR: the figures met in L1.8.04 and L1.8.06.

Sort itWhere would you look?

0 / 6 right

For each piece of information, pick the part of the reports you would open first.

  • The CET1 ratio for each of the last five quarters.

  • The areas the auditor found hardest to audit.

  • The board's view of the principal risks and how each is managed.

  • How much of the balance sheet is valued using unobservable model inputs (Level 3).

  • How risk-weighted assets split between credit, market and operational risk.

  • The economic scenarios and weights behind the expected credit loss allowance.

Explore

Open each part of a typical bank annual report to see what it holds and the risk information to look for. Then switch to a US Form 10-K, which orders things by numbered Items.

ExploreMap of a bank's annual report

  1. Letters from the chair and chief executive, the business model, strategy, key performance indicators and outlook.

    Risk to look for: A summary of the principal risks and emerging risks, and headline figures such as ROE and the CET1 ratio. Read it for the story, then check the numbers elsewhere.

And the Pillar 3 templates you will use most often:

The Pillar 3 templates to know first

  1. One table with capital, RWA, capital ratios, the leverage ratio, the LCR and the NSFR, for the latest five quarters.

    Risk to look for: The first page to open: trends in every headline regulatory ratio.

Worked example

Find and check Example Bank plc's CET1 ratio

Here is how a risk analyst would trace one number through the reports of Example Bank plc, the made-up bank from earlier lessons. Its KM1 table would show these year-end figures:

KM1: key metric31 December
Common Equity Tier 1 (CET1) capital£24.0bn
Tier 1 capital£24.0bn
Total capital£32.0bn
Total risk-weighted assets (RWA)£200.0bn
CET1 ratio12.0%
Tier 1 ratio12.0%
Total capital ratio16.0%
Leverage ratio exposure measure£540.0bn
Leverage ratio4.44%
Liquidity Coverage Ratio (LCR)144%

Tracing one number

Step 1 of 6
  1. 1

    Start at KM1

    CET1 capital £24.0bn, RWA £200.0bn, CET1 ratio 12.0%. Note the trend over the five quarters a real KM1 shows: a sudden drop needs explaining.

Regulatory lens

Pillar 3 is the third pillar of the Basel framework: market discipline through public disclosure. The Basel Committee's disclosure standards set the templates; the EU applies them through Part Eight of the Capital Requirements Regulation, and other jurisdictions through their own rules. In the accounts, IFRS 7 requires disclosures about credit, liquidity and market risk; in the US, the SEC's Regulation S-K sets what goes in a 10-K, including risk factors. EU insurers publish their SFCR under Solvency II. Later levels use these reports as source material for credit, market and liquidity risk.

Sparks

SparkWhy it is called Pillar 3
Basel II, agreed in 2004, rested on three pillars. Pillar 1 sets minimum capital requirements. Pillar 2 is supervisory review of each bank's risks and capital. Pillar 3 is market discipline: banks disclose enough for investors and creditors to judge their risk for themselves.
SparkThe auditor's shortlist
Auditors of listed companies now name the few areas where they used the most judgement: key audit matters under international auditing standards, critical audit matters in the US. For a bank, the expected credit loss allowance appears on that list almost every time. It is the quickest guide to where the accounts are softest.

Key takeaways

  • The annual report holds the strategic report, risk report, governance, auditor's report, financial statements and notes. The risk report and notes matter most for risk.
  • A US Form 10-K uses numbered Items: 1A Risk Factors, 7 MD&A, 7A Market Risk, 8 Financial Statements.
  • Pillar 3 reports use standard templates: KM1 key metrics, OV1 RWA, CC1 and CC2 capital, LR2 leverage, LIQ1 and LIQ2 liquidity, CR1 credit quality.
  • Trace a number across reports: KM1 to CC1 to CC2 to the balance sheet, then read management's narrative.
  • EU insurers publish an SFCR under Solvency II, with standard templates for the balance sheet, own funds and the SCR.

Reaction

Check what stuck

Question 1 · objective 1

You want a bank's CET1 ratio for each of the last five quarters, on one page. Where do you look first?

Question 2 · objective 2

In a US bank's Form 10-K, where is the interest rate sensitivity of its net interest income usually discussed?

Question 3 · objective 3

Which Pillar 3 template breaks risk-weighted assets down into credit, market and operational risk?

Question 4 · objective 4

A bank's equity on its balance sheet is £30bn, but its CET1 capital is £24bn. Where would you find the bridge between the two?

Question 5 · objective 4

What is the insurer's counterpart to a bank's Pillar 3 report in the EU?

Glossary

Annual report
The yearly report a listed company publishes: a narrative of the year, governance, and the audited financial statements.
Pillar 3 report
A bank's public report on its capital, risk exposures and liquidity, in standard templates set by the Basel Committee.
Form 10-K
The annual report US-listed companies file with the Securities and Exchange Commission (SEC).
Key audit matters
The matters the auditor judged most significant in the audit. Called critical audit matters in the US.
Fair value hierarchy
IFRS 13's three levels for fair values: quoted prices (Level 1), observable inputs (Level 2), and model inputs that cannot be observed (Level 3).
Alternative performance measure
Alternative performance measure: a ratio or figure a company defines itself, outside the accounting standards.
LCR
Liquidity Coverage Ratio: high-quality liquid assets divided by net cash outflows over 30 days of stress.
SFCR
Solvency and Financial Condition Report: the public annual report EU insurers publish under Solvency II.

Deep Dives & Origins

Deep Dives

  • Pick any large bank you know and open its latest annual report and Pillar 3 report side by side. Find KM1 first, then trace the CET1 ratio as in the worked example. Beginner.
  • Hull, Risk Management and Financial Institutions (Wiley), the chapters on Basel II and Basel III, for what sits behind each template. Intermediate.

Origins

  • BCBS, The Basel Framework, DIS: Disclosure requirements (the Pillar 3 templates).
  • BCBS, Pillar 3 disclosure requirements: consolidated and enhanced framework (March 2017).
  • Regulation (EU) No 575/2013 (Capital Requirements Regulation), Part Eight.
  • IASB, IFRS 7 Financial Instruments: Disclosures and IFRS 13 Fair Value Measurement.
  • US SEC, Form 10-K General Instructions and Regulation S-K.
  • Commission Delegated Regulation (EU) 2015/35 (Solvency II), articles 290 to 298 on the SFCR.

Module complete

You have finished Module 1.8 and Level 1's Core Path. Try the Lab Test for Module 1.8 →

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Key ratios for banks and insurers