Information asymmetry around operational risk announcements Ahmed Barakat a , Anna Chernobai b,⇑ , Mark Wahrenburg c a Economics and Finance Division, Nottingham University Business School, UK b Department of Finance, M.J. Whitman School of Management, Syracuse University, 721 University Avenue, Syracuse, NY 13244, USA c Department of Finance, Faculty of Economics and Business Administration, Goethe University, Frankfurt am Main, Germany article info Article history: Received 27 June 2013 Accepted 30 June 2014 Available online 19 July 2014 JEL classification: D82 G14 G30 Keywords: Operational risk Information asymmetry Market liquidity Bid-ask spread Corporate governance Enterprise risk management abstract Operational risk incidences are likely to increase the degree of information asymmetry between firms and investors. We analyze operational risk disclosures by US financial firms during 1995–2009 and their impact on different measures of information asymmetry in the firms’ equity markets. Effective spreads and the price impact of trades are shown to increase around the first announcements of such events and to revert after the announcement of their settlement. This is especially pronounced for internal fraud and business practices related events. Market makers respond to higher information risk around the first press cutting date by increasing the quoted depth to accommodate an increase in trading volumes. The degree of information asymmetry around operational risk events may be influenced by the bank’s risk management function and the bank’s governance structure. We indeed find that information asym- metry increases more strongly after events’ first announcements when firms have weaker governance structures—lower board independence ratios, lower equity incentives of executive directors, and lower levels of institutional ownership. In contrast, the firms’ risk management function has little to no impact on information asymmetry. We interpret this as evidence that the risk management function is primarily driven by regulatory compliance needs. The results of this study contribute to our understanding of infor- mation asymmetry around operational risk announcements. They help to shed light on the role that reg- ulation and corporate governance can play in order to establish effective disclosure practices and to promote a liquid and transparent securities market. Ó 2014 Published by Elsevier B.V. 1. Introduction We study information asymmetry in the equity market around operational risk announcements in US public financial firms. Better disclosure practices of financial information improve liquidity, pro- vide a monitoring role over the behavior of senior management, and help maintain the trust of stakeholders—shareholders, super- visors, governments, and depositors. Diamond (1985) argued that releasing information makes shareholders better-off by maximiz- ing their welfare. Recent US regulatory initiatives that address dis- closure include the Gramm–Leach–Bliley Act (GLBA) of 1999 that broadens the range of permissible banking activities and adds pro- visions regarding information-sharing, the Health Insurance Porta- bility and Accountability Act (HIPAA) of 1996 that deals with security and privacy of data in the healthcare industry, the Basel II Capital Accord of 2001 that mandates regulatory capital for risks and their market disclosure, the Sarbanes–Oxley Act (SOX) of 2002 that mandates disclosures of internal control weaknesses in com- pliance with the SEC’s disclosure laws, 1 and the Dodd–Frank Act of 2010 that calls for stricter reporting and disclosure requirements in the financial industry, along with a mortgage reform and con- sumer protection rules. The Basel Committee on Banking Supervision (BCBS) mandates the measurement and management of operational risk, defined as the risk of loss resulting from inadequate or failed internal pro- cesses, people, systems, or from external events. Operational risk may arise from diverse causes, such as unauthorized transactions, business disruptions due to technology and software failures, flawed financial models and products, poor business practices, nat- ural disasters, employment issues and discrimination, and execu- tion and delivery failures. Along with credit, market, and liquidity risks, operational risk has been acknowledged as a major source of material failures in financial firms. Trading errors and http://dx.doi.org/10.1016/j.jbankfin.2014.06.029 0378-4266/Ó 2014 Published by Elsevier B.V. ⇑ Corresponding author. Tel.: +1 315 443 3357; fax: +1 315 442 1461. E-mail addresses: Ahmed.Barakat@nottingham.ac.uk (A. Barakat), annac@syr. edu (A. Chernobai), wahrenburg@finance.uni-frankfurt.de (M. Wahrenburg). 1 SOX’s relevant sections are Section 302 (Corporate Responsibility for Financial Reports) and Section 404 (Management Assessment of Internal Controls). Journal of Banking & Finance 48 (2014) 152–179 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf