Risk Mitigation
   Overview: Risk Control
   Overview: Capital Adequacy
   Overview: Regulatory Co-operation
   Overview: Sales Practices
   Overview: Netting and Insolvency
   Overview: Accounting and Disclosure


Risk Mitigation

Overview: Accounting and Disclosure

Latest Update for may 2000

This key risk concept refers to the requirements that regulators make of firms (both financial and non-financial) to provide them, their counterparties and the public with appropriate and relevant information. The channels they can use are surveys, supervisory returns, quarterly financial accounts, annual reports, investment analysts' reports, stock exchange filings and other public documents.

Interested parties have always studied a firm's financial statements to keep themselves abreast of the financial condition of the firm (including the financial instruments the latter uses.) But accounting standards for financial instruments have not kept pace with innovations in the financial markets and the uses to which these instruments are put. A firm can substantially change its financial risk profile virtually instantaneously, by entering into interest rate or currency swaps, or by acquiring options or forward contracts to hedge or take positions on future price movements. No country has comprehensive accounting standards that address the accounting and reporting of transactions in all types of derivatives and cash market instruments. The lack of comprehensive standards means that different accounting treatments are allowed for transactions with comparable economic substance. This makes it difficult for users of financial statements to understand an organisation's use of derivatives and the accounting bases upon which the financial statements are drawn. This lack of transparency may lead to erroneous conclusions about a company's financial condition.

The inadequacies of existing accounting practices lie in its roots. Current practices are based on principles developed when the primary focus of accounting was on manufacturing companies that combine inputs (materials, labour, plant and equipment) and transform them into outputs (goods or services) for sale. Accounting for these revenue-generating processes is concerned primarily with accruing costs to be matched with revenues. A key point in this process is revenue realisation - the point at which a company is considered to have transformed its inputs into cash or claims to cash. These realisation and cost-based measurement concepts are inadequate because they take no account of unrealised gains and losses from movements in market rates between the transaction date and the date at which the financial statements are drawn.

Since no country has comprehensive accounting standards, it is not surprising there are no harmonised international standards. With financial institutions becoming global creatures, this problem takes on added urgency since the traditional audited financial statement provides very limited information. The need for common standards of high quality is well-recognised and the International Accounting Standards Committee, which was set up in 1973 to devise and implement global standards, is close to releasing a set of rules which has the agreement of the accounting industry and securities regulators.

In the absence of any agreed standards, the G-30 issued two recommendations on accounting standards in "Derivatives: Practices and Principles" (1993). Pending harmonisation of international standards, it recommends the following accounting practices:

  • Dealers should account for derivatives transactions by marking them to market, taking changes in value to income each period.
  • End-users should account for derivatives used to manage risks so as to achieve a consistency of income recognition treatment between those instruments and the risks being managed. Thus, if the risk being managed is accounted for at cost, changes in the value of a qualifying risk management instrument should be deferred until a gain or loss is recognised on the risk being managed. Or, if the risk being managed is marked to market with changes in value being taken to income, a qualifying risk management instrument should be treated in a comparable fashion.
  • End-users should account for derivatives not qualifying for risk management treatment on a mark-to-market basis.
  • Amounts due to and from counterparties should only be offset when there is a legal right to set-off or when enforceable netting arrangements are in place.

The G-30 says that it is a matter of priority that accounting standards-setting bodies in every country provide comprehensive guidance on accounting and reporting of transactions in financial instruments, including derivatives. A fuller report on accounting is contained in the Working paper of the Accounting and Reporting Subcommittee, which is available from the G-30.

In "Sound Practices for Loan Accounting and Disclosure" (1999), the Basle Committee gives very clear guidelines to banks and their supervisors on how to recognise and measure loans and impaired loans, how to establish loan loss allowances and how to recognise income because they are concerned about the adequacy of banks' processes for determining allowances and the adequacy of total allowances. There are 26 guidelines on loan accounting and disclosure; most of those on accounting are similar to those endorsed by the International Accounting Standards. For example, both bodies recommend that an impaired loan should be recognised by reducing the carrying amount of the loan through an allowance or charge-off and charging the income statement in the period in which the impairment occurs.

International accounting standards should be accompanied by appropriate disclosure. Disclosure practices have not kept pace with rapidly changing technologies, the integration of the world's financial markets and the growth of derivatives. They have however become of particular relevance in recent years as regulators have sought to encourage firms to disclose more information about the impact of derivatives and other off-balance sheet instruments on the risks inherent in the institution. Regulators view improved disclosure as complementing their supervisory efforts. If provided with meaningful information, investors, depositors, and creditors can impose strong market discipline on financial institutions to manage their trading and derivatives activities in a prudent fashion and in line with their stated business objectives. Market discipline can also reinforce the objectives of supervision by rewarding those that manage their risks effectively and penalising those whose risk management is weak or ineffective.

But in framing disclosure requirements, the regulatory community has to be careful about weighing the advantages and disadvantages of each piece of information demanded. The criteria regulators have borne in mind are;

  • The disclosed information must be meaningful in the sense of expressing how a particular firm does, in fact, assess and manage risk.
  • It must be easily understood and presented in an adequate context or paradigm for relating details to the overall concepts.
  • It should preserve proprietary information so that the firm need not reveal specific market opportunities and risks.
  • It should not be burdensome in cost- and time-terms.
  • It should be comparable and verifiable.
  • The approach should be flexible so that it does not stifle the further development of risk management concepts and disclosure practices.

The near collapse of Long-Term Capital Management has prompted regulators to place increasing emphasis on better disclosure. This is due to the fact that the central public policy issue raised by the LTCM episode is how to constrain excessive leverage more effectively. At the end of 1997, LTCM’s balance sheet leverage was 28-to-1; the hedge fund had been able to borrow large sums of money from many banks at generous terms (many of these banks did not know how much other banks had lent to LTCM.) The President’s Working Group on Financial Markets report on the LTCM episode recommends that ‘public companies, including financial institutions, should publicly disclose additional information about their material financial exposures to significantly leveraged institutions, including hedge funds.’ These proposed disclosures should be incorporated in the Management’s Discussion and Analysis or Description of Business in periodic financial statements. In their report "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management" (1999), the working group asserts that improved disclosure should help market participants make better, more informed judgements about market integrity and the creditworthiness of borrowers and counterparties. Hedge funds specifically, it is recommended, should be required to disclose more meaningful and up-to-date information to the public.

Meaningful disclosures can also advance the role of market discipline in promoting bank capital adequacy. "A New Capital Adequacy Framework: Pillar 3 - Market Discipline" (2000) provides detailed guidance on the relevant disclosures. The six recommendations cover a bank's level and composition of capital as well as a bank's risk profile on both its on- and off-balance sheet activities. Banks are also asked to provide an analysis of factors impacting their capital adequacy position - these include changes in capital structure and, contingency planning in times of stress. Banks are also encouraged to disclose their structure and process of allocating economic capital to their various business activities.

Because credit risk continues to be a major source of banking problems, the world's banking regulators have issued two complementary papers for banks to provide timely and relevant information on their credit risk profiles, so that market participants can assess for themselves where an institution's risks lies and whether its risk management systems are up to scratch. "Sound Practices for Loan Accounting and Disclosure" (1999) recommends that disclosures should be made in line with the materiality concept and on four main areas - accounting policies and practices, credit risk management, credit exposures and credit quality.

Unlike the IAS guidelines, banks are asked to disclose information about loans by major categories of borrowers, geographic information about impaired loans and past due loans, and summary information about troubled loans that have been restructured during the year. The Committee also asks for qualitative disclosures - it recommends that banks explain their accounting policies and the methods they use in determining specific and general allowances. Such information should include the key assumptions used in determining allowances, such as default rates, how they have considered historical default experience for different categories of loans, current conditions, changes in portfolio composition and trends in delinquencies and recoveries.

"Best Practices for Credit Risk Disclosure" (1999) takes an earlier Basle Committee report, "Enhancing Bank Transparency", one step further. The disclosure of credit risk information must satisfy four main criteria: relevant and timely, reliable, comparable and material. So the disclosures in a bank's annual report must be adapted to the size and nature of the bank's operations in accordance with the materiality concept; and thus need not cover all the recommendations contained in the above-mentioned report. The report recommends that banks should not just disclose current credit risk information such as allowances, but should also explain the reasons for changes in the elements and components of such allowances, so that a financial statement reader can understand how changes in risks in the portfolio relate to the allowances established at the end of the period. For instance, it may be appropriate to discuss how changes in estimation methods and assumptions affected allowances; why reallocations of the allowance among different parts of the portfolio or different elements of the allowance occurred; and how actual changes and expected trends in non-performing credit exposures affected the allowances. A total of 24 best practices have been put forth in the consultative paper; comments must be received by the BIS by 30th Nov 1999.

The report also recognises that supervisors need supplementary information, over and above that which is publicly disclosed. Such information may include detailed information on specific borrowers/counterparties included on the bank's " watch" list and detailed information on credit exposures to large borrowers/counterparties or to borrowers in particular sectors of the economy, including borrower identity, type of exposure and amount of exposure.

The Basle Committee and the IOSCO Technical Committees' concerns about supervisors receiving sufficient information on a bank's derivative activities caused them to issue Framework for Supervisory Information about Derivatives Activities of Banks and Securities Firms (1995). The proposed framework consists of two main parts. The first is a "catalogue" of quantitative information needed - on credit risk, liquidity risk, market risk and earnings. On credit risk, the Committee wants information on current and potential credit exposure, credit enhancements, concentration of credit risk and counterparty credit quality. Information which breaks down positions into exchange-traded and over-the-counter products is required for liquidity risk. Also useful is information on broad risk categories and types of instruments and OTC contracts subject to 'triggering agreements' (The latter generally entails contractual provisions requiring the liquidation of the contract or the posting of collateral if certain events, such as a downgrade in credit rating, occur). Market risk data should cover both cash and derivative positions and broken down into major risk classes (and by instrument and maturity if the firm has a huge trading book.) Supervisors also want information on the firm's value-at-risk models as well summary VAR numbers (high/low/average). Earnings should be broken down into trading and non-trading. Information can be decomposed into broad risk categories with larger organisations disaggregating their trading revenue within risk classes into origination revenue, credit spread revenue and other trading revenue. Supervisors would appreciate information on any material build-up of unrealised or deferred losses. The second part consists of a common minimum framework (illustrated in table 1-5 of Annex 3 and drawn from the catalogue of items just mentioned) which the Committee regards as the baseline of disclosure requirements for large and internationally active banks. In 1998, the Basle Committee and IOSCO followed up the 1995 proposal with an expanded framework to more comprehensively address the market risk exposure that arises from trading in both cash and derivative instruments. (The 1995 paper had concentrated on the market risks of derivatives only.) "Framework for Supervisory Information about Derivatives and Trading Activities" (1998) has been designed in such a way as to limit the regulatory burden of financial institutions and to be consistent with BIS risk management standards and capital adequacy requirements.

The framework followed an earlier report by the Euro-currency Standing Committee which looked at the types of information which could contribute to improved disclosure. "Public Disclosure of Market and Credit Risks by Financial Intermediaries (1994)" (also known as the Fisher report) was important because it was the first regulatory document which advocated disclosing market risks and the risk management performances of financial intermediaries. It recognised that without this information, the trading activities of financial institutions continue to be shrouded in opaqueness. This lack of transparency, the Committee felt, could cause a mis-allocation of capital among firms and amplify market disturbances.

In October, 1999, the Basle Committee and IOSCO issued their "Recommendations for Public Disclosure and Derivatives Activities of Banks and Securities Firms." The report supersedes an earlier report issued in November 1995, "Public Disclosure and Derivatives Activities of Banks and Securities Firms." The 1999 document represents the latest regulatory thinking on the public disclosure practices of financial institutions, and thus in essence also supercedes the Fisher report, though that report is officially written by another committee of the Bank for International Settlements. Two main themes dominate the recommendations. Firms are expected to disclose meaningful summary information, both qualitative and quantitative on the market, credit and liquidity risks of their trading, derivatives and non-trading activities. They should also disclose how these activities affect the firm's earnings profile. Secondly, firms must disclose information produced by their internal risk measurement and management systems on their risk exposures and their actual performance in managing these exposures. The committees stress that information disclosed must be both timely and forward-looking since banks and securities houses rapidly change their position and risk profile. The information must be disclosed in accordance with the concept of materiality.

Where the Committees' recommendations break new ground is in the type of qualitative information they expect firms to disclose. In credit risk for example, the committee's expects firms to discuss stress testing and provide information on the type of and assumptions involved in an internal credit risk model, if used. It also expects firms to describe how liquidity risk is considered when determining market values. As regards accounting and valuation methods, firms are expected to discuss methods used to determine the fair value of traded and non-traded derivative instruments as well as the methods used to estimate market value when quoted prices are not available. Some new quantitative information which the Committees want firms to disclose are providing a gap schedule for both trading and non-trading derivatives so that users have a better idea of the firm's liquidity risk and summary information on material gains/losses from broad trading strategies. The Committees also recommend the disclosure of summary VAR or Earnings at Risk (EAR) information and scenario analysis of the impact of rate shocks for non-traded portfolios. Firms are also expected to give information about the effect of off-balance sheet positions on their earnings.

The Basle Committee and the Technical Committee of IOSCO have conducted four surveys on how much financial institutions are disclosing in their annual reports. A total of 67 banks and 11 securities firms have been surveyed. The greatest improvements in disclosure have taken place in market risk. The most commonly provided information was a value-at-risk figure with on the relevant underlying assumptions. Many banks are also disclosing the number of times (days) the actual portfolio loss/gain exceeded VAR. Banks are also disclosing their market risk capital charge now that the Basle Capital Accord requires them to set aside capital to cover market risk. The 1999 survey also found that banks are also disclosing information about their market risk models as well as their methods for managing credit risk. The results also show that banks were best at giving overview information (82%) and worst for earnings information (27%). Full details of the surveys can be seen in "Public Disclosure of the Trading and Derivatives Activities of Banks and Securities Firms" (1995), "Survey of Disclosures about Trading and Derivatives Activities of Banks and Securities Firms" (1996) "Survey of Disclosures about Trading and Derivatives Activities of Banks and Securities Firms" (1997) and "Trading and Derivatives Disclosures of Banks and Securities Firms (1998)", "Trading and Derivatives Disclosures of Banks and Securities Firms(1999)".

A private initiative to develop meaningful disclosure standards for securities firms was undertaken by the Derivatives Policy Group, which comprises representatives of the largest securities houses in the United States. Their document, A Framework for Voluntary Oversight (1995) proposes an enhanced reporting framework for credit risk which is based on processes actually used by credit risk managers. It hopes that its disclosure format will provide credit agencies with timely and useful information in order to facilitate the monitoring of risk to individual firms and to the financial system in general.

The disclosed information falls into two main categories: credit concentration and portfolio credit quality. Financial intermediaries should report the top 20 current net exposures on a counterparty-by-counterparty basis, segmented by industry. Each of these exposures should also be accompanied by information on net replacement value, gross replacement value and potential additional credit exposure. There is also a 'Comments' section where additional information (for example details on credit enhancements, offsetting exposures in affiliated entities) judged to be important by the individual firms may be provided.

Information regarding the net exposure, the aggregate net replacement value and the gross replacement value for counterparties in the portfolio and the 10 largest geographic exposures would be provided in a credit portfolio report. Firms will use their own internal credit ratings in these reports.

Firms will also disclose monthly net revenue data for OTC derivatives and related activities in one of two ways: (1) by generic product type along the following four categories: interest rate, currency, equity and commodity; or (ii) by business unit categories incorporating one or more of these product types.

Better and more comparable disclosure of all the activities of a bank is enshrined in Principle 21 in the Basle Committee's "Core Principles for Effective Banking Supervision (1997)". Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of the financial condition and profitability of the bank. For the accounts to portray a true and fair view, it is essential that assets are recorded at values that are realistic and consistent, taking account of current values, where relevant, and that profit reflects what, on a net basis, is likely to be received and takes into account likely transfers to loan loss reserves.

In 1998, the Basle Committee issued "Enhancing Bank Transparency", which elaborates on Principle 21, because they recognised that markets contain disciplinary mechanisms that, under appropriate conditions, reinforce supervisory efforts by rewarding banks that manage risk effectively and penalising those who do not. But market discipline can only work if participants have access to timely, reliable, relevant and comparable information that enables them to assess a bank's activities and the risks inherent in those activities. The paper identifies six broad categories of information, and the types of useful information in each category:

  • Financial performance
  • Financial position (including capital, solvency and liquidity)
  • Risk management strategies and practices
  • Risk exposures (credit risk, market risk, liquidity risk, operational risk, legal risk and others)
  • Accounting policies
  • Basic business, management and corporate governance information.

Section 3 of the paper elaborates on the role of supervisors in improving transparency. Promoting comparability is one area well-suited to supervisors - by encouraging the use of supervisory definitions and reporting classifications in public disclosure, they facilitate comparability across jurisdictions and borders. For instance, banks can use the 1998 supervisory information framework on cash and derivatives trading (mentioned above) as a baseline for the types of information they could disclose publicly. Supervisory guidance could also facilitate industry agreement on harmonised disclosure standards and practices by alleviating co-ordination problems that banks face when they try to agree privately..

The G-30 believes that a framework to ensure consistent and meaningful disclosure of financial and risk information on a global, consolidated basis is one way of reducing systemic risk. In "Global Institutions, National Supervision and Systemic Risk" (1997), the G-30 suggests disclosed information to include business objectives, risk appetite, approach to risk management and actual risk-earnings performance. It argues, "An agreed approach for all core institutions would overcome the reluctance of individual firms to publish information about their inner workings that is not matched by other firms. Expanded information is needed so that counterparties can make sound judgements about the risks they are taking, but this is not only a concern in the case of financial transactions among core institutions. Other creditor and liability-holders must be in a position to make judgements about the creditworthiness of financial institutions if market discipline is to function effectively."

The G-30 believes that audit firms have a key role in developing such a framework. It calls on auditors to work with global firms, audit-standards bodies and supervisors to achieve an agreed upon approach to financial-statement audits and other information portraying risk.

The same report recommends that global institutions subject their worldwide operations to expanded review by a single, independent, external audit firm or firm group which acts as the principal auditor. It believes that such a course of action is required because "an annual audit's utility is reduced if it consists of a compendium of subsidiary audits by different firms, operating under a variety of audit and accounting standards and reported in a variety of formats." The expanded review should go beyond traditional reviews of a firm's financial statements. It should assess whether the risk control policies and procedures agreed upon by senior management are indeed implemented.

Discussions about ideal disclosure practices have concentrated, so far, on what private financial institutions should be encouraged to do. However, in September 1998, the Euro-Currency Standing Committee of the central banks of the G-10 countries, broke with tradition and issued a paper on the disclosure practices of central banks. The Asian crisis highlighted deficiencies in the availability of information relating to the on- and off-balance sheet foreign currency activities of central banks and other public sector entities. "Enhancing Transparency regarding the Authorities’ Foreign Currency Liquidity Position" (1998) attempts to address these shortcomings.

The working group of the Euro-Currency Standing Committee was asked to identify the statistical information that would enable markets to better assess the authorities’ foreign currency liquidity position. This position comprises the foreign exchange resources at the disposal of the authorities that are easily mobilisable in times of need and the potential drain on these resources associated with dealing with currency crises. The group identified that central banks should disclose their foreign currency reserves, IMF reserve positions, SDRs, and gold (valued according to disclosed conventions) as well as the components of the short-term drains on foreign currency reserves such as short-term loans, contingent liabilities, and aggregate short and long positions in the forwards, futures and options markets in foreign currencies. The first category of information should be disclosed at approximate market value while the second group should be disclosed at nominal value. This information should be disclosed on a one-month frequency with a disclosure lag not exceeding one month, to be implemented on or before end-June 1999.

But the report also acknowledged that were some specific presentational issues concerning the best way of applying the proposed valuation principles to derivative instruments and the relationship between the items singled out for disclosure and those currently identified in international balance-of-payments guidelines which needed to be clarified. The ECSC asked some technical experts to review the situation. Their proposals, released in December 1998 are:

  • To group (net) drains (inflows and outflows, shown separately, as before) into two broad categories, namely predetermined and contingent flows.
  • To make it clear that only instruments settled in foreign currency should be included in categories I to III, whereas instruments denominated in foreign currency or involving foreign currency in their denomination, but settled in domestic currency, should be reported in category IV
  • To treat options similarly to forwards and futures and to emphasise the distinction between short and long positions in the presentation of the information
  • To disclose the notional value of the overall short and long position and the notional value of the in-the-money options, in both cases for three time horizons: one month, three months and one year. A sensitivity analysis of these options under several exchange rate scenarios should be conducted.

Latest Update for May 2000

Key Risk Concepts * Risk Mitigation