2.2 The use of derivative instruments has added diversity and complexity to firms' financial assets, liabilities and off-balance-sheet commitments. This has rendered the assessment of their risk exposures more difficult. At the same time, derivative instruments have provided firms with new opportunities to assess, price and manage increasingly refined elements of financial risk. The development of methodologies for assessing the riskiness of portfolios or trading positions has increased firms' ability to assess and understand their overall risk exposures.

2.3 However, the evolution of trading and financial risk management practices in recent years has moved well ahead of the public disclosure of financial information made by most financial firms. As a result, a gap exists between the precision with which a firm's management can assess and adjust the firm's own risk exposures, and the information available to outsiders to help them assess the riskiness of that firm's activities. Indeed, market participants are increasingly aware of the contrast between their increased ability to assess and manage their own financial risks and their relative inability to assess the riskiness of other market participants on the same terms.

2.4 The lack of transparency of financial intermediaries' trading and risk management activities can cause a mix-allocation of capital among firms and can also amplify market disturbances. When the riskiness of firms' activities are not apparent to outsiders, the market allocation of capital to such firms is unlikely to reflect their actual risk-return prospects. During episodes of market stress, a lack of information about a firm's market and credit risk exposures can create an environment in which rumours alone can cause a firm's creditors and counterparties to reduce their dealings with the firm solely to avoid uncertainty. This may impair the firm’s market access and funding at the very time that these may be critical to the firm's survival. Moreover, problems encountered by one firm may cause funding or market access difficulties at other firms which, because of a lack of transparency, appear similar to outsiders. As counterparties withdraw from new transactions, market liquidity for some instruments may decline.

2.5 The problems caused by a lack of transparency affect all financial intermediaries and financial market participants. In order to address these problems, major market participants need to disclose more meaningful information about their risk exposures and risk management performance. While some firms' disclosures in these areas have improved in recent years, such improvements have been isolated and have lacked a framework that allows outsiders to assess firms' ability to manage the risk embedded in their portfolios.

2.6 It is important to recognize that current national accounting conventions do not provide a sufficient means of representing the risk exposures that are measured and managed by increasingly common risk management concepts such as value-at-risk and stress tests. Disclosure of information based on such concepts would be complementary to, but not a substitute for, continued efforts by the accounting profession to improve the accuracy of information contained in balance sheets and income statements.

2.7 Some regard it as desirable for accounting conventions to include or reflect risk management concepts so that firms' financial disclosures could provide a single consistent statement of income. Others, however, believe that any additional disclosure of risk management information should be kept entirely distinct from accounting conventions, which are seen as appropriately serving the limited purpose of providing a snap shot of firms' assets and liabilities as well as rules for the recognition of income. These differences reflect the continuous and healthy debate over appropriate accounting practices and differences in existing national accounting rules.

2.8 Despite the continued lack of harmony in national accounting practices, accounting principles should not hinder meaningful disclosure of firms' risk management activities. There is growing convergence among the major financial intermediaries in the basic analytic tools used for internal risk management. These can, in turn, be used as the starting point for providing improved disclosure about firms' performance in managing their risk.

2.9 In developing an approach for improved disclosure of risk management information, an effort should be made to assess the effectiveness of any proposal against potential costs. First, disclosure should be meaningful in the sense of expressing how a particular firm does, in fact, assess and manage risk. Second, it should be understandable by providing an adequate context or paradigm for relating details to the overall concepts. Third, it should preserve proprietary information of the firm, so that a firm would not need to reveal specific market opportunities (and risks). Fourth, it should not be burdensome, in that the cost of producing the information should not exceed the total benefits disclosure would bring to the firm, its shareholders and the market. Fifth, it should be comparable so that it can provide a basis for comparisons among firms. Sixth, it should be verifiable in the sense of being independently auditable. And finally, the approach should be flexible so that it does not stifle the further development of risk management concepts and disclosure practices.

2.10 In practice, there are obvious trade-offs and tensions among these criteria. For example, a disclosure regime that is sufficiently flexible to accommodate changing trading and risk management practices, and which encourages firms to provide the information they consider most meaningful and informative about their own risk management activities, may reduce the degree of comparability of disclosures across firms and over time. However, the gain in transparency and meaningfulness of disclosures made by individual firms about their risk exposures and risk management capacity would appear to make such an approach a reasonable starting point. Moreover, while the existence of these trade-offs has contributed to the difficulty of achieving consensus on public disclosure, a very large obstacle has been the reluctance of individual firms to forge ahead unilaterally.

2.11 In an environment of limited transparency, a firm that reveals more information about its risks than others may have reason to fear that outsiders perceive its risk to be greater than those of firms who conform to the status quo in disclosure. Given the general paucity of risk-related disclosures, a firm whose overall risks are low could still encounter difficulty convincing investors that its risks are lower than those of firms that do not make such disclosures.

2.12 However, a firm's ability to measure and control increasingly complex risks is of significant importance in determining the firm’s performance and standing in the market place. Hence, it is in the firm’s self-interest to communicate its risk management capabilities to the market place. A shift in the focus of disclosures from the language of traditional accounting conventions to the firm's own assessment of risks and its performance in managing those risks could make it easier for each firm to communicate its risk management performance to outsiders and should reduce the likelihood that such disclosures will be misconstrued by outsiders.

2.13 While it is desirable for firms to have the flexibility to disclose quantitative information which they consider meaningful, the information thus disclosed also needs to be capable of receiving or being subject to an objective, external check. This points to the need for the auditing profession to be closely involved in the public debate on disclosure because they will have an important role to play in ensuring that information disclosed about firms' risks represents an accurate statement both of the estimates of risk themselves and of the actual outcomes against which the estimates are assessed.

2.14 If firms with superior risk management systems begin to disclose information adapted from these systems, this approach could initiate a dynamic competitive process leading to enhanced disclosure practices and greater market transparency. In turn, the information revealed would allow outsiders to make informed judgments about the adequacy of the firm's capital in relation to its risk exposures and risk management capability. Firms that adopt such improved disclosures and are able to demonstrate that they take less risk - or manage risks better - than they are perceived to will be deemed more creditworthy than they otherwise would be. Such a process could also strengthen market discipline because firm management will correct and adjust their risk management strategy in anticipation of possible responses to their disclosures by market participants.