4.a Recommendation
4.1 All financial intermediaries, regulated and unregulated, should move in the direction of publicly disclosing periodic quantitative information which expresses, in summary form, the estimates relied upon by firm management of:
- the counterparty credit risks arising from its trading and risk management activities, including current credit exposure, potential future credit exposure, and counterparty creditworthiness, in a form which permits evaluation of the firm's performance in managing these credit risks.
4.2 Disclosures of credit risk arising from trading and risk management activity should provide information about all aspects of credit risk: current exposures, potential future exposures, and probabilities of default. As with market risk, these disclosures should be based upon the methodologies firms use internally for assessing their risks. The sophistication with which firms currently measure such risks varies. However, this recommendation encourages firms to refine these methodologies and develop techniques that most meaningfully convey information about their risks. When appropriate, elements of these disclosures could be based on the methodology used by the relevant supervisors. For example, the Basle Committee's Capital Accord includes a framework for measuring the credit exposure associated with certain off-balance sheet items for capital adequacy purposes.
4.3 Credit risk arises from the possibility that a firm will experience a loss when a counterparty defaults. The magnitude of the credit risk depends on the likelihood of default by the counterparty; on the potential value of the contracts with the counterparty at the time of default; and on the extent to which legally enforceable netting arrangements allow the value of offsetting contracts with that counterparty to be netted against each other, or collateral held against the contracts reduces credit exposure.
4.4 Measurement of credit risk is complicated by the fact that both credit exposures and the likelihood of default can vary over time and may be interdependent. The creditworthiness of counterparties shifts, as reflected in credit rating upgrades and downgrades. Counterparties that originally are highly rated are more likely to default later in a contract's life than earlier, while counterparties that originally are speculative grade are more likely to default earlier. Credit exposures in derivative contracts and structured products also vary as underlying prices (interest rates and exchange rates) on which contracts are based move, and can change dramatically over the life of the contract. This potential increase in credit exposure due to changes in underlying prices is called potential future credit exposure.
4.5 To date, most disclosures of credit risk in trading and risk management activity focus solely on current exposure. This exposure is measured as the current mark-to-market value (replacement cost) of the contracts with a counterparty after bilateral netting, if positive. While current exposure is undeniably an important component of credit risk, both the variability of exposure through time and the likelihood of default are also critical. Because both counterparties' creditworthiness and credit exposures are determined by variables that change over the business cycle, credit risk measurement is a complicated statistical problem.
4.6 Several initiatives by market participants to improve disclosure of credit risks in trading and risk management activity have recently been undertaken. These initiatives are based on the progress market participants have made in this aspect of risk management, and reflect as well their own concern to improve transparency. In recognition of that progress, the recommendation articulated in this report has features in common with these initiatives. The recommendation is complementary to these initiatives, and seeks to encourage market participants to broaden credit risk disclosures to encompass information about probabilities of default and potential future exposures as well. In the latter regard, in July 1994 the Basle Committee published a proposed amendment to the Capital Accord which would refine the calculation of capital charges associated with potential future credit exposures of certain off-balance sheet contracts.
4.7 A key feature of the recommendation is its focus on risk rather than exposures alone. A few firms have begun experimenting with disclosures that address risk. Some firms provide a breakdown of exposures by type of counterparty -- bank or non-bank -for example, but such data do not offer a very precise picture of the likelihood of default. A few firms have gone further, breaking down current exposures by the internal credit rating assigned to counterparties. The latter information allows more meaningful assessment of the probability of default. However, little if any quantitative information is currently being disclosed about potential future exposures. Practices consistent with this recommendation will require firms to refine their methodologies for measuring credit risk. Ultimately, the goal should be disclosures which integrate current and potential credit exposures with the estimated probabilities of default.
4.8 Firms should disclose information that allows readers of financial reports to assess how successfully the firms have managed credit risk. Information on the variability of exposures over the reporting period could be illustrative. Credit losses will not always correspond to ex ante credit riskiness due to the active management of credit exposures. For example, use of collateral, close-out provisions and other forms of credit enhancement will influence actual credit loss experience. Hence, some information about such credit risk management could be disclosed. Credit losses in trading activities could be placed in the context of the scope of that activity and the capital being used to support it.
4.9 Examples of credit risk disclosures are provided in the Appendix.