For a number of years now, the trading (on-balance-sheet instruments and off-balance-sheet derivatives) and non-trading derivatives activities² of large G-10 banks and securities firms have generally grown more rapidly than their traditional activities. For many of these institutions, notional amounts of off-balance-sheet derivatives transactions (indicative of overall activity in this area) now often exceed on-balance-sheet positions by a multiple. Even when measured in terms of credit-equivalent amounts, for many large institutions, derivatives activities are significant in relation to traditional on-balance-sheet positions. In addition, trading activities, involving both derivatives and on-balance-sheet instruments, have grown rapidly over recent years and, for many large dealer banks and securities firms, contribute significantly to total earnings.

While trading and derivatives activities generally involve types of risks that are similar to those associated with more traditional activities of banks and securities firms, the rapid growth and complexity of these activities pose new challenges for these institutions and their supervisors. Supervisors have increasingly endeavoured to develop supervisory tools that draw on the sophisticated systems that institutions have developed for internal risk measurement and management purposes. The responsibility for risk management and control continues to lie first with institutions themselves, with supervisors setting minimum standards, combined with positive incentives, to ensure the prudent measurement and management of risks by banking organisations and securities firms. For example, under the Basle Committee's market risk proposals released for industry comment in April 1995, banks would have the possibility of using their internal risk measurement models as a basis for determining their market risk capital requirements, subject to a series of minimum quantitative and qualitative standards.

The objectives of supervision can be reinforced through the public disclosure of information about how a bank or securities firm's trading and derivatives activities contribute to its overall risk profile and profitability and how well it manages the risks arising from these activities. Meaningful³ and accurate information reported in a timely manner provides an important foundation for the decisions of market participants. Well-informed investors, depositors, customers, creditors and counterparties can impose strong market discipline on an institution to manage its activities in a manner that is both prudent and consistent with its stated business objectives. Strong internal risk management and controls by banks and securities firms, reinforced through prudential supervision and enhanced public disclosure practices provide a sound framework for fostering market stability in an environment of rapid financial innovation and increasing complexity.

Banks, securities firms and other financial market participants should themselves be interested in enhanced and more meaningful disclosures of their trading and derivatives activities. Such disclosures can provide an institution with a clearer picture of the risk profile of its counterparties, thus enabling it to better manage its risks and to arrive at more informed business decisions. Moreover, an institution that provides little information about its risk profile may be susceptible to market rumours and misunderstandings by market participants in times of stress, which could possibly result in loss of business with counterparties, a higher cost of capital and funding difficulties. ⁴

It is important that the disclosure practices of banks and securities firms reflect and keep pace with the growth and innovation of their trading and derivatives activities and the internal systems used to manage these activities. Ideally, public disclosures should be consistent with approaches that institutions use internally to measure and manage risk, thus capturing enhancements in risk management practices over time. Drawing on information already produced internally for risk management purposes should also reduce costs and the burden of enhanced public disclosures.

As a guiding principle, public disclosures should focus on key information about an institution's material trading and derivatives activities. The Basle Committee and the Technical Committee of IOSCO (IOSCO) recognise that even among large, internationally active banks and securities firms, there are differences in the scope and nature of institutions' trading and derivatives activities. For example, some institutions are wholesale market makers in a range of cash and derivative instruments, while others primarily use derivatives for their own risk management purposes. The extent of information disclosed about trading and derivatives activities should stand in proportion to the importance of these activities to the institution's overall business, earnings and risk profile. Moreover, as a general principle, institutions should balance quantity, quality and usefulness of the information disclosed.

The Committees note that while the focus of this report is on trading and derivatives disclosures, this should not detract from the importance of continued assessments by banks and securities firms of the adequacy of their public disclosures in other important areas, such as investment, funding and, in the case of banks, lending activities and the impact of these activities on earnings. However, because of the rapid growth and complexity of institutions' trading and derivatives activities and the speed with which exposures and earnings from such activities can change, the Committees chose to concentrate first on this area of disclosure.

In this context, the remainder of this paper surveys large, internationally active banks' and securities firms' disclosures about their trading and derivatives activities in 1994 annual reports and the progress made since 1993 and it makes recommendations for further improvements in disclosure practices. These recommendations draw on the concepts developed in the Discussion Paper on Public Disclosure of Market and Credit Risks by Financial Intermediaries (the Fisher report), released by the Euro-currency Standing Committee of the G-10 central banks in September 1994 and on the Framework for Supervisory Information about the Derivatives Activities of Banks and Securities Firms (the Supervisory Information Framework), released jointly by the Basle Committee and IOSCO in May 1995. While the emphasis of this report is on large banks and securities firms, the concepts and recommendations also apply to other financial and non-financial institutions with significant trading or derivatives activities.

The Committees note that improvements in disclosure practices should not substitute for domestic and international efforts to develop sound accounting standards (including appropriate standards for measurement) for trading and derivatives activities. Like disclosure requirements, improved accounting standards are a necessary step to efficient market discipline and supervision. Accounting standards provide the foundation for credible and comparable financial statements and other financial reports. Fundamentally, such standards should define how the trading and derivatives instruments of banks and securities firms are valued and how they affect assets, liabilities and equity reported on the balance sheet and reported profits and losses. Thus, it is particularly important that accounting standard-setting organisations, industry groups and regulators continue to press for enhancements and, to the extent possible, future harmonisation of accounting standards for the trading and derivatives activities of internationally active banks and securities firms, as well as other financial and non-financial firms. However, the lack of harmony in accounting standards should not hinder meaningful disclosure of institutions' risk management activities, because such disclosure conveys information that current national accounting conventions may not necessarily provide.

As a cautionary note, the survey data and the recommendations contained in this document relate to banks' and securities firms' trading and derivatives activities mainly on a group-wide, consolidated basis. While disclosure on a consolidated basis is, in many cases, essential to gain an understanding of the overall trading and derivatives activities of a bank or securities firm, for the purposes of evaluating an institution's credit risk or other aspects of a counterparty's risk profile, it may also be necessary to consider the financial condition of individual subsidiaries and affiliates within the consolidated group.

Footnotes:

2. From now on referred to as "trading and derivatives" activities. A more detailed definition of what is meant by trading and non-trading activities is given in Annex 4 of the previous paper in this Compendium.

3. The term "meaningful" is used in relation to "information" and "disclosure" as indicative of their usefulness and sufficiency for the users and readers of financial statements who might need to make decisions on the information.

4. The Committees recognise that institutions' trading and derivatives positions may change significantly over time and that annual report disclosures can only provide a picture of a firm's past performance in managing its risk exposures. However, such disclosures provide an important context for evaluating how well a firm is able to manage its current trading and derivatives activities.