The Basle Committee and IOSCO encourage banks and securities firms to continue their efforts to improve disclosure practices by providing meaningful summary information, both qualitative and quantitative, about their trading and derivatives activities. Disclosures should provide a picture of the scope and nature of an institution's trading and derivatives activities, as well as information on the major risks associated with these activities, including credit risk, market risk and liquidity risk. Institutions should also disclose information on the actual performance in managing these risks, particularly with regard to exposure to market risk. ⁶ In addition, disclosures should provide meaningful, summary information on how trading and derivatives activities contribute to an institution's earnings profile.

As discussed in the Fisher report, institutions are encouraged to disclose quantitative information on their risk exposures and on their performance in managing these exposures in a manner that is consistent with the methodologies employed in their internal risk measurement and performance assessment systems. This should help ensure that disclosure practices keep pace with innovations in risk management practices over time, particularly in areas undergoing rapid evolution such as market risk, where an increasing number of institutions are introducing or developing further their value-at-risk methodologies. Disclosures should focus on material risk exposures and the amount of information should stand in relation to the importance of the activity in the institution's overall business, risk profile and earnings.

For fundamental disclosures of an institution's derivatives activities (trading and non-trading, including related on-balance-sheet positions), institutions are also encouraged to look to the common minimum framework that is presented in the Supervisory Information Framework. The common minimum framework calls for information on an institution's overall derivatives market activity and exposure to credit and, to a certain extent, market liquidity risks. The minimum framework can serve as a reference point for institutions that currently provide little or no quantitative information on their derivatives activities. Furthermore, disclosure of information that is consistent with the common minimum framework could improve the consistency and comparability of basic annual report disclosures.

The remainder of this section discusses these various points in greater detail, focusing first on qualitative disclosures and then discussing quantitative disclosures.

(A) Qualitative disclosures

Qualitative disclosures should provide an overview of an institution's overall business objectives, its risk-taking philosophy, how trading and derivatives activities fit into these overall objectives, as well as the principal internal control procedures that are in place for managing these activities. In addition, qualitative disclosures provide management with the opportunity to elaborate on and provide depth to the quantitative disclosures provided in the annual report.

More specifically, banks and securities firms are encouraged to consider the following types of summary qualitative information about their trading and derivatives activities:

Risks and management controls

• An overview of key aspects of the organisational structure central to the institution's risk management and control process for its trading and derivatives activities.

• A description of each of the major risks arising from an institution's trading and derivatives activities (including credit risk, market risk, liquidity risk, operational and legal risk) and the methods used to measure and manage these risks (for example limit policies for exposures to market risk and credit risk and how value-at-risk measures are used to manage market risks). In addition, a discussion of how the institution assesses its performance in managing these various risks.

• Information about the overall objectives and strategies of trading activities (involving all on- and off-balance-sheet components) and whether the institution is a wholesale market maker, engages in proprietary trading, or takes positions as an accommodation to customers.

• In the case of non-trading derivatives activities, a description of the general objectives for these activities. For example, in the case of banks, such disclosures could clarify how these instruments are being used to hedge risks inherent in banking activities such as foreign exchange or interest rate risk, or, where relevant, if they are being used for other risk management activities.

• A summary of activity in and the risks associated with high risk instruments or complex instruments such as leveraged derivatives.

• A discussion of the accounting policies and methods of income recognition that apply to trading activities (involving both cash instruments and derivatives) and to non-trading derivatives activities. Disclosures about accounting policies should be sufficient to enable the user of financial statements to understand important distinctions that may exist in the accounting treatments of various types or uses of derivatives instruments. In the absence of clear accounting standards for many types of derivatives activities, it is particularly important that an institution discuss the accounting treatments applied to its various derivatives holdings. For example, it would be useful to summarise the methods used to account for derivatives, the types of derivatives accounted for under each method and the criteria to be met for each accounting method to be used (e.g. criteria for recognising hedges). Furthermore, institutions are encouraged to specify the accounting treatment applied if the criteria for a given method are not met. Other important types of information include the accounting treatments for terminations of derivatives contracts, derivatives that are hedges of anticipated transactions, balance sheet netting of assets and liabilities arising from derivatives and credit losses on derivatives instruments.

• A general discussion of the valuation methodologies used, as well as information on whether adjustments are made after positions have been marked to market. In the case of instrument categories for which there are no quoted market prices, a general discussion of the market value estimation techniques used and a summary of the procedures for checking the accuracy of these estimates.

For background on the types of qualitative information about derivatives and related activities that may be appropriate for disclosure purposes, banks are encouraged to consider the report, Risk Management Guidelines for Derivatives and securities firms the report, Operational and Financial Risk Management Control Mechanisms for Over-the-Counter Derivatives Activities of Regulated Securities Firms. These reports were issued, respectively, by the Basle Committee and IOSCO with a joint cover note in July 1994 and they highlight key attributes of the risk management systems of banks and securities firms.

(B) Quantitative disclosures

1. Market activity, credit risk and market liquidity

With regard to derivatives activities (trading and non-trading), institutions should provide financial statement users with a clear picture of their involvement in the derivatives markets, both OTC and exchange-traded. Institutions could draw from the common minimum framework of the Supervisory Information Framework for guidance about basic disclosures of their derivatives activities and how these activities affect the overall risk profile of the institution. Where appropriate, institutions are encouraged to place information on derivatives in the context of related on-balance-sheet positions.

The common minimum framework is presented in detail in Section III and Annex 3 of the Supervisory Information Framework. It focuses primarily on meaningful summary information relating to overall market activity, credit risk and, to a certain extent, market liquidity. Information on market activity is provided by broad risk category (interest rate, exchange rate, precious metals, other commodities and equities), by broad instrument category (futures, forwards, swaps and options) and by maturity band (one year or less, over one year to five years, greater than five years). The minimum framework provides insight into whether derivatives are used primarily for trading or non-trading purposes (e.g. hedging) and whether an institution is primarily involved in exchange-traded or OTC derivatives activities. The framework also includes a variety of information on credit risk, taking into account counterparty credit quality as well as the availability of collateral and guarantees. Finally, the framework provides information on non-performing derivatives contracts and actual credit losses on these instruments.

Annex 4 of the Supervisory Information Framework presents definitions for the concepts used in the common minimum framework. For institutions that base their disclosures on the type of information contained in the common minimum framework, Annex 4 provides a basis for greater clarity and comparability of these disclosures. For example, for basic disclosures of information such as replacement cost, it should be clear to the financial statement user whether or not this information takes account of legally enforceable bilateral netting agreements.

Institutions that have developed alternative, more sophisticated internal methodologies for the type of information contained in the common minimum framework could base their public disclosures on these methods. For example, some institutions have developed simulation models for measuring potential credit exposure, which may produce more precise estimates of exposure than the add-ons approach of the Basle Capital Accord included in the common minimum framework. Furthermore, where material, institutions are encouraged to consider disclosing additional summary information about credit and liquidity risks (such as information on credit concentrations and funding risk). The "catalogue" section of the Supervisory Information Framework, issued in May 1995 and the risk management guidelines released by the Basle Committee and IOSCO in July 1994 discuss meaningful information that could be presented in annual report disclosures.

2. Market risk

Given the diversity and rapid evolution of measurement and risk management techniques in the area of market risk, it does not now seem desirable to recommend a uniform approach for market risk disclosures. Instead and as argued in the Fisher report, institutions should provide summary quantitative information on their exposure to market risk based on the methods they use for internal risk measurement purposes, together with information on their actual performance in managing these risks. The guidelines for managing the risks of derivatives, released by the two Committees in July 1994, stressed that dealer banks and securities firms should produce daily information on profits and losses on their trading activities for internal risk management purposes. Institutions are encouraged to draw from this internally-generated information for public disclosure purposes. Moreover, daily profit and loss disclosures should be combined with the corresponding daily value-at-risk numbers. The Fisher report provides a detailed discussion, including a series of illustrative examples, on how institutions could disclose such quantitative, performance-based information on market risks.

Quantitative disclosures should be supplemented with information on the major assumptions and parameters necessary to understanding an institution's market risk disclosures. For example, in the case of market risk disclosures based on value-at-risk measures, institutions could specify the type of model used (variance/covariance, historical simulation, etc.), the portfolios covered by the model, as well as information on the model's parameters such as the holding period, confidence level and the observation period.

3. Earnings

Institutions are encouraged to disclose information on how trading activities (derivatives and cash positions) affect earnings, as well as information on the earnings impact of non-trading derivatives activities. As with market risk information, the Committees encourage institutions to base these disclosures on their internal measurement and accounting systems. The Committees recognise that accounting standards and valuation techniques differ across member countries and that earnings disclosures are therefore not directly comparable at the international level. This makes it all the more important for institutions to provide additional qualitative information explaining the accounting and valuation techniques used in the financial statements (see qualitative section above).

For additional guidance on the type of earnings information that institutions could disclose, the Committees recommend that institutions refer to the "catalogue" section of the Supervisory Information Framework, which includes discussion of the following types of information:

• Revenues from trading activities: a summary of trading revenues, for cash and derivatives instruments combined, broken down by major risk category (interest rate, foreign exchange, equities, commodities and other). Alternatively, institutions could provide a breakdown by major product trading desk (i.e. bonds, swaps, foreign exchange, equities, etc.).

• Non-trading derivatives holdings: quantitative information about the effect on earnings of off-balance-sheet positions held by the organisation to manage interest rate risk, currency risk and other risks. This information provides insight into how derivatives are being used to manage non-trading risks (for example, exposure to interest rate risk) and the degree to which these efforts have been successful.

• Unrealised or deferred losses: for derivatives that are accounted for on a historical cost basis, summary information on the notional amounts, market values and unrealised losses on these instruments. In addition, information on the amount of realised losses on derivatives positions that have been deferred and the timing of their future recognition in the profit and loss account. This information provides insight into how future earnings and capital may be affected by losses that have not yet been realised, or that have been deferred.

• Derivatives valuation reserves and actual credit losses: information on the valuation reserves that an institution has established for derivatives activities, together with information on any material credit losses on derivatives instruments experienced during the period covered by the financial disclosures.

Footnote:

6. To date, statistical approaches for measuring performance in managing credit risk have not been developed as extensively in banks and securities firms as have market risk performance measures. Therefore, measuring an institution's performance in managing credit risk is generally more difficult than for market risk at this time. As these statistical techniques are developed further and become established, institutions should disclose summary information consistent with these performance measurement techniques.