59. Accounting standards and valuation techniques differ from country to country and many member supervisors have little or no legal authority in this area. The Committees therefore recognise that earnings information identified under this framework may not be fully comparable across member countries.

(a) Trading purposes

60. Many sophisticated market participants view cash and derivative instruments as ready substitutes; their use of derivatives is complementary to cash instruments and positions in financial instruments are often managed as a whole. For supervisors to consider information that concentrates solely on derivatives and to omit similar data on cash instruments could be misleading. In this context, the decomposition of trading revenues (from cash and derivative instruments) according to broad risk classes - interest rate risk, foreign exchange risk, commodities and equities exposures, or other risks to the firm - without regard to the type of instrument that produced the trading income, may better describe the outcome of overall risk-taking by the organisation.

61. The systems of some banks or securities firms may not decompose trading revenues by broad categories of risk. Under these circumstances, simplifying assumptions can be used to approximate this categorisation of income. For example, if a particular department of an institution typically handles domestic bonds and related derivatives, it may be appropriate to consider trading gains and losses on these instruments as interest related income. Further, the income from complex instruments that are exposed to both foreign exchange and interest rate risk could be classified according to the primary attribute of the instrument (e.g., either as a foreign currency or an interest rate instrument).

62. Finer disaggregation of trading revenue within risk categories, for example, by origination revenue, credit spread revenue and other trading revenue could be useful in evaluating an organisation's performance relative to its risk profile ¹⁹. However, even those dealers with sophisticated information systems may not now be able to differentiate income beyond broad risk categories. As the analytical abilities and systems of market participants evolve, it may be desirable to consider supervisory information that differentiates between revenue earned from meeting customer needs and that earned from other sources. Furthermore, as market participants' systems evolve, it may be desirable for supervisors to evaluate information that differentiates between trading revenue earned from cash and derivatives positions in each broad risk category. As with cash instruments, a rapid build-up of material trading losses on derivative instruments may indicate deficiency in an institution's risk management systems and other internal controls that it should promptly evaluate and correct.

(b) Purposes other than trading

63. Information about derivatives held for purposes other than trading (end-user derivatives holdings) can also be useful to supervisors. For example, quantitative information that includes the effect on reported earnings of off-balance-sheet positions held by the organisation to manage interest rate and other risks would be useful. When combined with information on other factors affecting net interest margins and interest rate sensitivity, this could provide insight into whether derivatives were being used to reduce interest rate risk or to take positions inconsistent with this objective.

(c) Identifying unrealised or deferred losses

64. As with cash instruments, any material build-up of unrealised losses or losses that have been realised but deferred by the institution may be an area of supervisory interest. At a minimum, the detection of such losses, and particularly, an accumulation of such losses, should prompt supervisory inquiry. Derivative contracts with unrealised losses or deferred losses may reduce future earnings and capital positions when these losses are reflected in profits and losses for accounting purposes. Therefore, when unrealised losses or deferred amounts are material, it is important for supervisors to consider an institution's plans for reflecting these losses in their reported profits and losses for accounting purposes. Moreover, a rapid build-up of material unrealised or deferred losses may indicate a deficiency in an institution's internal controls and accounting systems that it should promptly evaluate or correct.

(d) Derivatives valuation reserves and actual credit losses

65. Supervisors should assess information on the valuation reserves that an institution has established for its derivatives activities and on any credit losses on derivative instruments that the institution has experienced during the period. In assessing these valuation reserves and any credit losses, it is important to understand the institution's risk management policies and valuation practices regarding derivatives. In addition, supervisors should determine how the institution reflected valuation reserves and credit losses in its balance sheet and income statement. Information on valuation reserves and the treatment of credit losses is useful in understanding how adverse changes in derivatives risks can affect an institution's financial condition and earnings.

Footnote(s):

19. As industry participants have recognised, trading revenue components may include: (1) origination revenue that results from the initial calculation of the market value of new transactions; (2) credit spread revenue that results from changes during the period in the unearned credit spread; and (3) other trading revenues resulting from changes in the value of the portfolio due to market movements and the passage of time.