1. As part of its on-going efforts to address international bank supervisory issues, the Basle Committee on Banking Supervision is currently engaged in several activities to strengthen the prudential supervision of banks' derivatives operations. One of these activities has been a reassessment of the key elements of sound management of the risks involved in derivatives. In 1986, the Committee issued a document entitled "The management of banks' off balance sheet exposures: a supervisory perspective", and it has continued to consider the issues raised in that document. As a result, the Committee is now issuing the attached paper providing guidance on sound risk management of derivatives activities for use by supervisory authorities and banking organisations. In developing these guidelines, the Committee has drawn upon those established in member countries of the Committee and upon recommendations made by the financial industry.
2. The Basle Committee is distributing these guidelines to supervisors worldwide with the expectation that they will facilitate the further development of a prudent supervisory approach to the risk management of derivatives. Supervisors may wish to circulate the guidelines to the institutions under their jurisdiction, either in their entirety or as modified to take into account local conditions. The Committee wishes to emphasise that sound internal risk management is essential to the prudent operations of banks and that supervisory tools, such as capital requirements, are not by themselves sufficient. Sound internal risk management is also essential to promoting stability in the financial system as a whole.
3. Neither derivatives, nor the individual risks inherent in them are, by themselves, new. Institutions have been active for some time in forwards, swaps, and options and have routinely addressed credit, market, liquidity, operational and legal risks in their more traditional activities. However, the growing complexity, diversity and volume of derivatives products, facilitated by rapid advances in technology and communications pose increasing challenges to managing these risks. Sound risk management practices are an important element in meeting these challenges.
4. The guidelines bring together practices currently used by major international banks in a single framework. While no bank may follow the framework precisely, it could provide guidance to all banks. The applicability of the guidelines depends on the size and complexity of an institution's derivatives activities.
5. Supervisors should find the guidelines useful in reassessing their own existing supervisory methods and procedures for monitoring how banks control risks in derivatives. The exact approach chosen by individual supervisors to supervise derivatives activities depends upon a host of factors, including their own legal authority, use of on-site and off-site supervisory techniques and the degree to which external auditors are also used in a supervisory function.
6. One outstanding feature of financial markets is the increasing use of sophisticated models by major institutions as their principal means of measuring and managing risk. As a consequence, supervisory agencies will need to assure that they (and external auditors) have staff with sufficient mathematical knowledge to understand the issues and that the reliability of models can be independently verified by external experts.