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         I. Introduction
         II. Catalogue of information for supervi...
         III. Common minimum information framewor...
         Annexes 1-4










 

Framework For Supervisory Information About The Derivatives Activities Of Banks And Securities Firms

II. Catalogue of information for supervisory purposes

16. In monitoring the activities of a financial institution involved in derivatives, supervisors need to be satisfied that the firm has the ability to measure, analyse and manage these risks. In order to achieve these objectives, supervisors should seek to ensure that the firm has both quantitative and qualitative information on its derivatives activities.

17. Quantitative information. Quantitative information about derivatives activities should address the following broad areas:

  • credit risk
  • liquidity risk
  • market risk
  • earnings
Recognising that exchange-traded and OTC derivatives generally differ in their credit risk, liquidity risk and the potential for complexity, the overall reporting framework distinguishes between exchange-traded and OTC derivatives in identifying information needed for supervisory assessment.Each of the four broad areas is discussed in greater detail in sections 1 to 4 below.

18. Qualitative information. In order to effectively evaluate banks' and securities firms' derivatives activities and related risks, supervisors should assess qualitative information about institutions' systems, policies and practices for measuring and managing the risks of derivatives. This includes, for example, information on the risk limits that banks and securities firms use to manage their exposures and any changes in these limits. The risk management guidelines for derivatives, which were issued by the two Committeesin July 1994 and which highlight key attributes of the risk management systems of banks and securities firms, may be used as a guide in requesting information on institutions' systems, policies and practices.

19. The following sections describe in greater detail the different elements of the framework for supervisory information about derivatives activities. The narrative discussion is summarised in tabular form in Annex 1. In Annex 1, two columns are provided for each of the major risk categories. The first column identifies a supervisory concern or use, and the second column describes the information that could be applicable to that use. Explanations follow that summarise how each data item might be used or why it is important from a supervisory perspective. In general, the data and related explanations reflect widely accepted concepts and techniques for measurement of risk exposure that are based on new developments in practice. Some information elements address multiple supervisory uses listed in the first column of Annex 1. To summarise such overlaps, Annex 2 cross-references the information elements with the supervisory uses that have been identified.

1. Credit risk

20. Credit risk is the risk that a counterparty may fail to fully perform on its financial obligations. With respect to derivatives, it is appropriate to differentiate between the credit risk of exchange-traded and OTC instruments. Owing to the reduction in credit risk achieved by organised exchanges and clearing houses, supervisors may need to evaluate less information on exchange-traded derivatives for credit risk purposes than on OTC instruments. Accordingly, the following discussion on credit risk pertains primarily to OTC contracts.

21. The Committees recognise that the notional amount of OTC derivative contracts does not reflect the actual counterparty risk. Credit risk for an OTC contract is best broken into two components, current credit exposure to the counterparty and the potential credit exposure that may result from changes in the market value underlying the derivative contract. To the extent possible, credit risk from derivatives should be considered as part of an institution's overall credit risk exposure. This should include exposure from other off-balance-sheet credit instruments such as standby letters of credit as well as the credit risk from on-balance-sheet positions.

    (a) Current credit exposure
22. Current credit exposure is measured as the cost of replacing the cash flow of contracts with positive mark-to-market value (replacement cost) if the counterparty defaults. Legally enforceable bilateral netting agreements can significantly reduce the amount of an institution's credit risk to each of its counterparties. These netting agreements can extend across different product types such as foreign exchange, interest rate, equity-linked and commodity contracts. Therefore, an institution's current credit exposure from derivative contracts is best measured as the positive mark-to-market replacement cost of all derivative products on a counterparty by counterparty basis, taking account of any legally enforceable bilateral netting agreements.

23. For individual institutions, breaking out the gross positive and negative market values of contracts may have supervisory value by providing an indication of the extent to which legally enforceable bilateral netting agreements reduce an institution's credit exposure.

    (b) Potential credit exposure
24. In light of the potential volatility of replacement costs over time, prudential analysis should not only focus on replacement cost at a given point in time but also on its potential to change. Potential credit exposure can be defined as the exposure of the contract that may be realised over its remaining life due to movements in the rates or prices underlying the contract. For banks, under the requirements of the 1988 Basle Capital Accord, potential exposure is captured through a so-called "add-on", which is calculated by multiplying the contract's gross or effective notional principal by a conversion factor that is based on the price volatility of the underlying contract. Bank supervisors should therefore evaluate information on the add-ons that banks must already compile for their risk-based capital calculations. Such information could include notional amounts by product category (i.e. interest rate, foreign exchange, equities, precious metals and other commodities) and by remaining maturity (i.e. one year or less, over one year to five years and more than five years). The Basle Accord defines remaining maturity as the maturity of the derivative contract. However, supervisors could also take into account information on the instrument underlying the derivative contract.

25. Some banks and securities firms have developed sophisticated simulation models that may produce more precise estimates of their potential credit exposures than under the add-ons approach, and supervisors may wish to take account of the results of these models. These models are generally based on probability analysis and techniques modelling the volatility of the underlying variables (exchange rates, interest rates, equity prices, etc.) and the expected effect of movements of these variables on the contract value over time. Estimates of potential credit exposure by simulations are heavily influenced by the parameters used (a discussion of the major parameters that can influence simulation results is included in the market risk section below). Supervisors and firms should discuss the parameters and other aspects of the models to ensure an appropriate level of understanding and confidence in the use of such models.

    (c) Credit enhancements
26. Information on credit enhancements used in connection with OTC derivative transactions is important to an effective supervisory assessment of the credit risk inherent in an institution's derivatives positions. Collateral can be required by an institution to reduce both its current and potential credit risk exposure. Collateral held against the current exposure of derivative contracts with a counterparty effectively reduces credit risk and, therefore, merits supervisory attention. However, supervisors need to consider the legal enforceability of netting agreements and the quality and marketability of collateral. For supervisory analysis purposes, collateral held by an institution in excess of its netted credit exposure to a counterparty would not reduce current credit exposure below zero but could reduce potential credit exposure. Supervisors could obtain a better understanding of how collateral reduces credit risk by collecting information separately on collateral with a market value less than or equal to the netted current exposure to the counterparty and collateral with market values in excess of the netted current exposure and of the nature of that collateral.

27. OTC contract provisions that require a counterparty to post initial collateral (or additional collateral as netted current exposure increases) may be used to reduce potential credit exposure. An OTC contract that is subject to a collateral or margin agreement may have lower potential exposure, since collateral would be required in the future to offset any increase in credit exposure. Accordingly, information about the notional amount and market value of OTC contracts subject to collateral agreements could enhance supervisory understanding of an institution's potential credit risk.

    (d) Concentration of credit risk
28. As with loans, an identification of significant counterparty OTC credit exposures relative to an institution's capital is important for an evaluation of credit risk. This information should be evaluated together with qualitative information on an institution's credit risk controls. To identify significant exposures and limit reporting burden, supervisors could focus on thosecounterparties presenting netted current and potential credit exposure above a certain threshold. As a minimum, supervisors could identify the 10 largest counterparties to which an institution is exposed, subject to the minimum threshold used.

29. Since counterparty exposure may stem from different instruments, overall risk concentrations with single counterparties or groups of counterparties cannot be measured accurately if the analysis is limited to single instruments (e.g. swaps) or classes of instruments (e.g. OTC derivatives). For this reason, institutions should aim to monitor counterparty exposures on an integrated basis, taking into consideration both cash instruments and off-balance-sheet relationships. Supervisors could also consider information on exposure to counterparties in specific business sectors or to counterparties within a certain country or region.

30. Supervisors could also analyse information on aggregate exposures to various exchanges, both on- and off-balance-sheet, and on exposures to certain types of collateral supporting derivative instruments. Overexposure to specific issues or markets can lead to additional credit concerns, particularly in the case of banks and securities firms with significant activity in securities markets. Some securities supervisors address this concentration risk by deducting from capital all positions above a certain level of market turnover or by applying some other suitable benchmarks. Supervisors without such provisions should ensure that they are at least informed about these concentrations, whether in the form of holdings of the underlying security itself or in the form of OTC derivatives positions which require the firm to deliver or receive such concentrated positions.

    (e) Counterparty credit quality
31. Credit risk is jointly dependent upon credit exposure to the counterparty and the probability of the counterparty's default. Information on the current and potential credit exposure to counterparties of various credit quality would increase supervisory insights into the probability of credit loss. Information indicative of counterparty credit quality includes total current and potential credit exposure - taking into account legally enforceable bilateral netting agreements - to counterparties with various characteristics, e.g. Basle Capital Accord risk weights (for banks), credit ratings assigned by rating agencies, or the institution's internal credit rating system. Information on guarantees, standby letters of credit, or other credit enhancements may also enhance supervisory understanding of credit quality. Aggregate information on past-due status and past-due information by major counterparties, together with information on actual credit losses, may be of particular interest for identifying pending counterparty credit quality problems in the OTC derivatives markets.

2. Liquidity risk

32. As with cash instruments, there are two basic types of liquidity risk that can be associated with derivative instruments: market liquidity risk and funding risk.

    (a) Market liquidity risk
33. Market liquidity risk is the risk that a position cannot be eliminated quickly by either liquidating the instrument or by establishing an offsetting position. Information that breaks out exchange-traded and OTC derivatives could further supervisory understanding of an institution's market liquidity risk. Although exchange-traded and OTC markets both contain liquid and illiquid contracts, the basic differences between the two markets give an indication of the comparative difficulty of offsetting exposures using other instruments. Among both OTC and exchange-traded products, information on broad risk categories (i.e., interest rate, foreign exchange, equities and commodities) and types of instrument would be useful in judging the market liquidity of an institution's positions. Accordingly, notional amounts and market values of exchange-traded and OTC instruments by type (and perhaps by maturity and by product) could enhance a supervisor's understanding of an institution's market liquidity risk. In addition, supervisors could gain important insights into an institution's market liquidity by taking into account the availability of alternative hedging strategies and closely substitutable instruments.

34. To understand the market liquidity risk arising from an institution's derivatives activities, supervisors would benefit greatly from a picture of the aggregate size of the market in which the institution is active. This is particularly important for OTC derivatives, which are generally tailored to the specific needs of customers and for which marking to market is more difficult than for standardised products with liquid markets. As a result, it may be difficult to unwind a position in an appropriate time frame because of its size, the availability of suitable counterparties, or the narrowness of the market.Currently available information on notional values of derivative instruments provides, at best, an incomplete indication of the aggregate size of the market for a particular derivative instrument or of an institution's participation in that market. An alternative, yet still imperfect, measure of market size would be the gross positive and gross negative market values of contracts by risk category or product. Such data would provide an indication of the economic or market value of the derivative instruments held by banks and securities firms in a particular market at a point in time and an institution's concentration in that market.

    (b) Funding risk
35. Funding risk is the risk of derivatives activities placing adverse funding and cash flow pressures on an institution. Funding risk stemming from derivatives alone provides only a partial picture of an institution's liquidity position. In general, funding risk is best analysed on an institution-wide basis across all financial instruments. However, it is also important for supervisors to understand the impact of derivatives on an institution's overall liquidity position.

36. Separate analysis of notional contract amounts of exchange-traded and OTC instruments (as described earlier) should augment supervisory awareness of funding risks, particularly given the requirements for margin and daily cash settlement of exchange-traded instruments and the resulting demands for liquidity that large positions in these instruments may entail. For example, significant positions in OTC contracts hedged with exchange-traded instruments could result in liquidity pressures arising from the daily margin and cash requirements of the exchange-traded products.Data on OTC contracts with collateral or other "margin-like" requirements may also be necessary for assessing liquidity risk. In addition, information about the notional amounts and expected cash flows of derivatives according to specified time intervals would be helpful in assessing funding risk.

37. Information on OTC contracts subject to "triggering agreements" provides further information about funding risk. Triggering agreements generally entail contractual provisions requiring the liquidation of the contract or the posting of collateral if certain events, such as a downgrade in credit rating, occur. Substantial positions in contracts with triggering agreements could increase funding risk by requiring the liquidation of contracts or the pledging of collateral when the institution is experiencing financial stress. Accordingly, information on the total notional amount and replacement cost of OTC contracts (aggregated across products) with triggering provisions provides supervisors with important information about liquidity risk.

38. Supervisors should also consider evaluating information based on institutions' sensitivity analyses of the effect of adverse market developments on their funding requirements. This information would shed light on the potential for additional margin or collateral calls associated with exchange-traded and OTC derivatives positions due to changes in market variables such as interest rates and exchange rates.

3. Market risk

39. Market risk is the risk that the value of on- or off-balance-sheet positions will decline before the positions can be liquidated or offset with other positions. Supervisors should assess information on market risk by major categories of risk, such as interest rates, foreign exchange rates, equity prices and commodities. The market risk of derivatives is best assessed for the entire institution and should combine cash and derivatives positions. The assessment should cover all types of activities generating market risks Supervisors may also consider breakdowns of positions at the level of individual portfolios, including, in the case of banks, trading and non-trading activities.

40. Supervisors will be interested in some or all of the following: position data that would allow independent supervisory assessment of market risk through the use of some supervisory model or monitoring criteria and data derived from an institution's own internal estimates of market risk.

41. For certain institutions, particularly those that are not major dealers, it may be appropriate to obtain position data (e.g. equities, debt securities, foreign exchange and commodities), which could be drawn from the framework of the Basle Committee's standardised approach for market risk, once adopted, or from other approaches adopted by national banking and securitiessupervisors. The collection of position data could be carried out at various levels of detail, depending on the nature and scope of the institution's trading and derivatives activities. The detail can range from a broad measure of exposure at the portfolio level to a finer disaggregation by instrument and maturity.

42. As an alternative or supplement to assessing position data, supervisors could evaluate available information on an institution's internal estimates of market risk. For some institutions, this information could be derived from their internal value-at-risk methodology, which involves the assessment of potential losses due to adverse movements in market prices of a specified probability over a defined period of time. As an alternative to value-at-risk, supervisors may find it useful on a case-by-case basis to assess internally-generated information on earnings-at-risk, duration or gap analysis, scenario analyses, or any other approach that sheds light on an institution's market risk. Whatever the approach taken, supervisors should consider the measure of market risk exposure in the context of the institution's limit policies.

43. If a firm uses value-at-risk models for measuring market risks, the supervisor should evaluate in detail the methodology used, including its main parameters. Key parameters for evaluating value-at-risk estimates include: (1) the volatility and correlation assumptions of the model (either implied or historical volatilities), (2) the holding period over which the change in portfolio value is measured (e.g. two weeks), (3) the confidence interval used to estimate exposure (e.g. 99% of all outcomes) and (4) the historical sample period (e.g. one year or two years) over which risk factor prices are observed.

44. Value-at-risk measured solely at a point in time may not provide appropriate insights about market risk due to the speed with which positions in derivatives and other instruments can be altered. Such difficulties may be addressed by the use of summary statistics for the period over which the institution is reporting. For example, supervisors could require institutions to communicate information on the highest value-at-risk number measured during the reporting period, together with monthly or quarterly averages of value-at-risk exposures. By comparing end-of-period value-at-risk with these other measures, supervisors can better understand the volatility which has occurred in these measures during the period. Supervisors could also encourage or require institutions to convey comparisons of daily value-at-risk estimates with daily changes in actual portfolio value over a given period. Internal models should be validated by comparing past estimates of risk with actual results and by assessing the models' major assumptions.

45. Institutions with significant trading books should subject their portfolios on a regular basis to stress tests using various assumptions and scenarios. These analyses of the portfolio under "worst-case" scenarios should preferably be performed on an institution-wide basis and should include an identification of the major assumptions used. Quantitative information on the results of stress scenarios, which could be specified by supervisors or institutions themselves, coupled with qualitative analyses of the actions that management might take under particular scenarios, would be very useful for supervisory purposes. Examples of scenarios for interest rate risk include a parallel yield curve shift of a determined amount, a steepening or flattening of the yield curve, or a change of correlation assumptions.

46. To minimise burden, supervisory assessment of market risks should draw as much as possible on the information that institutions must collect for supervisory capital purposes. In the case of the banking sector, the Basle Committee's market risk capital requirements, once finalised and implemented, should serve as a basis for supervisory information on banks' market risks. In addition, bank supervisors should consider adopting some of the definitions of the market risk capital standards for reporting purposes, such as the definition of the trading book.

4. Earnings

47. As with cash market instruments, the profitability of derivatives activities and related on-balance-sheet positions are of interest to supervisors. The separate effects on income of trading activities and activities other than trading would also be of interest.

48. 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
49. 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.

50. 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).

51. 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. 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
52. 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
53. 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, particularly for banking supervisors. 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
54. 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.

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