Financial Derivatives: Actions Taken or Proposed Since May 1994 (Chapter
Report, 11/01/96, GAO/GGD/AIMD-97-8).
GAO conducted a follow-up review of the regulation of financial
derivative products, focusing on actions taken or proposed since May
1994 to: (1) strengthen corporate governance and internal controls for
derivatives dealers and major end-users; (2) improve regulation of major
U.S. derivatives dealers; (3) provide federal oversight of major
derivatives dealers that are unregulated affiliates of securities firms
and insurance companies; (4) promulgate comprehensive and consistent
accounting and disclosure requirements for derivatives; and (5)
harmonize regulatory and accounting standards internationally.
GAO found that: (1) many U.S. derivatives dealers and end-users have
indicated in industry surveys that they have strengthened their
corporate governance systems, improved risk management and internal
controls in accordance with banking and securities laws, and developed
and refined certain recommended practices to improve controls over
derivatives activities; (2) bank regulators are imposing capital
requirements that better reflect derivatives risks, collecting more
extensive information on banks' derivatives activities, and using bank
examination guidelines that focus better on derivatives risks; (3) the
Securities and Exchange Commission (SEC) and the Commodity Futures
Trading Commission are collecting more extensive risk information and
working with securities firms that have major over-the-counter
derivatives affiliates in a voluntary oversight program; (4) SEC
proposed additional qualitative and quantitative disclosures about
derivatives use by SEC-regulated firms; (5) the Financial Accounting
Standards Board (FASB) issued enhanced disclosure rules, as GAO
recommended, and proposed an accounting standard for derivatives that
should reduce misleading accounting practices and would require that all
derivatives be recorded in financial statements; (6) there has been
progress toward greater international regulatory harmonization and
coordination through major international regulatory initiatives and
information-sharing agreements; (7) SEC believes that it is more
appropriate for it to focus on market risk of derivative products than
on management or auditor reports on derivatives-using SEC registrants'
internal control systems; (8) FASB has proposed, but not issued,
comprehensive accounting standards for derivatives; and (9) actions
taken or proposed by regulators, market participants, and others are
consistent with the 1994 GAO recommendations, but many GAO concerns are
still valid, and many of its recommendations have not yet been fully
implemented.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD/AIMD-97-8
TITLE: Financial Derivatives: Actions Taken or Proposed Since May
1994
DATE: 11/01/96
SUBJECT: Information disclosure
Derivative securities
Reporting requirements
Banking regulation
Securities regulation
Risk management
Internal controls
Accounting procedures
Auditing standards
International economic relations
IDENTIFIER: Bank Insurance Fund
Savings Association Insurance Fund
BIF
SAIF
OCC Supervision by Risk Program
Federal Reserve Uniform Financial Institutions Rating System
Federal Reserve CAMEL System
Australia
Germany
Japan
Singapore
Switzerland
United Kingdom
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Cover
================================================================ COVER
Report to Congressional Committees
November 1996
FINANCIAL DERIVATIVES - ACTIONS
TAKEN OR PROPOSED SINCE MAY 1994
GAO/GGD/AIMD-97-8
GAO/GGD-97-8
Financial Derivatives
(233468)
Abbreviations
=============================================================== ABBREV
AFS - available-for-sale
AICPA - American Institute of Certified Public Accountants
BIS - Bank for International Settlements
CAD - Capital Adequacy Directive
CFTC - Commodity Futures Trading Commission
CMO - collateralized mortgage obligation
COFI - Cost of Funds Index
COSO - Committee of Sponsoring Organizations of the Treadway
Commission
DPG - Derivatives Policy Group
EITF - Emerging Issues Task Force
EU - European Union
FASB - Financial Accounting Standards Board
FCM - futures commission merchant
FDIC - Federal Deposit Insurance Corporation
FDICIA - Federal Deposit Insurance Corporation Improvement Act of
1991
FFIEC - Federal Financial Institutions Examination Council
FIA - Futures Industry Association
GASB - Governmental Accounting Standards Board
GSE - government-sponsored enterprise
IASC - International Accounting Standards Committee
IOSCO - International Organization of Securities Commissions
ISDA - International Swaps and Derivatives Association
LIBOR - London Interbank Offered Rate
MGFI - MG Futures, Inc.
MGR&M - MG Refining and Marketing
NAIC - National Association of Insurance Commissioners
OCC - Office of the Comptroller of the Currency
OTC - over-the-counter
OTS - Office of Thrift Supervision
SEC - Securities and Exchange Commission
SFA - Securities and Futures Authority Ltd.
SFAS - Statements of Financial Accounting Standards
Letter
=============================================================== LETTER
B-260656
November 1, 1996
The Honorable Richard G. Lugar
Chairman
The Honorable Patrick J. Leahy
Ranking Minority Member
Committee on Agriculture, Nutrition
and Forestry
United States Senate
The Honorable Alfonse M. D'Amato
Chairman
The Honorable Paul S. Sarbanes
Ranking Minority Member
Committee on Banking, Housing,
and Urban Affairs
United States Senate
The Honorable Pat Roberts
Chairman
The Honorable E (Kika) de la Garza
Ranking Minority Member
Committee on Agriculture
House of Representatives
The Honorable Jim Leach
Chairman
The Honorable Henry B. Gonzalez
Ranking Minority Member
Committee on Banking and Financial Services
House of Representatives
The Honorable Thomas J. Bliley, Jr.
Chairman
The Honorable John D. Dingell
Ranking Minority Member
Committee on Commerce
House of Representatives
The Honorable Jack Fields
Chairman
The Honorable Edward J. Markey
Ranking Minority Member
Subcommittee on Telecommunications
and Finance
Committee on Commerce
House of Representatives
This report is a follow-up to a report we issued in May 1994 that
responded to your requests concerning derivative products. Our 1994
report identified a number of risks, both to individual firms and to
the financial system as a whole, associated with those products. We
initiated this follow-up review to determine what progress has been
made by financial regulators and industry participants to address the
areas of concern we identified in 1994 and to determine what still
needs to be done. In particular, we examined what actions were taken
or proposed to (1) strengthen corporate governance and internal
controls for derivatives dealers and major end-users, (2) improve
regulation of major U.S. derivatives dealers, (3) provide federal
oversight of major derivatives dealers that are unregulated
affiliates of securities firms and insurance companies, (4)
promulgate comprehensive and consistent accounting and disclosure
requirements for derivatives, and (5) harmonize regulatory and
accounting standards internationally.
We are sending copies of this report to other appropriate
congressional committees; executive branch agencies, including the
Secretary of the Treasury, the Chairman of the Securities and
Exchange Commission, the Chairperson of the Commodity Futures Trading
Commission, the Chairman of the Federal Reserve Board, the
Comptroller of the Currency, the Chairman of the Federal Deposit
Insurance Corporation, and the Acting Director of the Office of
Thrift Supervision; and other interested parties. We will also make
copies available to others on request.
Major contributors to this report are listed in appendix X. I may be
reached on (202) 512-8678 if you or your staff have any questions.
James L. Bothwell
Director, Financial Institutions
and Markets Issues
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
In May 1994, GAO issued its report on financial derivatives that
identified a number of risks, both to individual firms and to the
financial system as a whole, associated with those products.\1
The report made a series of recommendations to federal financial
regulators and to Congress to improve the monitoring and management
of these risks and to close certain regulatory gaps that GAO
identified. The report also recommended that the Financial
Accounting Standards Board (FASB) promulgate comprehensive and
consistent accounting and disclosure standards for derivatives.
The volume of derivatives activity has continued to grow rapidly
since 1994, which indicates that derivatives are increasingly viewed
by market participants as valuable and important risk management
tools. The Bank for International Settlements (BIS)\2
estimated that the total outstanding, global notional/contract amount
of derivative products as of March 31, 1995, was about $55.7
trillion.\3 In addition, after GAO's report was issued, some major
banks, commercial corporations, and local governments experienced
major losses attributed to their use of derivatives. Such losses
underscored the risks that GAO identified in its report.
GAO initiated this follow-up review to determine what progress has
been made by financial regulators and industry participants to
address the areas of concern identified by GAO in its May 1994 report
and to determine what still needs to be done. In particular, GAO
examined what actions were taken or proposed to (1) strengthen
corporate governance and internal controls for derivatives dealers
and major end-users, (2) improve regulation of major U.S.
derivatives dealers, (3) provide federal oversight of major
derivatives dealers that are unregulated affiliates of securities
firms and insurance companies, (4) promulgate comprehensive and
consistent accounting and disclosure requirements for derivatives,
and (5) harmonize regulatory and accounting standards
internationally.
--------------------
\1 Derivatives are financial products whose value is determined from
an underlying reference rate, index, or asset. The underlying
include stocks, bonds, commodities, interest rates, foreign currency
exchange rates, and indexes that reflect the collective value of
various financial products. See Financial Derivatives: Actions
Needed to Protect the Financial System (GAO/GGD-94-133, May 18,
1994).
\2 BIS was established in 1930 in Basle, Switzerland, by European
central banks. The objectives of BIS are to promote the cooperation
of central banks, to provide additional facilities for international
operations, and to act as trustee for international financial
settlements.
\3 In 1995, central banks in 26 countries conducted a global survey
of derivatives markets. BIS coordinated the survey and aggregated
the data to produce global market statistics. The notional/contract
amounts are one way derivatives activity is measured. However, while
notional/contract amounts are indicators of volume, they are not
necessarily meaningful measures of the actual risk involved. The
actual amounts at risk for many derivatives vary both by the type of
product and the type of risk being measured.
BACKGROUND
---------------------------------------------------------- Chapter 0:2
Derivatives serve an important function in the global financial
marketplace and, appropriately managed, can provide effective ways to
reduce financial risks, lower financing costs, or generate profits.
Controlling the risks derivatives pose to market participants and the
financial system is primarily the responsibility of boards of
directors and senior managers of dealers and end-users, as well as
financial regulators.
Carrying out this responsibility effectively is important because
derivatives can contribute to catastrophic losses if they are not
properly managed and controlled. In 1994 and 1995, banks, commercial
corporations, and local governments reported billions of dollars in
losses involving derivatives and related financial products. These
losses also resulted in enforcement actions brought by regulators
against Bankers Trust New York Corporation (and two of its
subsidiaries), a major U.S. derivatives dealer; the filing for
bankruptcy by California's Orange County, one of the largest and
wealthiest U.S. counties; and the failure of Baring Brothers & Co.,
Ltd., a U.K. merchant bank with a 200-year history.
GAO focused its 1994 report on four basic types of
derivatives--forwards, futures, options, and swaps. This report
addresses these four types of derivatives and also discusses losses
attributed to structured notes and a type of mortgaged-backed
security called collateralized mortgage obligations (CMO). These
financial products have characteristics and risks similar to those of
derivatives. As shown in table 1, some derivatives are standardized
contracts traded on organized exchanges. Others, called
over-the-counter (OTC) derivatives, are customized contracts that are
not traded on exchanges. They include negotiated terms, such as
amount, payment timing, and interest or currency rates.
Table 1
Definitions of Financial Products
Type of financial
product Definition
---------------------- ----------------------------------------------
Derivatives
----------------------------------------------------------------------
Forwards (OTC) Forwards and futures obligate the holder to
buy or sell a specific amount or value of an
Futures (must be underlying asset, reference rate, or index at
exchange-traded in the a specified price on a specified future date.
United States unless
specifically
exempted)
Options (OTC or Options grant the purchaser the right but not
exchange-traded) the obligation to buy or sell a specific
amount of the underlying at a particular price
within a specified period.
Swaps (generally OTC) Swaps are agreements between counterparties to
make periodic payments to each other for a
specified period.
Other financial products
----------------------------------------------------------------------
Structured notes (OTC) Structured notes are a type of debt security
whose cash-flow characteristics depend upon
one or more indexes. They may have added
features such as embedded options.
Collateralized CMOs entitle their purchasers to receive a
mortgage obligations share of the cash flows from a pool of home
(OTC) mortgages.
----------------------------------------------------------------------
Source: GAO.
The markets for these products vary in size. The $55.7 trillion in
total notional/contract amounts outstanding reported by BIS
represents the results of the first comprehensive central bank survey
to measure the size of the global derivatives market. Of this total
amount, the four basic types of OTC derivatives totaled $47.5
trillion and exchange-traded derivatives totaled $8.2 trillion, both
adjusted for double counting. BIS also reported gross market values
for OTC derivatives outstanding, which provide a better measure of
the economic significance of these derivatives contracts than do the
notional/contract amounts.\4 These values were about $2.2 trillion
dollars, or 4.6 percent of the $47.5 trillion in notional/contract
amounts outstanding of OTC derivatives. To our knowledge, directly
comparable data for structured notes and CMOs do not exist. The best
available data show the amounts of these products issued by U.S.
government-sponsored enterprises each year. These data indicate that
the total amounts of these products issued in calendar year 1995 were
about $10 billion for structured notes and about $23 billion for
CMOs.
OTC derivatives dealing in the United States continued to be
concentrated in seven banks, five securities firms, and three
insurance companies or their affiliates, some of which were federally
regulated and some of which were not. Derivatives dealers and
markets have also remained extensively linked internationally, as
illustrated by the Barings failure, which involved regulators and
market participants around the world.
GAO focused this review on the derivatives oversight activities of
federal financial regulators in the United States and selected
foreign financial regulators. In addition, GAO reviewed regulatory
and auditor reports related to selected losses associated with
derivatives. GAO also reviewed the accounting practices of a
judgmentally selected sample of banks and thrifts, determined whether
they had established relevant internal control systems to manage the
risks of derivatives, and analyzed what the potential effects of
proposed accounting standards would be on these and other
institutions. Finally, GAO assessed derivatives disclosure practices
and initiatives to improve those practices. GAO recognizes that many
of the derivatives-related issues addressed in this report, such as
risk management and corporate governance, have broader applications
to firms' overall activities.
--------------------
\4 Gross market values were defined as the costs that would have been
incurred if the outstanding contracts had been replaced at market
prices prevailing as of March 31, 1995. They equal gross positive
plus gross negative market values.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
Market participants, regulators, and others have taken or proposed a
number of actions to improve the management, oversight, and
disclosure of derivatives risks consistent with GAO's prior
recommendations. For example, many U.S. derivatives dealers and
end-users indicated in industry surveys that they have strengthened
their corporate governance systems and improved risk management and
internal controls.\5 Market participants and others have also
developed and refined recommended practices intended to improve
internal controls over derivatives activities.
Federal bank regulators are (1) requiring capital that more
accurately reflects derivatives risks, (2) collecting more extensive
information on bank derivatives activities, and (3) examining banks
using guidelines that are better focused on derivatives risks. The
Securities and Exchange Commission (SEC), in cooperation with the
Commodity Futures Trading Commission (CFTC), is also collecting more
extensive information and working with securities firms that have
major OTC derivatives affiliates in a voluntary program to provide
some federal oversight to these large, unregulated nonbank dealers.
FASB has issued enhanced disclosure rules, as GAO recommended, and
has proposed an accounting standard for derivatives that should help
stem misleading accounting practices and, for the first time, would
require that all derivatives be recorded in financial statements.
SEC has also proposed more qualitative and quantitative disclosures
about derivatives use by public companies.
Internationally, there has been progress toward greater regulatory
harmonization and coordination, as evidenced by major international
regulatory initiatives and information-sharing agreements. These
include the joint guidance on sound risk management practices issued
by the Basle Committee on Banking Supervision\6 and the International
Organization of Securities Commissions (IOSCO), and an international
agreement among regulators of futures markets intended to improve
their coordination and communication in the wake of the Barings
collapse.
Although market participants, regulators, and others have acted to
improve the management, oversight, and disclosure of derivatives
risks, many of the concerns that GAO identified in its 1994 report
still remain. For example, in the cases GAO reviewed, each of the
derivatives dealers and end-users that suffered major losses had
serious weaknesses in their risk management, internal control, and
corporate governance systems. Compliance with guidelines and
recommended risk management practices is essentially voluntary for
derivatives dealers and end-users other than regulated entities, and
some surveys have shown that firms using derivatives are not
involving their boards of directors in risk management. SEC has
acknowledged that there may be benefits associated with management or
auditor reports on internal control systems of SEC registrants that
are major dealers and end-users of complex derivative products as GAO
recommended. In fact, SEC receives these types of reports through a
voluntary program with securities firms that have affiliates that are
major OTC derivatives dealers. However, SEC has stated that it is
focusing on accounting for and providing greater disclosure of market
risk for derivative products, which it views as a more appropriate
priority at this time. In addition, the OTC derivatives dealing
activities of securities firm and insurance company affiliates, which
are still growing, continue to be largely unregulated. Finally, FASB
has proposed, but still has not issued, comprehensive accounting
standards for derivatives that would provide financial statement
users with appropriate, consistent financial information on which to
base their investment, management, or oversight decisions. FASB's
proposal faces much opposition. The public comment period on the
proposal ended October 11, 1996.
The actions regulators, market participants, and others have taken or
proposed to improve the management, disclosure, and regulatory
oversight of derivatives risk are consistent with GAO's 1994 report
recommendations. However, many of the concerns expressed in GAO's
1994 report are still valid; it is too soon to determine the
effectiveness of many of the actions taken or proposed to date; and
some of GAO's recommendations have yet to be fully implemented.
--------------------
\5 Governance systems involve the internal functioning of
organizations through which economic activity is conducted. These
systems have to do with transactions and relationships within the
organization itself, including who controls what, who makes
decisions, and who has what responsibilities for what claims against
the revenues and assets of a company or government. While this
report refers to these systems as corporate governance, the systems
discussed also apply generally to governmental entities.
\6 The Basle Committee on Banking Supervision is a committee of
banking supervisory authorities that was established by the Central
Bank Governors of the Group of Ten countries in 1975. It meets under
the auspices of BIS in Basle, Switzerland. The Group of Ten consists
of 11 major industrialized member countries--Belgium, Canada, France,
Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the
United States, and the United Kingdom.
PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4
WEAKNESSES IN CORPORATE
GOVERNANCE AND INTERNAL
CONTROLS CONTRIBUTED TO MAJOR
LOSSES
---------------------------------------------------------- Chapter 0:5
Given the risks associated with derivative products, weaknesses in
corporate governance systems and inattention to the importance of
effective internal controls can leave major derivatives end-users and
dealers particularly vulnerable to significant losses. During 1994
and 1995, a number of entities sustained major losses associated with
derivatives and related financial products that were attributed
largely to flawed corporate governance systems that did not establish
effective risk-management and internal controls. In some cases the
losses were so severe that the entities filed for bankruptcy or
failed. For example, in December 1994, Orange County, California,
filed for bankruptcy after losing an estimated $1.7 billion on the
county Treasurer's large and highly leveraged investments. After the
bankruptcy filing, reports by auditors and others indicated that the
county's Board of Supervisors failed to act on its responsibilities.
The losses reportedly occurred in an atmosphere of inadequate risk
management and poor supervision of the county Treasurer's investment
strategies. Other reports raised concerns about the county's
reliance on investment income to fund a significant portion of the
budget and warned that it was not fiscally responsible to continue
budgeting in this manner.
Similarly, in February 1995, Barings failed as a result of over $1
billion in futures and options trading losses incurred by one of its
employees. According to the British Board of Banking Supervision
Inquiry, Barings' management failed at various levels to institute a
proper system of internal controls; to enforce accountability for all
profits, risks, and operations; and to adequately follow up on a
number of warning signals over a prolonged period. Of the many
internal control weaknesses cited, one of the most basic inadequacies
was the employee's responsibility for both initiating and recording
trades on the bank's books. This control weakness allowed him to
hide losses and continue trading until those losses exceeded the
bank's capital. This control weakness had been reported by the
bank's internal auditors, but Barings' management took no action and
did not follow up on the internal audit reports' findings.
Industry surveys, which GAO did not verify, show that some market
participants have reported making improvements in their corporate
governance systems and internal controls over derivatives. According
to a follow-up survey of derivatives dealers and end-users conducted
by the Group of Thirty in 1994, more dealers and end-users are
including their directors and senior managers in risk-management
decisions.\7 Other market participants, however, have indicated in
different surveys that firms using derivatives are not involving
their boards of directors in derivatives risk management. Adherence
to any set of recommended or benchmark derivatives risk-management
practices is essentially voluntary, except for regulated entities
such as banks, and this is reflected in the mixed results of the
surveys.
Formal assessments of internal controls similar to those required of
large U.S. banks and thrifts under the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA) can provide a model for
improving corporate governance and internal controls.\8 Five
securities firms that have major OTC derivatives dealer affiliates
voluntarily provide SEC these types of assessments. However, SEC's
general approach has been to focus on providing enhanced accounting
for and disclosure of market risk inherent in derivative products.
SEC has proposed requiring additional public disclosures regarding
dealer and end-user risk exposures, objectives, general strategies,
and instruments specifically used to manage risks. These proposed
disclosures, however, may not provide sufficient assurance that
appropriate risk management policies are in fact being followed.
Without denying the importance of internal controls over activities
involving financial instruments and assurances that these controls
are working, SEC has stated that its focus on additional market risk
information may be a more appropriate priority at this time. GAO
continues to believe that periodic assessments of internal controls,
accompanied by public reporting on the results of those assessments,
would make boards of directors and senior managers more accountable
to shareholders, regulators, and the general public about the
effectiveness of the system of controls and, thereby, help to prevent
large losses.
--------------------
\7 The Group of Thirty is an international financial policy
organization whose members include representatives of central banks,
international banks and securities firms, and academia.
\8 FDICIA requires (1) management of large banks and thrifts to
perform annual, comprehensive assessments of financial institutions'
systems of internal controls over financial reporting; (2) the
institutions' independent external auditor to review management's
assessment; and (3) management to report the results of these
assessments to federal regulators.
FEDERAL BANK REGULATORS HAVE
ACTED TO IMPROVE DERIVATIVES
OVERSIGHT
---------------------------------------------------------- Chapter 0:6
Federal bank regulators have taken several steps to improve their
oversight of U.S. banks' derivatives activities that are consistent
with GAO's prior recommendations. As required by FDICIA, bank
regulators strengthened their risk-based capital standards by
incorporating concentration of credit risk, risk of nontraditional
activities, and interest rate risk. In September 1996, final rules
were issued that would also incorporate market risk into bank capital
standards. Banks deemed to have inadequate controls for these risks
may be required to hold capital above the minimum requirements. In
addition, federal bank regulators have expanded bank reporting
requirements designed to better enable them to monitor and oversee
banks' derivatives activities. For example, banks are now required
to report separately the notional/contract amounts for their OTC and
exchange-traded derivatives contracts, and certain banks must report
information on revenues from their trading activities. Federal bank
regulators, however, disagreed with GAO's recommendation that they
collect information on the concentration of counterparty credit
exposures for those banks that are major OTC derivatives dealers.
They said that this information is available through their ongoing
monitoring and surveillance activities and changes too frequently to
be useful if collected periodically. GAO continues to believe that
such information would enable regulators to identify credit
concentrations across the industry and manage potential threats to
the financial system that could arise if counterparties were to fail
or experience financial difficulties.
In addition to improving bank capital standards and reporting
requirements, federal bank regulators have also implemented new
procedures to better focus their examination activities on specific
risks and on the way banks manage these risks. For example, the
Office of the Comptroller of the Currency has begun implementing a
risk-based approach to supervising certain large national banks.
This new supervisory approach revolves around nine categories of risk
and is designed to determine how well these banks measure, monitor,
and manage those risks. In addition, GAO reviewed a total of 12 bank
examination reports for the period 1992 to 1994 for the 7 largest
U.S. bank derivatives dealers and found improvements in the way
federal examiners reviewed these banks' derivatives risks.
SEC AND CFTC HAVE WORKED TO
ADDRESS REGULATORY GAPS
---------------------------------------------------------- Chapter 0:7
Since 1994, CFTC has implemented risk-assessment rules that are
generally equivalent to the risk-assessment rules SEC implemented in
1992. These rules give CFTC and SEC access to information about the
activities of OTC derivatives dealers that are unregulated affiliates
of registered futures commission merchants and registered
broker-dealers, respectively. Further, SEC initiated the Derivatives
Policy Group (DPG), comprising the six U.S. broker-dealers with the
highest volume OTC derivatives affiliates and worked with this group,
in cooperation with CFTC, to develop a voluntary framework for
oversight of broker-dealers' unregulated OTC derivatives
activities.\9
The DPG framework explicitly addressed some of GAO's concerns about
the lack of federal oversight of these large, nonbank OTC derivatives
dealers. Specifically, the DPG members volunteered to abide by
internal control guidance they, SEC, and CFTC agreed would enhance
their risk management practices. Five of the six members also agreed
to have their external auditors provide reports to SEC and CFTC on
their compliance with the internal control guidance and to provide
additional information to SEC and CFTC about the OTC derivatives
activities of their unregulated affiliates. Accordingly, since the
first quarter of 1995, SEC and CFTC have received quarterly
information from each of the five DPG members on their OTC
derivatives affiliates' trading revenues, individual counterparty
exposures, credit concentrations, and estimated amounts of capital at
risk. Although the DPG framework was not intended to serve as a
means of imposing capital standards, the information provided to SEC
and CFTC gives regulators a basis for assessing the adequacy of
capital.
Although the DPG framework is a positive step toward having some
federal oversight of the large, OTC derivatives dealers that are
affiliates of securities firms, compliance with it is voluntary and
has been limited to the six DPG member firms. Furthermore, neither
SEC nor CFTC has the explicit authority to enforce operational
changes, conduct examinations, or impose capital requirements on the
unregistered OTC derivatives affiliates of broker-dealers and futures
commission merchants.
A regulatory gap remains for the three insurance companies that are
OTC derivatives dealers. While the National Association of Insurance
Commissioners has recommended improvements in derivatives disclosures
and examinations for insurance companies, these recommendations do
not apply to the activities of the OTC derivatives dealer affiliates
of insurance companies.
--------------------
\9 The six DPG members are CS First Boston, Goldman Sachs, Lehman
Brothers, Merrill Lynch, Morgan Stanley, and Salomon Brothers. While
CS First Boston is a DPG member, it has an OTC derivatives affiliate
that reports to, and is regulated by, the Bank of England.
Therefore, it does not report information to SEC or CFTC.
ACCOUNTING ISSUES CONTINUE TO
BE OF CONCERN
---------------------------------------------------------- Chapter 0:8
Accounting standards for derivatives continue to be insufficient,
thus inhibiting the quality of information reported in derivatives
end-users' financial statements. Required financial statement
disclosures about derivatives, while improved, are not adequate to
make up for the lack of standards governing how derivatives
transactions are to be recorded in end-users' financial statements.
GAO's review of 12 banks and thrifts that were end-users of
derivatives indicated that over half of these institutions were using
deferral hedge accounting for risk-adjusting activities based on
anticipated market movements. The deferral hedge accounting
practices used by these institutions allowed them to delay
recognizing gains or losses on these derivatives transactions. GAO
believes that deferral hedge accounting should be limited to
activities intended to decrease an entity's exposure to risk of loss
and should not be applied to derivatives activity that attempts to
profit from or speculate on market movements.
GAO also found that a similar problem existed with accounting for
investment securities, particularly structured notes and CMOs. The
use of historical cost accounting for these securities has allowed
some investment managers to hide losses in the market value of the
securities and, in some cases, to mask the resulting weakened
financial condition of an entity.
GAO believes that the solution to the accounting problems of both
derivatives and investment securities lies in the adoption of
comprehensive market value accounting. Comprehensive market value
accounting would require that all changes in market values of
derivatives, investment securities, and other financial instruments
be recorded in income when they occur, thus advising financial
statement users of such changes. GAO recognizes, however, that
implementing a comprehensive market value accounting model presents
difficult issues, such as determining appropriate values for
instruments that are not regularly traded. These issues have
generated considerable opposition to this method of accounting and
would have to be considered and addressed before comprehensive market
value accounting could be adopted.
In March 1996, the Governmental Accounting Standards Board (GASB)
issued a proposed standard that would require all investment
securities to be carried at fair value.\10 This proposed standard, if
adopted, would resolve many of GAO's concerns about state and local
governmental entities' accounting for investment securities.
However, the proposed standard does not address accounting for
off-balance sheet derivatives, which are gaining greater use by state
and local governmental entities. In addition, it does not require
disclosure of market risk in the entities' financial statements.
In June 1996, FASB issued a proposed standard that would require all
derivatives, including structured notes and CMOs, to be recorded at
fair value on the balance sheet. The related changes in fair value
would be recognized in earnings or a component of equity, depending
on the designated reason for holding derivatives. In cases where
derivatives were used to hedge existing assets or liabilities, the
offsetting gains or losses in fair value of the assets or liabilities
would be accelerated and recognized in earnings in the same period.
This proposed standard helps address GAO's concerns about the use of
deferral hedge accounting for derivatives activities that do not
reduce an entity's exposure to risk of loss and about the use of
historical cost accounting for investment securities with
derivatives-like characteristics. However, because the proposed
standard does not provide for market (or fair) value accounting for
all financial instruments, it would not resolve issues related to
continued use of historical cost accounting for many investment
securities and other financial instruments. In addition, because it
would require a matching of derivatives transactions with underlying
assets or liabilities, the proposed standard has raised concerns
among those who use derivatives to hedge on a portfolio-wide, or
macro, basis that such hedging activity will not be easily
accommodated.
While FASB's proposed standard includes enhanced disclosure
requirements, it, like GASB's proposed standard, does not include
required disclosures that quantify market risk from derivatives and
other investment activities. SEC issued proposed disclosure
requirements in December 1995 that would include market risk
disclosures. However, these proposed requirements, if adopted, would
be required only for public companies.
While FASB's and GASB's proposed standards are a step in the right
direction, comprehensive market value accounting for all financial
instruments would provide a more viable method to address the issues
regarding accounting for financial instruments--including those
raised by macrohedgers. Because stemming inappropriate accounting
practices is needed now, FASB's current proposed standard would
provide an interim solution until the issues surrounding adoption of
a comprehensive market value accounting approach can be addressed.
In addition, SEC's proposed disclosure requirements would help
bolster this interim solution by requiring disclosure of market risk
and other useful information. The SEC, GASB, and FASB proposals are
controversial, and therefore the final outcome of these proposals is
uncertain.
--------------------
\10 GASB establishes accounting standards for state and local
governments.
PROGRESS IS BEING MADE
INTERNATIONALLY
---------------------------------------------------------- Chapter 0:9
Like their U.S. regulatory counterparts, financial regulators in the
six foreign countries GAO reviewed used a number of different
approaches intended to enhance their oversight of derivatives
activities. As GAO recommended in 1994, U.S. regulators have
increased their efforts to work cooperatively with foreign regulators
to better harmonize international regulatory standards. For example,
in July 1994, the Basle Committee on Banking Supervision and IOSCO
for the first time concurrently issued guidance to banking and
securities regulators worldwide on sound risk management of
derivatives activities. U.S. and foreign bank regulators, working
through the Basle Committee on Banking Supervision, have also
expanded their risk-based capital standards for derivatives. SEC and
CFTC have participated in IOSCO working groups discussing capital
standards internationally and how to improve regulatory coordination.
They have also entered into agreements with foreign regulators to
share information and conduct joint examinations of international
firms.
Further, the Barings failure motivated CFTC and the British
Securities and Investments Board to host a meeting of 16 regulatory
authorities responsible for supervising the world's major futures and
options markets.\11 The May 1995 meeting resulted in the Windsor
Declaration, which proposed that regulatory authorities take steps to
improve their coordination and communication. Information sharing
agreements were signed nearly a year later in March 1996, with
exchanges and clearing organizations signing one agreement and
regulators signing a separate, companion agreement. However, some
countries could not participate because of legal restrictions, which
they are trying to overcome. Further, confidentiality concerns may
limit the effectiveness of the agreements for exchanges in some
countries. The success of regulators' attempts to overcome these
concerns through their companion agreement depends on the willingness
of exchanges to go to their regulator to get the needed information
to the appropriate parties.
--------------------
\11 Regulatory authorities from the following countries participated
in the meeting: Australia, Brazil, Canada, France, Germany, Hong
Kong, Italy, Japan, the Netherlands, Singapore, South Africa, Spain,
Sweden, Switzerland, the United Kingdom, and the United States.
RECOMMENDATIONS
--------------------------------------------------------- Chapter 0:10
A number of actions have been taken or proposed since 1994 that are
consistent with the recommendations that GAO made in its 1994 report.
However, GAO notes that its key recommendations to improve corporate
governance and internal controls for major derivatives dealers and
end-users, close regulatory gaps, establish comprehensive and
consistent accounting standards, and harmonize regulatory and
accounting standards internationally have yet to be fully
implemented. While GAO is making no new recommendations in this
report, it believes that regulators, accounting standards-setters,
and others need to continue to take actions necessary to completely
respond to the intent of its prior recommendations.
AGENCY COMMENTS
--------------------------------------------------------- Chapter 0:11
GAO requested comments on a draft of this report from the Chairman,
Securities and Exchange Commission; Chairperson, Commodity Futures
Trading Commission; Chairman, Board of Governors of the Federal
Reserve System; the Comptroller of the Currency; the Chairman,
Financial Accounting Standards Board; and the Chairman, Governmental
Accounting Standards Board. GAO met with representatives of each of
the federal regulators who gave us technical comments on the draft
report. Where appropriate, GAO incorporated these comments in the
report. GAO discussed the draft report with a FASB staff member who
provided technical comments. We also received technical comments
from GASB staff. FASB and GASB staff comments were incorporated
where appropriate in the report.
INTRODUCTION
============================================================ Chapter 1
Over the past 2 years much attention has been focused on derivative
products, most of which has centered on the well-publicized
multibillion-dollar losses suffered during this period by major
commercial corporations, banks, and local governments. Despite the
losses, derivatives use has continued to grow rapidly, reaching about
$55.7 trillion outstanding worldwide by 1995. Although they can be
complex, derivatives provide effective ways to manage financial
risks, generate profits, and lower financing costs, and the vast
majority of the firms using derivatives did so without reporting
major unanticipated losses.
The losses attributed to derivatives in 1994 and 1995 focused
regulators' and market participants' attention on the importance of
sound derivatives risk-management and internal control systems. Some
of the losses showed that understanding the risks in how profits are
generated can be as important as determining why losses occurred. As
pointed out in our May 1994 report, the risks that derivatives pose
are not new or unique, but certain derivatives can be more complex
and volatile than other financial instruments. The associated risks
can be difficult to identify, measure, monitor, and manage. For
example, they may contain potential leverage, or leverage
multipliers, that can greatly increase an investor's gains or losses.
BACKGROUND
---------------------------------------------------------- Chapter 1:1
Derivatives are globally used financial products that essentially
unbundle and transfer risks from entities less able or willing to
manage them to those more willing or able to do so. The general
types of risk associated with derivatives--credit, market, legal, and
operations--exist for many financial activities. The values of
derivatives are based on, or derived from, the value of an underlying
asset, reference rate, or index--called the underlying. Common types
of underlying assets are stocks, bonds, and physical commodities,
such as wheat, oil, and lumber. An example of an underlying
reference rate is the interest rate on the 3-month U.S. Treasury
bill. An example of an underlying index is the Standard & Poor's 500
Index, which measures the performance of 500 common stocks.
Derivatives include customized and standardized contracts. Some
derivatives are customized contracts between parties (also called
counterparties) that include one or more negotiated terms in addition
to price. Negotiated terms can include the quality and quantity of
the underlying, time and place of delivery, and method of payment.
Other derivatives are standardized contracts whose terms are
fixed--except for price, which the market determines. Derivatives
can be privately negotiated by the parties; these are called
over-the-counter (OTC) derivatives. Derivatives also can be traded
through central locations, called organized exchanges, where buyers
and sellers or their representatives meet to determine derivatives
prices; these are called exchange-traded derivatives.
Derivative products include forwards, futures, options, and swaps.
Forwards, futures, and options are typically used to hedge or to
speculate. Swaps are typically used to hedge or to obtain more
desirable financing. All derivative products can be combined to
create more complex derivatives, called hybrid derivatives. Forwards
and futures are contracts that obligate the holder to buy or sell a
specific underlying at a specified price, quantity, and date in the
future. Forwards are commercial, private contracts for the delivery
of a commodity where delivery is deferred for convenience. Futures
are usually standardized contracts traded on organized exchanges.
Option contracts, which can be either customized and privately
negotiated or standardized, give the purchaser the right to buy (call
option) or sell (put option) a specified quantity of a commodity or
financial asset at a particular price (the exercise price) on or
before a certain future date.\1 Swaps are generally OTC agreements
between counterparties to make periodic payments to each other for a
stated time. Some swaps are now exchange traded.
Derivatives market participants include end-users and dealers.
End-users include banks, securities firms, insurance companies,
governments, mutual and pension funds, and commercial entities
worldwide. Certain institutions that use derivatives also act as
dealers by quoting prices to, buying derivatives from, and selling
derivatives to end-users and other dealers. They also develop
customized derivative products for their clients.
Market participants can use derivatives to protect against adverse
changes in the values of assets or liabilities, called hedging.
Hedgers try to protect themselves from market risk, which is the
exposure to financial loss caused by adverse changes in the values of
assets or liabilities. They protect themselves by entering into
derivatives transactions whose values are expected to change in the
opposite direction as the values of their assets or liabilities. For
example, a hedger can protect asset values through derivatives
transactions that increase in value as the asset values decline. The
increases in value of the derivatives contracts (profits) will
offset, or hedge, the decrease in values of the assets (losses).
In contrast, market participants can also use derivatives to take on
risk in an attempt to profit from changes in the values of
derivatives or their underlyings, called speculating. Rather than
purchasing the underlying, speculators can use derivatives to attempt
to profit by anticipating movements in market rates and prices. As
speculators enter into transactions with hedgers and other
speculators, they provide liquidity to the derivatives markets,
thereby helping to ensure that high volumes of trading can occur
without significantly affecting prices.
Derivatives can be more cost-effective for market participants than
transactions in the underlying cash markets because of the reduced
transaction costs and the leverage that derivatives provide. For
example, instead of buying or selling $100,000 worth of U.S.
Treasury bonds, a market participant can realize the benefits of
buying or selling the same amount of bonds by using a derivatives
contract and posting a deposit, called a margin, of only about
$1,500, or 1.5 percent of the face amount of the bonds. Likewise, a
market participant can achieve a result similar to buying or selling
all of the stocks in the Standard & Poor's 500 Index by buying or
selling a derivatives contract on this index for as little as 5 to 10
percent of the cost of the underlying stocks.
--------------------
\1 This is the definition of an American-style option. A
European-style option can be exercised only on its expiration date.
STRUCTURED NOTES AND
MORTGAGE-BACKED SECURITIES
---------------------------------------------------------- Chapter 1:2
Some of the losses attributed to derivatives have involved either
structured notes or a specific type of mortgage-backed security
called a collateralized mortgage obligation (CMO). These financial
products have characteristics and risks similar to derivatives. We
include them in our discussion of losses but focus on the four
traditional types of derivatives--forwards, futures, options, and
swaps--when we discuss derivatives and derivatives oversight
throughout the report, unless otherwise indicated.
Structured notes are debt securities. Their cash flows, which
resemble those of derivatives, depend on one or more indexes, and
they may have added features such as embedded options. Structured
notes are treated similarly to derivatives by banking regulators.
Indexes that typically are used to determine the cash flows
associated with structured notes include the Federal Funds Rate, the
London Interbank Offered Rate (LIBOR),\2 and the Cost of Funds
Index.\3 Some common types of structured notes are
-- range bonds that pay investors on the basis of whether a
reference rate is between levels of a specific index established
at issue,
-- index amortizing notes that pay investors on the basis of a
predetermined amortization schedule linked to the level of a
specific index,
-- inverse floaters that have coupon rates that increase as
interest rates decline and decrease as rates rise, and
-- dual index notes that have coupon rates determined by the
difference between two market indexes.
In addition, some analysts consider step-up bonds to be structured
notes. The investor in these bonds is paid at an above-market yield
for Treasury securities for a short noncall period, and then, if not
called, the coupon rate steps up to a higher rate.\4
Investors in structured notes that are issued by U.S.
government-sponsored enterprises (GSE) perceive little, if any,
credit risk because of investors' perception of implied U.S.
government backing.\5 The investor, however, is exposed to market
risks.
Mortgage-backed securities are financial products whose payments are
derived from a pool of home mortgages. CMOs are one of the most
common types of multiclass mortgage-backed securities.\6 By
repackaging the mortgage payments, issuers of multiclass
mortgage-backed securities can create securities that are customized
regarding yield, risk, and maturities. For example, payments to
investors can be separated into principal-only and interest-only
securities that can be sold separately. The values of these
securities are sensitive to mortgage prepayment rates driven largely
by changing interest rates. That is, if interest rates decline,
mortgagors are more likely to prepay their mortgages. These
prepayments accelerate the payment of principal-only securities and
reduce payments of interest-only securities. Some classes of CMOs
and interest-only and principal-only securities are more risky than
other classes, because their payments can be especially sensitive to
prepayment rates.
Multiclass mortgage-backed securities issuance is dominated by two
GSEs: the Federal National Mortgage Association, also called Fannie
Mae, and the Federal Home Loan Mortgage Corporation, also called
Freddie Mac. These securities are also issued by non-GSE conduits
that securitize mortgages not qualified for purchase by Fannie Mae
and Freddie Mac.\7
--------------------
\2 LIBOR is the rate that banks charge each other for loans of
Eurodollars in the London money market.
\3 The Cost of Funds Index refers to an index for the 11th District
of the Federal Home Loan Bank of San Francisco. It reflects the
actual interest expenses incurred during a given month by all savings
institutions headquartered in Arizona, California, and Nevada.
\4 The issuer of these bonds specifies when the bond can be repaid,
or called.
\5 GSEs are privately owned financial corporations that were
chartered by Congress to achieve the public purpose of facilitating
the flow of credit to certain sectors of the economy, such as
housing, agriculture, and higher education. Major GSEs include the
Federal National Mortgage Association, the Federal Home Loan Mortgage
Corporation, the Federal Home Loan Bank System, the Farm Credit
System, and the Student Loan Marketing Association. The GSE issuing
the structured note typically enters into a swap to eliminate its
exposure to the customized terms of the note.
\6 Real Estate Mortgage Investment Conduits and CMOs are
interchangeable terms.
\7 For a discussion of Fannie Mae and Freddie Mac, see Housing
Enterprises: Potential Impacts of Saving Government Sponsorship
GAO/GGD-196-120, May 13, 1996).
VOLUME OF DERIVATIVES ACTIVITY
---------------------------------------------------------- Chapter 1:3
In 1996, the Bank for International Settlements (BIS) reported the
results of a comprehensive derivatives survey by the central banks of
26 countries.\8 That survey estimated that total notional/contract
amounts of derivatives contracts outstanding worldwide were about
$55.7 trillion as of the end of March 1995.\9
About $47.5 trillion of this amount were OTC contracts and $8.2
trillion were exchange-traded contracts.\10 Although
notional/contract amounts are indicators of volume, gross market
values, or replacement costs, provide a more accurate measure of the
economic significance of the derivatives contracts outstanding.\11
BIS reported the gross market values of the OTC derivatives as being
$2.2 trillion, or about 4.6 percent of the notional/contract amounts.
To our knowledge, directly comparable data for structured notes and
CMOs do not exist. The best available data show the amounts of these
products issued by U.S. GSEs each year. These data indicate that
the total amounts of these products issued in calendar year 1995 were
about $10 billion for structured notes and about $23 billion for
CMOs.
Table 1.1 shows derivatives volumes from the annual reports of the 15
major U.S. OTC derivatives dealers we identified.\12 These volumes
increased every year. Among the dealers we identified, bank dealers
dominate total derivatives volume, accounting for about 69 percent
each year since 1990; securities firms accounted for about 27 percent
and insurance companies the remaining 4 percent. The derivatives
volumes reported by insurance company affiliates grew more than the
volumes reported by either banks or securities firms in 4 of the 5
years we analyzed, from year-end 1990 through year-end 1995. Banks
reported the largest growth in 1994. Figure 1.1 shows the percentage
of change in derivatives volumes for the 15 major U.S. OTC
derivatives dealers from 1990 to 1995.
Table 1.1. Notional/Contract Amounts of
Derivatives Reported by the 15 Major
U.S. OTC Derivatives Dealers Year-End
1990 Through Year-End 1995
(Dollars in billions)
Dealers 1990 1991 1992 1993 1994 1995
---------------------------- ----- ----- ----- ----- ----- -----
Banks (7) $5,35 $5,81 $ $10,3 $13,7 $15,8
0 1 7,574 53 24 09
Securities firms (5) 1,730 2,188 2,967 4,474 5,880 6,966
Insurance companies (3) 193 257 403 634 798 985
======================================================================
Total (15) $7,27 $8,25 $10,9 $15,4 $20,4 $23,7
3 6 44 61 02 60
----------------------------------------------------------------------
Note 1: These amounts have not been adjusted for double counting.
Note 2: The 15 major U.S. OTC derivatives dealers are The Chase
Manhattan Corporation; Citicorp; J.P. Morgan & Co., Inc.; Bankers
Trust New York Corporation; BankAmerica Corporation; NationsBank
Corporation; First Chicago Corporation; The Goldman Sachs Group,
L.P.; Salomon, Inc.; Merrill Lynch & Co., Inc.; Morgan Stanley Group,
Inc.; Lehman Brothers; American International Group, Inc.; The
Prudential Insurance Company of America; and General Re Corporation.
Source: Annual reports of the 15 dealers.
Figure 1.1: Percent Changes in
Derivatives Volume Reported by
15 Major U.S. OTC Derivatives
Dealers, Year-End 1990 Through
Year-End 1995
(See figure in printed
edition.)
Source: Annual reports of the 15 dealers.
--------------------
\8 BIS was established in 1930 in Basle, Switzerland, by European
central banks. The objectives of BIS are to promote the cooperation
of central banks, to provide additional facilities for international
operations, and to act as trustee for international financial
settlements. BIS also provides secretariats for various committees.
BIS coordinated the survey and aggregated the data to produce global
market statistics.
\9 The notional, or principal, amount of derivatives contracts is one
way that derivatives activity is measured. However, it is not a
necessarily meaningful measure of the actual risk involved. The
actual amount at risk for many derivatives varies by both the type of
product and the type of risk being measured.
\10 The amount for OTC contracts was adjusted for local and
cross-border double counting. The amount for
exchange-traded-contracts was halved to adjust approximately for
double counting.
\11 BIS defines gross market value as the cost that would have been
incurred if the outstanding contracts had been replaced at market
prices prevailing as of March 31, 1995. It equals gross positive
plus gross negative market values.
\12 They are the same dealers we discussed in our 1994 report, except
that Chemical Banking Corporation and The Chase Manhattan Corporation
merged in 1995, and NationsBank Corporation joined the ranks of the
top seven bank dealers.
REGULATORY FRAMEWORK
---------------------------------------------------------- Chapter 1:4
Derivatives dealers and end-user financial institutions may be
regulated by federal bank regulators, the Securities and Exchange
Commission (SEC), and the Commodity Futures Trading Commission
(CFTC), depending on how the institutions are organized. State
insurance departments are responsible for monitoring the derivatives
activities of insurance companies that are both domiciled and
licensed to operate in their respective states.
Four federal regulators oversee banks and thrifts, some of which are
also subject to state regulatory oversight. The Office of the
Comptroller of the Currency (OCC) oversees banks with national
charters. The Federal Reserve System (Federal Reserve) oversees all
bank holding companies and those banks with state charters that are
members of the Federal Reserve. State-chartered banks that are not
Federal Reserve members are subject to the oversight of the Federal
Deposit Insurance Corporation (FDIC) and state banking authorities.
The Office of Thrift Supervision (OTS) oversees federally insured
thrifts and thrift holding companies, whether they are state or
federally chartered. The Federal Reserve, the lender of last resort
for banks and other financial institutions, has the additional
responsibility of ensuring the overall stability of the U.S.
financial system. FDIC also has some backup responsibilities for all
federally insured depository institutions, even those primarily
overseen by the Federal Reserve, OCC, and OTS.
As part of this oversight responsibility, bank regulators assess bank
and thrift compliance with the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA). FDICIA requires management of
large banks and thrifts to annually assess and publicly report on the
effectiveness of each institution's internal control system over
financial reporting. It also requires an independent external
auditor to attest to management's assertions in a separate report.
In addition, FDICIA requires large institutions to have an audit
committee made up of outside directors who are independent of
institution management and to establish a reporting link between the
audit committee and external auditors. For the largest institutions,
FDICIA requires that audit committees include members with banking or
related financial management experience.
SEC regulates activities involving securities and the firms that
trade these products, including broker-dealers, which must register
with SEC and comply with requirements for regulatory reporting,
minimum capital, and examinations. Broker-dealers must also comply
with the requirements of the various exchanges and industry
associations of which they are members, such as the New York Stock
Exchange and National Association of Securities Dealers, which are
granted self-regulatory authority under the Securities Exchange Act
of 1934. CFTC regulates activities involving futures and the firms
that trade these products, including futures commission merchants
(FCM)--firms that buy and sell contracts as agents for customers.
These firms also must comply with rules imposed by the various
futures exchanges and industry associations, such as the Chicago
Mercantile Exchange and the Chicago Board of Trade, as well as the
National Futures Association, all of which act as self-regulatory
organizations under the Commodity Exchange Act. For the most part,
neither SEC nor CFTC directly regulates OTC derivative products or
the dealers of these products unless their trading is conducted in a
regulated entity.
The regulatory approaches of these financial regulators differ. A
primary mission of bank regulators is to promote the safety and
soundness of the financial system and protect the federal deposit
insurance funds--the Bank Insurance Fund and the Savings Association
Insurance Fund.\13 They address this goal through various actions,
including establishing capital requirements, establishing information
reporting requirements, conducting periodic examinations, and issuing
enforcement actions. SEC's and CFTC's primary purposes are to
protect investors or customers in the public securities and futures
markets and to maintain fair and orderly markets. Unlike bank
regulators, who can regulate all bank activities, SEC and CFTC are
authorized to regulate only activities involving securities and
futures and only those firms that trade these products. To the
extent OTC derivatives are not securities or futures, neither agency
directly regulates those products nor the dealers of those products,
unless such trading is conducted in a regulated entity.
Federal financial regulators share information and ideas through
groups and task forces, such as the President's Working Group on
Financial Markets.\14 Individual agencies also work together on
various issues. For example, the banking regulators coordinate
certain activities through the Federal Financial Institutions
Examination Council (FFIEC), which develops uniform principles,
standards, and report forms and coordinates the development of
uniform reporting systems and regulations. Internationally, U.S.
and foreign regulators work together through various committees, such
as the Basle Committee on Banking Supervision, which develops capital
standards and issues various types of guidance for banks.\15
Likewise, SEC and CFTC participate in the International Organization
of Securities Commissions (IOSCO) and their respective staffs
regularly serve on its Technical Committee, which issues reports and
provides guidance on securities regulation.\16
--------------------
\13 The Bank Insurance Fund and the Savings Association Insurance
Fund are funded primarily through assessments from federally insured
banks and thrifts, respectively. Each is administered by FDIC. The
proceeds of these funds are used to compensate depositors, if
necessary, should a federally insured institution fail.
\14 This working group was originally established by Executive Order
of the President on March 18, 1988, in response to the October 1987
market decline. It is chaired by the Secretary of the Treasury and
includes the chairs of the Federal Reserve Board, SEC, and CFTC. In
addition, the meetings often include representatives of other
financial regulators, including OCC, OTS, FDIC, and the Federal
Reserve Bank of New York.
\15 The Basle Committee on Banking Supervision is a committee of
banking supervisory authorities that was established by the Central
Bank Governors of the Group of Ten countries in 1975. It meets under
the auspices of BIS in Basle, Switzerland. The Group of Ten consists
of 11 major industrialized member countries--Belgium, Canada, France,
Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the
United States, and the United Kingdom.
\16 As of August 1996, IOSCO had 121 member agencies from 73
countries.
ACCOUNTING STANDARDS SETTING
---------------------------------------------------------- Chapter 1:5
Investors, creditors, regulators, and other users of financial
reports generally depend upon accounting rules to help ensure the
consistency and reliability of information in these reports. The
effective functioning of our economy depends upon financial
information that is widely used being reliable and clearly
understood. Such widespread use, understanding, and confidence in
financial statements requires that they be prepared in conformance
with established accounting rules. The Financial Accounting
Standards Board (FASB) establishes standards of financial accounting
and reporting for private sector entities. These standards are
referred to as generally accepted accounting principles and are
promulgated through the issuance of statements of financial
accounting standards (SFAS) by FASB. SFAS are officially regarded as
authoritative by SEC and the American Institute of Certified Public
Accountants (AICPA). AICPA, through its Accounting Standards
Executive Committee, issues accounting guidance on issues not
otherwise covered in authoritative literature. SEC has statutory
authority to set accounting principles, but as a matter of policy, it
generally relies on FASB and AICPA to provide leadership in
establishing and improving accounting principles. However, SEC
frequently issues accounting and disclosure regulations to supplement
guidance provided by FASB and AICPA.
The Governmental Accounting Standards Board (GASB) establishes
standards of financial accounting and reporting for state and local
governmental entities. GASB pronouncements are recognized as
authoritative by AICPA.
LEGISLATIVE ACTIVITY SINCE OUR
1994 REPORT
---------------------------------------------------------- Chapter 1:6
Six derivatives-related bills were introduced in Congress in 1994.\17
These bills included proposals to
-- regulate derivatives activity and promote uniformity of such
regulation;
-- require increased disclosure about derivatives activity;
-- require that GAO study the speculative uses of derivatives and
the feasibility of imposing taxes and margin requirements on
speculative derivatives activity;
-- establish principles and standards related to accounting,
customer suitability, and risk management;
-- require derivatives dealers to register with SEC; and
-- prohibit depository institutions from using derivatives for
speculation.
None of these bills were passed.
As of June 30, 1996, four new derivatives-related bills were
introduced.\18 These bills included proposals to
-- establish a federal derivatives commission to set principles and
standards for the supervision of derivatives activities;
-- authorize the Federal Reserve to create a self-regulatory
organization whose members would include derivatives dealers not
under the direct regulation of SEC or CFTC;
-- require regulatory agencies to jointly establish principles and
standards relating to capital, accounting, disclosure, customer
suitability, and risk management;
-- require financial institutions to have a management plan that
ensures appropriate management oversight;
-- establish prudent standards for managing risk and provide a
framework for internal controls;
-- require that all derivatives dealers register and be subject to
SEC regulation; and
-- prohibit depository institutions and credit unions from engaging
in certain derivatives activities.
As of July 1996, all four of the bills had been referred to committee
with no further action taken.
--------------------
\17 Three of the bills predated our May 1994 report: S. 2123, May
17, 1994; H.R. 3748, Jan. 26, 1994; and H.R. 4170, April 12, 1994.
The bills introduced after our report were: S. 2291, July 18, 1994;
H.R. 4503, May 26, 1994; and H.R. 4745, July 13, 1994.
\18 These bills included H.R. 20, H.R. 31, H.R. 1063, and S. 557.
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:7
Our May 1994 report on derivatives identified the need for (1)
strengthened corporate governance and internal controls for
derivatives dealers and major end-users, (2) improved regulation of
major U.S. derivatives dealers, (3) comprehensive federal oversight
of major U.S. derivatives dealers that are unregulated affiliates of
securities firms and insurance companies, (4) comprehensive and
consistent accounting and disclosure requirements for derivatives,
and (5) international harmonization of regulatory and accounting
standards. The objectives of this follow-up report were to determine
what actions have been taken or proposed to address each of these
needs and what still needs to be done, as well as to analyze the
causes of large losses attributed to derivatives use.
To update actions taken or proposed since our May 1994 report, we
reviewed relevant literature and interviewed various regulatory and
industry officials. We contacted selected U.S. and foreign
financial regulators. We reviewed regulatory and industry data and
annual reports. We identified the 15 major U.S. OTC derivatives
dealers by using information on derivatives activities from bank
regulators, SEC, the Securities Industry Association,\19 and the
dealers' annual reports (see table 1.1). These 15 dealers--7 banks,
5 securities firms, and 3 insurance companies--had the highest levels
of derivatives activity in their respective industries. The seven
banks and five securities firms we focused on had considerably higher
levels of derivatives activity than others in their industry; and the
three insurance companies were the only U.S. insurance companies we
could identify as derivatives dealers.
To update information on activities related to corporate governance
and internal controls, we reviewed existing guidance and frameworks
issued by regulators, industry participants, and related parties. We
also reviewed the causes of reported losses involving derivatives,
structured notes, and CMOs for a judgmentally selected sample of
corporations, banks, and local governments. To understand the role
corporate governance may have played in losses involving Bankers
Trust and Gibson Greetings; Orange County, California; Capital
Corporate Credit Union (Cap Corp); and Barings PLC (Barings), we
reviewed regulatory examination and enforcement documents, court
documents, and relevant audit, regulatory, and investigative reports
that addressed derivatives use and the reasons behind the losses. We
also discussed these reports and conclusions with knowledgeable
regulatory and industry individuals.
We reviewed key controls relevant to oversight and management of
derivatives at 12 judgmentally selected end-user banks and
thrifts.\20 To determine whether key controls had been designed into
institutions' systems, we compared their controls to a list of key
internal controls that all institutions should have in place. We
compiled the list of key controls from various sources, which
included bank regulators' examination guidance; guidance from AICPA
and the Committee of Sponsoring Organizations of the Treadway
Commission (COSO);\21 and recommendations from the Group of Thirty
(G-30).\22 To determine the internal controls in place at each of the
12 institutions, we reviewed bank regulatory examination workpapers
and discussed controls with examiners, institution management, and,
when possible, internal auditors. We did not test the controls to
determine if they were functioning as described. We also discussed
FDICIA requirements, such as formal internal control assessments and
external auditor attestations, with institution management to
determine their usefulness.
To update information on bank regulators, we reviewed their
examination guidance, examiner training, special studies, and other
relevant documents. Our analysis focused on the Federal Reserve and
OCC because they were the primary regulators of the seven major bank
derivatives dealers. To evaluate the quality and content of bank
regulatory examination activities relative to derivatives, we
reviewed a total of 12 bank examination reports from 1992 to 1994 for
the 7 largest U.S. bank OTC derivatives dealers and conducted
follow-up interviews with examination staff. OCC examiners performed
7 of the 12 examinations we reviewed. Federal Reserve examiners
performed the remaining five. As part of our review, we used bank
examination guidance and G-30 recommendations as criteria to identify
the vital elements of an effective risk-management system. We
reviewed examination workpapers and interviewed examiners to
determine whether examiners had evaluated bank compliance for each
element. The focus of our review of the examinations of the seven
bank derivatives dealers was to evaluate the adequacy of the portion
of the bank regulators' examination process that involved derivatives
activities.
To update activities on the oversight of securities firms and
insurance companies with derivatives affiliates, we interviewed SEC
and CFTC about their derivatives oversight activities since 1994. In
addition, we contacted state regulatory officials in Delaware, New
Jersey, and New York about their derivatives oversight activities
since our May 1994 report.\23 We also obtained information on
industry activities involving derivatives. In addition, we reviewed
derivatives-related enforcement actions taken by the regulators. We
also contacted National Association of Insurance Commissioners (NAIC)
officials about its activities.
To determine what impact, if any, current derivatives accounting
standards had on financial reporting, we reviewed accounting
practices at the 12 selected banks and thrifts. Specifically, we
reviewed (1) how they were using and accounting for derivatives
labeled as hedges and (2) what effect proposed accounting standards
might have on their derivatives activities. We determined the extent
and use of derivatives for hedging purposes at each of the 12 banks
and thrifts on the basis of data from their Consolidated Reports of
Condition and Income (call reports) or their equivalent as of
December 31, 1993, and from each institution's 1993 or 1994
regulatory examination. We reviewed the examination workpapers,
supplemented by discussions with the examiners and institution
management, to understand each institution's extent and use of
derivatives, the underlying strategies behind derivatives use, and
the accounting methods for these activities. We compared our
understanding with the institutions' 1993 and 1994 annual report
disclosures. We then used existing accounting standards as a basis
to assess the institution's accounting treatment of derivatives for
hedging purposes. We met with management at all 12 of the
institutions to obtain their opinions and suggestions on current and
proposed accounting and disclosure requirements and practices.
However, we generally did not discuss our conclusions concerning the
institutions' use of hedge accounting with management or their
external accountants.
To determine the current accounting standards for derivatives, we
reviewed existing and proposed generally accepted accounting
principles and other accounting guidance relevant to derivatives. We
also had discussions with staff from FASB and GASB and reviewed
various discussion papers, correspondence, and memoranda on
accounting for derivatives prepared by FASB staff.
In addition, we analyzed existing and proposed disclosure standards,
including SFAS No. 119 and SEC's proposal for derivatives
disclosures. We discussed SEC's disclosure proposal and other issues
associated with accounting for derivatives with SEC's Chief
Accountant. Finally, to determine the amount of information
disclosed about OTC derivatives, we evaluated the annual report
disclosures of a judgmentally selected sample of 37 banks and
thrifts.\24 Separately, we analyzed the annual report disclosures of
the 15 largest OTC derivatives dealers as of December 31, 1994.
To determine the status of progress being made internationally, we
reviewed information issued since 1994 by several international
organizations--the European Union (EU),\25 BIS, the Basle Committee
on Banking Supervision, the Euro-currency Standing Committee of the
Group of Ten countries, and the Technical Committee of IOSCO. In
addition, to determine what actions, if any, had been taken since our
1994 report, we contacted a total of 11 bank and securities
regulators in 6 countries--Australia, Germany, Japan, Singapore,
Switzerland, and the United Kingdom.\26
We recognize that many of the issues addressed in this report have
broader application to the overall activities of firms. For example,
our discussions of corporate governance, which includes risk
management and internal controls, apply to the entire operations of a
corporation.
We did our work between April 1994 and August 1996 in accordance with
generally accepted government auditing standards.
--------------------
\19 The Securities Industry Association is a trade group that
represents broker-dealers that account for about 90 percent of the
securities business in North America.
\20 We selected end-user banks and thrifts that had a minimum of $1
billion in total assets and notional/contract amounts of derivatives
exceeding 25 percent of the amount of total assets. In addition, we
ensured that at least two of the selected institutions were examined
by each of the four bank and thrift regulatory agencies. We
specifically excluded the institutions that were reviewed in our May
1994 report.
\21 COSO issued a framework entitled "Internal Control-Integrated
Framework" in September 1992 that has been widely accepted and
provides a common basis for assessing the adequacy of internal
control systems.
\22 The G-30 is an international financial policy organization whose
members include representatives of central banks, international
banks, securities firms, and academia.
\23 In our May 1994 report, we identified three insurance companies
that had a major OTC derivatives dealer affiliate or subsidiary.
Those three insurance companies were domiciled in Delaware, New
Jersey, and New York.
\24 The 37 banks and thrifts include 11 of the 12 banks and thrifts
whose derivatives accounting practices we reviewed and 26 other
financial institutions.
\25 The EU includes Belgium, Denmark, France, Germany, Greece,
Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and the
United Kingdom. Its purpose is to unite these countries under one
system of rules and regulations in all aspects of trade, including
financial markets.
\26 Commission Bancaire in France did not respond to our requests for
updated information.
AGENCY COMMENTS
---------------------------------------------------------- Chapter 1:8
We requested comments on a draft of this report from the Chairman,
Securities and Exchange Commission; Chairperson, Commodity Futures
Trading Commission; Chairman, Board of Governors of the Federal
Reserve System; the Comptroller of the Currency; the Chairman,
Financial Accounting Standards Board; and the Chairman, Governmental
Accounting Standards Board. We met with representatives of each of
the federal regulators who gave us technical comments on the draft
report. Where appropriate, we incorporated these comments in the
report. We met with representatives of both of the boards that set
accounting standards. FASB and GASB representatives gave us
technical comments on the draft report that we incorporated into the
report where appropriate.
(For reader convenience, we have included findings and
recommendations from our 1994 report at the beginning of each of the
following chapters.)
Chapter 2 May 1994 Report Summary
FINDINGS
Strong corporate governance, which includes competent supervision by
firms' boards of directors and senior management, can ensure that
risk management and internal control systems are in place and
functioning as anticipated. The audit committees of the boards of
directors can provide oversight of internal and external auditor
activity to ensure appropriate focus and to ensure that management is
not overriding internal controls. Although accountability for
controlling the risks associated with derivatives rests with the
boards of directors and senior management, auditors can play a
primary role in testing compliance with risk-management policies and
controls. Management accountability for internal controls can be
enhanced through annual formal assessments and public reporting on
the effectiveness of risk-management policies and controls. Review
by the external auditor can enhance the reliability of such reports.
The likely effect of such assessments and reporting would be to
increase the attention given to derivatives risk management by senior
management and boards of directors.
Until the publication in 1993 of a report sponsored by the G-30,
entities lacked comprehensive guidelines for evaluating their
risk-management practices. That report recommended specific
derivatives risk-management practices as benchmarks for entities'
use. Bank regulators also found some serious weaknesses in major
dealers' risk-management systems. However, the 15 major U.S.
dealers that we visited described derivatives risk-management systems
that generally conformed with the G-30 recommendations.
No regulation exists to bring all major derivatives dealers into
compliance with the recommendations of the G-30. To help rectify
this weakness, we believed the internal control and audit committee
provisions of FDICIA could be used as a model for strengthening
corporate governance systems. Applying the type of corporate
governance provisions included in FDICIA to all major dealers as well
as insured banks would provide needed safeguards for the public's
interest. In addition, these corporate governance provisions also
are applicable to major end-users of derivatives.
RECOMMENDATIONS
We recommended that SEC ensure that its registrants that are major
end- users of complex derivative products establish and implement
corporate requirements for independent, knowledgeable audit
committees and public reporting on internal controls. Internal
control reporting should include assessments of controls over
derivatives risk-management systems. We recommended that such
reporting should be attested to by external auditors. We also
recommended that the appropriate regulatory authorities establish
comparable requirements for all major derivatives dealers.
STRONG CORPORATE GOVERNANCE IS
CRITICAL TO MANAGING DERIVATIVES
RISKS
============================================================ Chapter 2
Since our 1994 report, some dealers and end-users of derivatives and
similar financial instruments reported major financial losses. These
entities all had serious weaknesses in their corporate governance
systems.\1 Regulators and financial industry groups have responded to
these losses, as well as to recommendations we and others have made,
by issuing guidelines and recommendations for improving risk
management and internal controls--essential elements of strong
corporate governance. Various industry surveys, while mixed,
generally indicate that many derivatives market participants--both
dealers and end-users--have voluntarily improved their risk
management and internal control systems. Although these voluntary
actions for improving corporate governance and controls are valuable,
they may not be adopted by all of those who are vulnerable to the
risks associated with derivatives, structured notes, and CMOs. In
addition, we continue to be concerned that favorable market
conditions may mask the need for further improvements and that the
passage of time may lessen the vigilance of entities' directors and
senior management.
We discussed the internal control assessments and reporting required
under FDICIA with officials from 12 end-user banks and thrifts. They
told us that they generally found the assessments and reports useful
in enhancing internal controls for these institutions. We continue
to believe that internal control assessments and reporting are
essential for ensuring that the directors and senior management of
major OTC derivatives dealers and end-users exercise their fiduciary
responsibilities regarding derivatives and similar financial
instruments. SEC has acknowledged that there may be benefits
associated with management or auditor reports on internal control
systems of SEC registrants that are major dealers and end-users of
complex derivative products, as GAO recommended. However, SEC has
stated that it is focusing on accounting for and providing greater
disclosure of market risk for derivative products, which it views as
a more appropriate priority at this time.
--------------------
\1 Governance systems involve the internal functioning of
organizations through which economic activity is conducted. These
systems concern transactions and relationships within an organization
itself, including who controls what, who makes decisions, and who has
what responsibilities for what claims against the revenues and assets
of a company or government. While this report refers to these
systems as corporate governance, the systems discussed also apply
generally to governmental entities.
CORPORATE GOVERNANCE WEAKNESSES
CONTRIBUTED TO LOSSES
---------------------------------------------------------- Chapter 2:1
Since our May 1994 report, some financial institutions, commercial
corporations, and local governments have sustained significant losses
attributed to activities involving derivatives, structured notes, and
CMOs. A common factor in each of the losses was a weak corporate
governance system that did not establish, maintain, or monitor
effective risk management and internal controls.
Characteristics of an effective corporate governance system include
-- a responsible board of directors that approves policies
governing the nature and extent of derivatives use in the
context of an overall risk-management policy and that provides
effective oversight;
-- management that properly implements board-approved policies and
risk limits and that establishes controls to ensure that the
risks of derivatives activities are managed in accordance with
the board's authorization;
-- qualified personnel and comprehensive systems that match the
scope, size, and complexity of derivatives activities and risks;
-- established functions for monitoring activities that are
independent of trading personnel and allow for effective
supervision of risks;
-- audits that help ensure that approved policies, procedures, and
limits associated with significant risks are effectively
implemented, followed, and not circumvented by management; and
-- independent and knowledgeable audit committees that provide
effective oversight of compliance with internal controls related
to derivatives activities.
Although no corporate governance system, however elaborate, can
prevent all losses, the following examples of some of the most
publicized losses from derivatives activities illustrate that the
severe losses that occurred might have been avoided or reduced in
severity if the basic principles of sound internal controls and
governance systems had been followed. These examples are discussed
in more detail in appendix I.
The first example involved losses by a major OTC derivatives dealer,
Bankers Trust.\2 According to the Federal Reserve Bank of New York,
Bankers Trust failed to adjust its internal controls in response to a
riskier new line of business, marketing and sales of leveraged
derivatives. Subsequent investigations by the Federal Reserve, SEC,
and CFTC found problems related to this new line of business and
failure of the entity's management to reasonably supervise
individuals involved. Bankers Trust suffered significant losses
because of OTC derivatives when some of its clients decided not to
honor their derivatives obligations and sued Bankers Trust.
According to the SEC settlement, Gibson Greetings, one of Bankers
Trust's clients that defaulted on its obligations to Bankers Trust
and subsequently sued it, also lacked appropriate controls over
derivatives activities. Several key Gibson officials did not fully
understand either derivatives or the risks involved in the
speculative structure of their investments with Bankers Trust and
were unable to readily determine the value of Gibson's derivatives
holdings. According to an SEC release, Gibson relied totally on
Bankers Trust to establish values for use in preparing its financial
statements and in periodic reports filed with SEC. As a result,
according to SEC's release, representatives of Bankers Trust were
able to mislead Gibson about the value of the company's derivatives
positions by providing values that significantly understated the
magnitude of the losses.
An example of significant derivatives losses concerning a local
government occurred in Orange County, California. According to a
California State Auditor's report, Orange County filed for bankruptcy
when the county Treasurer's flawed investment strategy, which
stressed yield over liquidity or security, resulted in about $1.7
billion in losses. The losses reportedly occurred in an atmosphere
of inadequate risk management and poor supervision by the county
board. A report by a committee of the California legislature cited a
lack of involvement by the County Board of Supervisors as one cause
of the bankruptcy filing. Other reports by the County Auditor and an
outside consultant identified numerous internal control weaknesses
that may have contributed to the collapse of Orange County's
investment pool. The outside consultant also noted that the county's
investment policy did not define a diversification strategy,
establish limits on levels of certain high-risk investments, or
prohibit leveraging of the investment portfolio. In addition, the
report stated that the Treasurer's office did not periodically report
the results, status, or makeup of the investment portfolio, and
periodic reviews of securities' market values were not documented and
maintained. Because the County Board of Supervisors and management
did not perform their basic governance responsibilities, they did not
deal effectively with the significant risks of the investment
activities being carried out by the Treasurer. This lack of
oversight, combined with the basic control weaknesses, resulted in
unchecked high-risk investment strategies that proved detrimental to
the participants in the Orange County investment pool.
Another example of significant losses involved Cap Corp, which was
formerly one of the nation's largest corporate credit unions with
reported assets of $1.6 billion. Cap Corp failed in January 1995 and
was placed into conservatorship by the National Credit Union
Administration.\3 By February 1995, when we testified before the
Senate Committee on Banking, Housing, and Urban Affairs, the total
loss on Cap Corp's portfolio was about $61 million.\4 We said that
Cap Corp's failure was, in part, the result of inadequate oversight
by the board of directors of a risky investment strategy, no internal
audit function, and other weaknesses in internal controls. In
particular, Cap Corp lacked a model to test the overall sensitivity
of its investment portfolio to potential changes in interest rates.
Cap Corp also failed to react readily to the growing mismatch between
its assets and liabilities. Cap Corp's board of directors not only
failed to ensure that an adequate risk-management system was
established and functioning, it also did not appear to adequately
oversee Cap Corp's investment activities. Virtually all
responsibility for Cap Corp's investment activities was delegated to
an investment committee comprising Cap Corp's senior management, and
the board showed little interest in the decisions this committee
made.
Finally, in February 1995, Barings, a British investment bank,
collapsed after losing over $1 billion trading financial futures and
options on exchanges in Singapore and Japan. The Bank of England
report issued after the bank's failure indicated that one employee's
trading activities apparently were responsible for all the losses.\5
The regulators said that these losses went undetected as a
consequence of failed management oversight and a lack of basic
internal controls. For example, Barings' management did not
adequately follow up on a number of warning signs, including findings
reported by the internal auditors, over a prolonged period.
According to the regulators' report, this employee originally was
authorized to perform certain limited trading activities for
customers. However, he began to generate profits through
unauthorized trading for Barings' own account. Despite significant
reported profits, Barings' management believed that his activity
represented no significant risk to Barings until the large losses
suddenly became evident. Until this time, he was able to conceal his
losses largely because he was responsible for both initiating and
recording trades--a lack of basic separation of duties.\6 Barings
collapsed because of its management's failure to institute a proper
system of internal controls; enforce accountability for profits,
risks, and operations; and follow up on warning systems.
The losses experienced by these entities occurred in part because
their boards of directors and top management did not effectively
monitor derivatives activities or require corrective action to
establish controls when significant weaknesses were noted. The
Chairman of the Board of Governors of the Federal Reserve, in
testimony before the Senate Committee on Banking, Housing, and Urban
Affairs on November 27, 1995, stated that conditions such as the
concealment of losses by employees and management threaten the
integrity of our financial system. In commenting on a loss at a U.S.
branch of Daiwa bank,\7 as well as the loss at Barings, he said:
"The over $1 billion loss suffered by Daiwa and the catastrophic
losses suffered by Barings in Singapore because of a rogue
trader illustrate the enormity of the damage that can be
incurred by global trading banks when internal control systems
are less than adequate. . . . The lesson forcefully taught
by these cases is that management must pay as much attention to
such seemingly mundane tasks as back office settlement and
internal audit functions as to the more exotic high technology
front-end trading systems."
Given the lax corporate governance associated with the losses
reported since 1994, we continue to support the wider application of
FDICIA-type internal control assessments and reporting to cover more
than large insured depository institutions. Losses at these entities
clearly illustrate the results that can occur when effective
risk-management and internal control systems are not developed,
properly implemented, and vigilantly enforced. Management
assessments of internal control and risk-management systems could
have identified areas where controls were weak or nonexistent and,
overall, could have reinforced good management. In addition,
required public reporting on these assessments could have motivated
the board and management of the affected organizations to improve
corporate governance systems.
--------------------
\2 In this report, unless otherwise indicated, Bankers Trust refers
to the parent firm, Bankers Trust New York Corporation, a bank
holding company, and two of its wholly owned subsidiaries--Bankers
Trust Company, a bank, and BT Securities Corporation, a securities
broker-dealer.
\3 Corporate credit unions are nonprofit cooperatives that are owned
by their respective member credit unions. They serve their member
credit unions by providing liquidity loans, investment products, and
other services.
\4 Credit Unions: The Failure of Capital Corporate Federal Credit
Union (GAO/T-GGD-95-107, Feb. 28, 1995).
\5 "Report of the Board of Banking Supervision Inquiry into the
Circumstances of the Collapse of Barings," Bank of England, (July 13,
1995).
\6 Trading activities are referred to as "front office" activities,
in contrast to administrative activities like bookkeeping that are
referred to as "back office" activities.
\7 Daiwa bank, a large Japanese bank, incurred $1.1 billion in losses
at its New York branch from U.S. government bond trading activities
over an 11-year period.
INTERNAL CONTROL GUIDANCE IS
CONSISTENT WITH FDICIA
OBJECTIVES BUT IS PRIMARILY
VOLUNTARY
---------------------------------------------------------- Chapter 2:2
The recurring linkage between weak corporate governance systems and
derivatives losses has focused attention on improving internal
controls. Market participants and others have issued various types
of guidance and frameworks that represent best practices for
improving internal controls over derivatives activities.\8 As
discussed in more detail in chapters 4 and 6, we believe that these
best practices provide good ideas for improving internal controls on
a voluntary basis. However, we continue to believe that all major
OTC derivatives dealers and end-users could benefit from the types of
internal control assessments and reporting required under FDICIA. In
general, officials of some end-user banks and thrifts, which are
subject to FDICIA requirements, told us that the formal assessment of
internal controls required by FDICIA was beneficial. We found that
many of the corporate governance concepts embodied in FDICIA and our
previous recommendations were reflected in recommended practices
outlined in the various types of guidance. However, the recommended
practices differ in two important ways: (1) they are not mandated,
and (2) they do not require public reporting by management on its
assessment of the effectiveness of internal controls. Further, only
the guidance of the Derivatives Policy Group (DPG)\9 calls for a
periodic assessment of the effectiveness of these controls by
auditors, but it does not require public reporting of the results.\10
We are concerned that should market conditions improve, there will be
less pressure to mandate these important practices, leaving firms
vulnerable to substantial losses when conditions change.
--------------------
\8 These include the G-30 recommendations, the Derivatives Policy
Group framework, the Futures Industry Association's Global Task Force
on Financial Integrity recommendations, and guidance from AICPA,
COSO, Government Finance Officers Association, Basle Committee on
Banking Supervision, and IOSCO.
\9 DPG was organized in 1994 to address the public policy issues
raised by the OTC derivatives activities of unregistered affiliates
of SEC-registered broker-dealers and CFTC-registered FCMs and is
consistent with the recommendations in our 1994 report. DPG-member
firms include CS First Boston, Goldman Sachs, Lehman Brothers,
Merrill Lynch, Morgan Stanley, and Salomon Brothers.
\10 This aspect of the framework is consistent with IOSCO guidance
that suggests that regulators require management assessments and
regulatory examinations or auditor's reports on controls (with
reports submitted to regulators).
END-USER BANKS AND THRIFTS
FOUND FDICIA REQUIREMENTS
GENERALLY USEFUL
-------------------------------------------------------- Chapter 2:2.1
To determine the usefulness of FDICIA's required assessments, we
discussed the formal assessments of internal controls over financial
reporting with officials of the 12 end-user banks and thrifts that we
reviewed. Officials at most of the institutions told us that the
formal assessments were beneficial.
Most of the officials told us they used COSO's framework for
assessing the adequacy of the internal controls in preparing their
FDICIA assessments. We were provided access to and reviewed the
documentation of controls over derivatives activities that three of
the institutions prepared in conjunction with their internal control
assessments and found that these institutions had done a substantial
amount of analysis in the form of questionnaires, flowcharts, and
risk-evaluation working papers. The use of those kinds of materials
is suggested by the COSO framework documents. Management's
observations on the FDICIA assessments at the selected banks and
thrifts are also discussed in appendix II.
DPG ISSUED GUIDELINES TO
IMPROVE RISK MANAGEMENT
-------------------------------------------------------- Chapter 2:2.2
In its March 1995 report, Framework for Voluntary Oversight, DPG
developed a self-regulatory framework for voluntary oversight of its
members' unregulated OTC derivatives dealer affiliates.\11
Although CS First Boston is not a reporting intermediary, the
remaining five firms represent over 90 percent of the total U.S.
broker-dealer OTC derivatives trading activity.\12 DPG's
self-regulatory framework consists of four interrelated components:
(1) management controls, (2) enhanced reporting, (3) evaluation of
risk in relation to capital, and (4) counterparty relationships.
(The last three components are discussed in ch. 4.)
The first component outlines risk-management guidance, including
suggestions for the implementation of internal controls for measuring
and monitoring the various risks a firm may be exposed to as a result
of its dealings in derivative products. This component also
establishes that an effective system of internal controls should
include (1) the adoption of risk management guidelines at an
appropriate level of management; and (2) the implementation of risk
monitoring systems to identify, measure, monitor, and report exposure
to relevant risks and of risk management processes to control those
risks.
Under the framework, SEC and CFTC are to receive external auditors'
reports on firms' internal and risk management controls. The
external audit reports, which are to be submitted annually, are to
address the firm's compliance with its risk-management objectives,
guidelines, and internal procedures, which are called for by the DPG
framework. SEC and CFTC have agreed to maintain all information
obtained from DPG members, including the reporting on internal
controls, on a confidential basis. Independent verification of
management's assessment on controls by external auditors could help
provide valuable evidence that such controls exist for these firms.
However, unlike FDICIA assessments, which are publicly available,
maintaining information on a confidential basis does not provide
public accountability.
--------------------
\11 As stated in the framework, DPG contemplated that it would apply
to any affiliate of an SEC-registered broker-dealer (1) that is not
subject to supervisory oversight with respect to capital; (2) that is
primarily engaged in the business of holding itself out to
unaffiliated counterparties as a professional intermediary willing to
structure and enter into either side of an OTC derivatives
transaction as a principal; and (3) whose OTC derivatives activities
are likely to have a material impact, directly or indirectly, on its
SEC-registered broker-dealer affiliate.
\12 CS First Boston has an OTC derivatives affiliate that is
regulated as a bank by the Bank of England. Although it does not
report to SEC under the framework, SEC officials told us that under
their risk assessment rules, they receive copies of quarterly
financial reports the affiliate files with the Bank of England.
INSTITUTIONS' SYSTEMS OF
CONTROLS WERE GENERALLY
DESIGNED TO INCLUDE KEY
CONTROLS
---------------------------------------------------------- Chapter 2:3
In general, we found the 12 banks and thrifts we selected had systems
of controls that were designed to include most of the key controls
relevant to the types of derivatives activity in which they were
engaged.\13 We reviewed various guidance-related documents, including
AICPA audit guides and regulatory guidance, to identify key controls
related to derivatives. Most of these controls were included in more
than one guidance and were contained in the COSO derivatives
guidance.\14 Appendix II includes a table of the key controls for
derivatives activities that we developed on the basis of our review
of information from the various guidance documents.
Although the 12 banks and thrifts had most of the key controls, we
also noted that regulatory examiners and internal auditors found that
certain of these controls could be improved. Controls needing
improvements included
-- management-approved written policies setting risk limits;
-- credit limits established for counterparty exposures;\15
-- regular committee meetings to oversee the hedging program, to
report to the board of directors, and to maintain documentation
of decisions and actions; and
-- procedures to monitor risk limits and exposures on a daily or
regular basis.
The fact that these controls needed improvement argues for the
importance of regular and effective audit and regulatory oversight.
Such oversight plays a critical role in monitoring derivatives risk
and in maintaining a strong system of corporate governance.
--------------------
\13 For the remaining key controls, we found incomplete data to
verify that they were designed into the system.
\14 In addition to the 1992 framework established by COSO for
assessing the adequacy of internal controls, in June 1996, COSO
issued guidance to illustrate how the COSO framework might be applied
to derivatives activities. This specific application of the COSO
framework recognizes the widespread use and growing importance of
derivatives in managing risks and recognizes that many directors and
senior executives may request assurance that their organizations
could minimize exposure to undue loss from inappropriate derivatives
use.
\15 Counterparty exposure is the risk of loss that would occur if an
entity's counterparty failed to meet its financial obligations.
INDUSTRY SURVEYS INDICATE SOME
PROGRESS ON INTERNAL CONTROLS
---------------------------------------------------------- Chapter 2:4
Several industry surveys that have been completed since our 1994
report assessed internal control practices at derivatives dealers and
end-users. A 1994 G-30 survey indicated that derivatives dealers and
end-users had made progress in implementing the corporate governance
recommendations in its July 1993 derivatives report. However, the
survey also showed that not all the G-30 recommendations had been
implemented. Other surveys that reported on board of director
involvement with derivatives activities showed mixed results. We did
not attempt to verify or evaluate the quality of any of the survey
data. Although these surveys provide some indication of others'
recognition of the importance of corporate governance, formal
assessments of and public reporting on internal controls would
provide a better gauge of progress in this area.
G-30 SURVEY INDICATES
PROGRESS
-------------------------------------------------------- Chapter 2:4.1
In December 1994, the G-30 published the results of a survey that
showed a high percentage of derivatives dealers and end-users
responding had adopted or were planning to adopt many of the G-30's
recommended practices regarding corporate governance.\16 Of the 125
dealer and 149 end-user respondents to the survey, the majority
acknowledged that they had, or were planning to implement within 12
months, policies relating to corporate governance, including the
following:
-- The board of directors reviews and approves an entity's overall
risk-management and capital policies.
-- The board of directors reviews and approves any changes to
overall risk-management and capital policies made by senior
management in response to changes in business conditions.
-- Management establishes and implements clearly defined risk-
management policies, procedures, and controls.
-- Senior financial management reviews and approves procedures and
controls for implementing the entity's risk-management policies
governing derivatives trading, operations, accounting, and
disclosure.
-- Senior financial management reviews derivatives policies as
business and market circumstances materially change.
-- Senior financial management periodically reviews risk-management
reports that specifically identify derivatives activities used
in the hedging of underlying business exposures (end-user
respondents only).
-- Policies and procedures governing and controlling risk
management and derivatives specifically address the purpose of
derivatives transactions and the types of risks that can be
taken (end-user respondents only).
Although the results of the G-30 survey are encouraging, many
end-users thought that recommendations concerning the assessment of
market risk did not apply to them. For example, about 36 percent
responded "does not apply" to a question concerning their use of
market simulations to test the performance of their portfolios under
abnormal market conditions. However, without investigating each
respondent's individual circumstances, we could not determine whether
such responses were reasonable. In addition, although the survey
indicated a positive trend, it did not request, and its results did
not provide, information about how entities ensure that these
important policies and procedures are effectively implemented and
monitored.
--------------------
\16 "Derivatives: Practices and Principles, Follow-Up Surveys of
Industry Practice," Group of Thirty, (Dec. 1994).
OTHER SURVEYS SHOWED
PROBLEMS PERSIST
-------------------------------------------------------- Chapter 2:4.2
Other surveys also reported on the involvement of boards of directors
in establishing and monitoring derivatives activities. A survey of
the use of derivative instruments in multinational companies,
conducted by Ernst & Young LLP, showed that boards of directors,
executives, and senior management reported establishing policies to
monitor and control derivatives activities at 96 percent of the
companies responding.\17 In a different survey also conducted by
Ernst & Young LLP, nearly two-thirds of investment funds that used
derivatives reported that they did not have a supervisory board or a
risk-management committee responsible for setting limits on
derivatives use.\18
The survey responses showed that only a few boards of directors had a
representative familiar with complex financial instruments or risk
management.
Another survey, conducted by the Wharton School at the University of
Pennsylvania in conjunction with the Canadian Imperial Bank of
Commerce, indicated that fewer than half of the entities surveyed
regularly reported to their boards on derivatives usage.\19 This
survey also reported that about one-quarter of the entities surveyed
did not have a documented policy on derivatives.
--------------------
\17 "The Use of Derivatives Investments in Multinational Companies,"
Ernst & Young, LLP, (Feb. 1995). An informal survey of 105 of the
world's largest multinational corporations.
\18 "Derivatives Usage by Investment Funds," Ernst & Young, LLP,
(Oct. 1995). Ernst & Young conducted 143 surveys with a
judgmentally selected sample of U.S. and foreign investment fund
companies in 1995.
\19 "Wharton/CIBC Wood Gundy Survey of Derivatives Usage Among U.S.
Nonfinancial Firms," The Wharton School of the University of
Pennsylvania, (Oct. 1995). Questionnaires were mailed to a random
probability sample of 2,158 nonfinancial corporations.
SEC IS CONTINUING TO LOOK AT
ISSUES RELATED TO OUR MAY 1994
RECOMMENDATION
---------------------------------------------------------- Chapter 2:5
In our May 1994 report, we recommended that SEC ensure that its
registrants that are major dealers and end-users of complex
derivative products establish and implement corporate requirements
for independent, knowledgeable audit committees and public reporting
on internal controls. Internal control reporting by boards of
directors, managers, and external auditors should include assessments
of derivatives risk-management systems. Despite SEC's recognition
that there may be benefits associated with management or auditor
reports on internal controls of SEC registrants that are major
dealers and end-users of complex derivative products and discussions
about an alternative way to meet the intent of this recommendation,
SEC has not yet agreed to implement it. Although SEC does not deny
the importance of internal controls over activities involving
financial instruments and assurances that those controls are working,
it has stated that it is focusing on expanding disclosure
requirements on market risk as a more appropriate priority for SEC at
this time. Although we believe expanded disclosure is valuable, it
does not provide the additional accountability for boards of
directors and senior managers that would be accomplished through
public reporting of internal control assessments.
SEC officials expressed concern about the potential costs of imposing
responsibilities for public reporting on internal controls over
derivatives, especially if this included a requirement for
attestation on such reports by independent public accountants. Their
concerns stemmed from the fact that a number of years ago SEC
withdrew two proposals for public internal control reporting by
management because of substantive public opposition based in part on
the claim that the proposals would be too costly. The first proposal
would have required auditor attestation; the second did not,
recognizing to some extent the cost objection to the first proposal.
In our discussions with these officials, we pointed out that our
recommendation was confined to major end-users of derivative
products. However, they were still concerned about the cost imposed
on even the limited number of companies that we recommended be
required to report publicly. To address this concern, we suggested
another less costly way to meet the intent of our recommendation.
Instead of SEC requiring management reports and auditor attestation
as recommended in our May 1994 report, we suggested that SEC could
issue guidelines for directors' oversight of derivatives activities.
Such guidelines could be based on guidance for directors already
issued by bank regulators and others. Our list of suggested
guidelines appears in appendix III. We reasoned that these
guidelines would require that directors carefully review derivatives
policies and risk limits and the controls over them. If not
satisfied, they could call upon independent auditors to assist them.
At SEC's request, we also prepared and presented a draft prototype
report on internal controls over derivatives activities to illustrate
the kind of public reporting we were recommending. This report
describes an entity's derivative products, the establishment of its
risk limits and related controls, and the involvement of the board of
directors and the board's audit committee. We stated that the report
was only illustrative, that it could well be shortened or simplified,
and could be broadened to include a wider range of important internal
controls. This prototype draft report is presented as appendix IV.
SEC officials recognized that there may be benefits associated with
management or auditors' reports on public companies\20 internal
control systems but expressed some concerns with our alternative
recommendations. They said that SEC issuance of director guidelines
would represent unprecedented involvement in corporate governance and
expressed concern about the potential for director liabilities that
might flow even from nonauthoritative guidelines. SEC is focusing on
accounting for and providing greater disclosure of market risk for
derivative products, which it views as a more appropriate priority at
this time.
In December 1995, SEC released for comment proposed expanded
derivatives disclosure requirements for public companies. Under the
proposed requirements, additional public disclosures would be made
regarding derivatives dealers' and end-users' risk exposures,
objectives, general strategies, and financial instruments used to
manage risk. We discuss these requirements in more detail in chapter
5.
--------------------
\20 We use public companies in this report to mean companies that
register their securities with SEC and that are subject to SEC's
disclosure requirements.
CONCLUSIONS
---------------------------------------------------------- Chapter 2:6
Recent losses at the entities discussed in this chapter, as well as
others, emphasize the need for strong accountability over derivatives
activities. The losses also illustrate the potential danger
associated with entities that do not embrace the need for sound
corporate governance to establish, maintain, and monitor effective
internal control systems.
Although voluntary efforts to strengthen corporate governance and
internal controls over derivatives can be valuable, they leave
stakeholders vulnerable if not uniformly adopted. SEC's proposed
requirements begin to address our concerns, but they may not provide
sufficient assurance to the public that appropriate risk-management
policies are, in fact, being followed. We continue to believe the
actions recommended by our May 1994 report for effective corporate
governance and management assessment and reporting on internal
controls are still appropriate. Periodic assessments of internal
controls, accompanied by public reporting on the results of those
assessments, would make boards of directors and senior managers more
accountable to shareholders, regulators, and the general public about
the effectiveness of the systems of controls and, thereby, help to
prevent large losses. We believe that regulators at all levels of
government should consider the recommendations to facilitate
effective actions by management and boards of directors in managing
derivatives activities.
Chapter 3 MAY 1994 REPORT SUMMARY
FINDINGS
Bank regulators use three primary means to oversee bank activities:
requiring adherence to minimum capital standards;\1 reviewing
required reports; and conducting periodic examinations to verify
compliance with capital, reporting, and other regulatory
requirements. Although regulators had made progress, improvements
were still needed in regulatory reporting and examinations. We found
that although regulators required banks to report information
quarterly, they did not require sufficient information on credit risk
and earnings. In addition, capital requirements did not address all
risks, focusing instead on credit risk. However, U.S. bank
regulators participated in developing a proposal to incorporate
market risk through the Basle Committee on Bank Supervision. Other
ongoing efforts addressed interest rate risk, credit concentration,
risks from nontraditional activities, and broader recognition of
bilateral netting. We also found that although bank examinations
addressed derivatives, they did not adequately address internal
controls.
RECOMMENDATIONS
We recommended that financial regulators take several actions to
improve their capability to oversee OTC derivatives activities and
respond to any financial crisis involving derivatives. The
recommended actions were to develop and adopt a consistent set of
capital standards; develop and maintain a centralized repository of
information (including information on counterparty concentrations and
earnings); and provide leadership in working with industry
representatives and regulators internationally to harmonize standards
for disclosure, capital, examination, and accounting.
--------------------
\1 Capital serves as a buffer against unexpected losses that cannot
be absorbed from current earnings. As a bank's capital approaches
low levels, regulators are warned that a bank's financial health is
threatened and that they may have to intervene.
BANK REGULATORY OVERSIGHT
CONTINUES TO IMPROVE
============================================================ Chapter 3
OCC, the Federal Reserve, FDIC, and OTS have made progress in
improving their oversight of derivatives activities consistent with
the recommendations we made to financial regulators in our 1994
report.\2 They have expanded their risk-based capital standards to
more accurately reflect risk exposures and to include market risk.
They have also expanded their regulatory reporting requirements to
include additional information on derivatives activities. Further,
they have improved their examination process by taking several
actions to more adequately address risks and risk management. In
1994, the Federal Reserve took an enforcement action against a bank
holding company for activities related to its derivatives business.
--------------------
\2 This report focuses on the activities of the Federal Reserve and
OCC, because they are the primary regulators responsible for the
seven major bank dealers we reviewed. However, FDIC and OTS also
have been active participants in improving derivatives oversight.
RISK-BASED CAPITAL STANDARDS
WERE EXPANDED
---------------------------------------------------------- Chapter 3:1
Expanding risk-based capital standards continues to be an active area
of reform for bank regulators.\3 Reforms include efforts to ensure
that the major types of risk are reflected in capital requirements.
Although some of the reforms apply specifically to derivatives
activities, others apply more broadly to nonderivatives activities as
well. In December 1994, U.S. bank regulators issued final
risk-based capital rules that should result in banks holding capital
that more accurately reflects their actual risk exposure. These
rules (1) provide broader recognition of offsetting risk exposures by
allowing banks to net these exposures and (2) revise the way banks
calculate the amount of capital needed to cover potential future
changes in derivatives contract values. Also, in December 1994, bank
regulators amended their risk-based capital guidance to include
concentrations of credit risk and an institution's ability to manage
such concentrations as important factors in assessing overall capital
adequacy. In August 1995, the regulators issued a final rule
requiring that risk-based capital requirements take account of
interest rate risk throughout an institution. Further, in September
1996, they issued a joint final rule to incorporate the market risk
of the trading activities of internationally active banks into the
risk-based capital calculation. Finally, the Federal Reserve has
requested comment on an innovative approach to capital that would
require banks to set their own capital requirements for their trading
risks and would provide incentives in the form of penalties to ensure
that the capital is adequate.
--------------------
\3 Risk-based capital requirements call for capital to be held
against on- and off-balance sheet risks in varying amounts according
to measures of relative risk assigned by the regulators.
CAPITAL RULES WERE AMENDED
TO ALLOW BROADER RECOGNITION
OF BILATERAL NETTING AND TO
MORE ACCURATELY REFLECT
POTENTIAL FUTURE CREDIT
EXPOSURE
-------------------------------------------------------- Chapter 3:1.1
In response to amendments to the Basle Accord that allowed broader
recognition of qualified bilateral netting agreements,\4
U.S. bank regulators issued a final rule for such netting (effective
December 1994).\5 This risk-based capital rule allows a bank to net,
for risk-based capital purposes, negative and positive market values
of interest and exchange rate contracts with the same counterparty.
The contracts must be subject to qualifying bilateral netting
agreements. To ensure that a legal basis exists to support the
enforceability of a netting contract, U.S. banks must obtain a
written legal opinion that the contract is enforceable in all
relevant jurisdictions. The broader recognition of qualifying
legally enforceable bilateral netting agreements is significant
because such arrangements help to reduce financial institutions'
counterparty exposure and settlement risks. Previously, U.S. banks
were only allowed to net obligations that were denominated in the
same currency and due on the same date on derivatives contracts with
other counterparties.\6
U.S. bank regulators issued a final rule (effective October 1995) to
implement amendments to the Basle Accord governing the calculation of
potential future credit exposures. The first part of the rule
authorized banks to recognize qualifying legally enforceable
bilateral netting agreements in calculating potential future
exposures for risk-based capital purposes. The other part expanded
the coverage and increased the maximum level of the credit conversion
factors used to calculate the add-on amount.\7
The conversion factors in the original Basle Accord ranged from 0 to
5 percent, covered interest rate and exchange rate contracts, and had
two maturity categories--1 year or less and over 1 year. According
to one regulator, this final rule responded to concerns that these
original factors did not cover enough types of products and were not
high enough to cover potential exposures on contracts with long-dated
maturities. The amended conversion factors range from 0 to 15
percent; cover six types of derivatives contracts (interest rate,
exchange rate, equity, gold, other precious metals, and other
commodities); and include maturity categories of 1 year or less, 1 to
5 years, and over 5 years.
--------------------
\4 "The International Convergence of Capital Measurement and Capital
Standards," also known as the Basle Accord, is a risk-based framework
endorsed by bank regulators from the United States and 11 other
countries in 1988. Although it is not legally enforceable as a
treaty, members regard the framework as binding.
\5 Bilateral netting, for U.S. bank regulatory purposes, is an
arrangement between a bank and a counterparty that creates a single
legal obligation covering all included individual contracts. This
means that a bank's obligation, in the event of the default or
insolvency of one of the parties, would be the net sum of all
positive and negative fair values of contracts included in the
bilateral netting agreement.
\6 This is known as netting by novation.
\7 Conversion factors are used to estimate how much future movements
of market rates and prices can increase current amounts owed by a
counterparty on derivatives contracts. The factors are expressed as
a percentage. Thus, a contract with a notional value of $1 million
that was subject to a 15 percent conversion factor would be
calculated as having a potential future credit exposure of $150,000.
U.S. BANK REGULATORS ISSUED
FINAL RULES TO ADDRESS
ADDITIONAL RISKS
-------------------------------------------------------- Chapter 3:1.2
Section 305 of FDICIA required, among other things, that bank
regulators revise their risk-based capital standards to include
concentration of credit risk, risks of nontraditional activities, and
interest rate risk.\8 In response, on December 13, 1994, bank
regulators amended risk-based capital standards for insured
depository institutions to "ensure that those standards take adequate
account of concentration of credit risk and the risks of
nontraditional activities," which include derivatives activities.
Regulators are to consider the risks from nontraditional activities
and management's ability to monitor and control these risks when
assessing the adequacy of a bank's capital. Similarly, institutions
identified through the examination process as having exposure to
concentration of credit risk or as not adequately managing their
concentration of risk are required to hold capital above the
regulatory minimums. Because no generally accepted approach exists
for identifying and quantifying the magnitude of risk associated with
concentrations of credit, bank regulators determined that including a
formula-based calculation to quantify the related risk was not
feasible.
U.S. bank regulators addressed the interest rate risk portion of
section 305 through a two-step process. Step one consisted of a
final rule issued on August 2, 1995, that amended the capital
standards to specify that bank regulators will include in their
evaluations of a bank's capital adequacy an assessment of the
exposure to declines in the economic value of the bank's capital due
to changes in interest rates. The final rules specify that examiners
will also consider the adequacy of the bank's internal interest rate
risk management. Step one also included a proposed joint policy
statement that was issued concurrently with the final rule. This
joint policy statement described how bank regulators would measure
and assess a bank's exposure to interest rate risk.
Originally, bank regulators intended that step two would be the
issuance of a proposed rule based on the August 2, 1995, joint policy
statement that would have established an explicit minimum capital
requirement for interest rate risk. Subsequently, bank regulators
elected not to pursue a standardized measure and explicit capital
charge for interest rate risk. According to the bank regulators'
June 26, 1996, joint policy statement on interest rate risk, the
decision not to pursue an explicit measure reflects concerns about
the burden, accuracy, and complexity of developing a standardized
model and the realization that interest rate risk measurement
techniques continue to evolve. Nonetheless, bank regulators said
they will continue to place significant emphasis on the level of a
bank's interest rate risk exposure and the quality of its
risk-management process when they are evaluating its capital
adequacy. The bank regulators have recommended to FFIEC that
additional call report information be collected on interest rate risk
to improve their ability to monitor banks' exposures. They
anticipate that this information will be included in the 1997 call
reports.
--------------------
\8 Interest rate risk is the risk of potential loss arising from
changes in interest rates. It exists in traditional banking
activities, such as deposit-taking and loan provision, as well as in
securities and derivatives activities.
U.S. REGULATORS ISSUED A
FINAL RULE TO ADDRESS MARKET
RISK
-------------------------------------------------------- Chapter 3:1.3
In September 1996, U.S. bank regulators issued a final rule based on
the Basle Committee on Banking Supervision's January 1996 amendment
to the Basle Accord. The rule developed consistent capital standards
for market risk in internationally active dealer banks.\9 The final
rule requires that institutions adjust their risk-based capital ratio
to take into account both the general and specific risk of their debt
and equity positions in their trading accounts and the general market
risk associated with foreign exchange and commodity positions,
whether or not they are in the trading account. The rule requires
that banks use their own internal models to provide a measure of the
institutions' "value at risk," subject to regulatory modeling
criteria.\10 According to bank regulators, the elimination of the
standardized-model approach suggested in the Basle Committee on
Banking Supervision's May 1993 proposed rule to address market risk
reflected strong industry opposition to the use of standardized
models. Industry officials felt a standardized model approach would
be unduly cumbersome, potentially inaccurate, and a disincentive to
innovations and improvements in internal models. Bank regulators
believe that banks with significant trading activities need to have
good internal value-at-risk models and that a standardized model
would be inappropriate and inadequate for such firms.
In order to adapt banks' internal models for regulatory purposes, the
bank regulators have developed minimum qualitative and quantitative
requirements that all banks subject to the market risk capital
standard will have to use in generating their estimates of value at
risk. The qualitative requirements reiterate the basic elements of
sound risk management. According to the final rule, quantitative
requirements are designed to ensure that an institution has adequate
levels of capital and that capital charges are sufficiently
consistent across institutions with similar exposures. (See app. V
for a detailed discussion of criteria.) A bank's calculation of value
at risk, even with the quantitative criteria applied, may not measure
the full amount of capital necessary to protect against potential
market risk losses. The value-at-risk models, for example, may not
capture unusual market events. As a result, regulators require that
a bank's value-at-risk capital charge be the larger of the previous
day's value at risk, or the average daily value at risk over the last
60 business days multiplied by at least 3.
The final rule also requires banks to conduct periodic backtesting.
Banks are to compare daily value-at-risk estimates generated by
internal models against actual daily trading results to determine how
effectively the value-at-risk measure identified the boundaries of
gains or losses, consistent with the predetermined statistical
confidence level. Regulators are to use the backtesting results to
adjust the multiplication factor (multiplier) that banks use to
determine their capital requirement.\11
--------------------
\9 The rules apply to any bank or bank holding company whose trading
activity equals 10 percent or more of its total assets or whose
trading activity equals $1 billion or more. In addition, a regulator
can include an institution that does not meet the criteria if deemed
necessary for safety and soundness purposes or can exclude
institutions that meet the applicability criteria. The new rules
become effective January 1, 1998, but banks can begin implementing
them as of January 1, 1997.
\10 Value at risk represents an estimate of the amount by which an
institution's positions in a risk category could decline due to
general market movements during a given holding period, measured with
a specified confidence interval.
\11 For example, if a bank exceeds its value-at-risk estimate 10 or
more times in the previous 250 business days, its multiplier could be
increased from 3 to 4.
THE FEDERAL RESERVE EXPLORES
A DIFFERENT APPROACH TO
CAPITAL
-------------------------------------------------------- Chapter 3:1.4
On July 25, 1995, the Federal Reserve issued a request for comment on
a "pre-commitment approach" to capital requirements for market risks
in banks' trading activities. Under the pre-commitment approach, the
bank would tell the regulator, in advance, how much of its capital
was allocated for trading risks during some specified period of time,
such as the next quarter. The estimate would determine the bank's
regulatory capital requirement. To ensure that a bank's capital
commitment was adequate to cover both its trading position risks and
its ability to manage those risks, a regulator would provide
incentives in the form of penalties for a bank's failure to contain
its loss within the committed-capital amount. These penalties could
include fines, higher capital requirements, restrictions on trading
activities, or public announcement of the bank's delinquency.
Further, both the commitment and a bank's risk-management system
would be subject to review by regulatory authorities, who would have
to be satisfied that the pre-committed amount was consistent with the
bank's trading position and risk-management system.
This proposed approach presumes that methods for measuring and
managing market risk will continue to evolve. It could encourage
development of progressive risk management tools, because the
proposed approach would devolve responsibility for setting capital
from regulators to banks and provide incentives for banks to set
capital prudently. If enacted with carefully designed penalties, it
could create incentives for banks to set aside adequate capital for
the purpose of meeting unexpected losses. According to a Federal
Reserve Bank president, the Federal Reserve recognizes that the
penalties cannot be so severe that they impair profitability or push
a bank into financial distress. The approach could also encourage
banks to implement adequate risk-management systems and internal
models. Although no further action had been taken on this approach
as of July 1996, industry reactions have been generally favorable.
According to a Federal Reserve Bank president, the New York Clearing
House Association is organizing a pilot study of pre-commitment that
"will provide valuable experience with this innovative approach."\12
--------------------
\12 The New York Clearing House Association, a pioneer American
clearinghouse, was organized in 1853. In addition to its operational
clearinghouse functions, its objectives are also promotional and
self-regulative.
BANK REGULATORS HAVE EXPANDED
REGULATORY REPORTING
REQUIREMENTS
---------------------------------------------------------- Chapter 3:2
As part of their oversight, bank regulators collect information
through quarterly call reports, which include information on
derivatives activities. We recommended in our May 1994 report that
financial regulators collect information on the extent of major
counterparty concentrations and the sources and amounts of their
derivatives earnings. Effective March 31, 1995, call report
requirements were expanded to include much of the information on
derivatives-related activities that we had recommended. Beginning in
1996, the call report was further expanded to include information on
credit losses from derivatives.
The expanded call reports require separate reporting of
notional/contract amounts for exchange-traded and OTC contracts. For
each of the four types of underlying risk exposure--interest rate,
foreign exchange, equity derivatives, and commodity and
other--notional/contract amounts of off-balance sheet derivatives
contracts are reported separately for trading or nontrading
activities.\13 Banks also are required to report the amortized cost
and fair value of their high-risk mortgage securities and structured
notes that are held in either the held-to-maturity or
available-for-sale (AFS) portfolios.
Banks with greater than $100 million in assets are subject to
additional reporting requirements. For example, for each of the four
types of underlying risk exposure, these banks are required to report
the gross positive and negative fair values separately for (1)
contracts held for trading purposes, (2) contracts held for purposes
other than trading whose values are marked to market for call
reporting purposes, and (3) contracts held for purposes other than
trading whose values are not marked to market. In addition, these
banks are required to report the combined revenue from trading cash
and derivative instruments. They are also required to report the
impact that derivatives contracts held for nontrading purposes have
on the bank's net income. Further, these banks are required to
separately disclose the net effect of derivatives on interest income,
interest expense, and noninterest income and expense.
Although bank regulators now collect more derivatives information
through call reports, the reports do not include information on
individual counterparty exposures. Bank regulators did not view this
information-reporting omission as a major concern because they said
the information is available to them through their ongoing monitoring
and surveillance activities. OCC told us that its examiners obtained
and reviewed counterparty information on an ongoing and as-needed
basis during the bank examination process, including information on
the extent of major OTC dealers' counterparty concentrations. OCC
officials also told us that collecting information on counterparty
exposures through the call report would create confidentiality
problems because of the sensitivity of the information. Federal
Reserve officials told us that collecting quarterly individual credit
exposure information would not be useful because it is
fluid--counterparty exposures change frequently--and collateral is
involved. In addition, they said that they are in constant contact
with bank officials and have access to management reports, which
would include this type of information.
We note, however, that routinely gathering information on individual
counterparty credit exposures would enable regulators to identify
credit concentrations across the industry. In addition, analyzing
industrywide credit concentrations could help regulators manage
potential threats to the financial system that could arise if
counterparties were to fail or experience financial difficulties.
Further, if a large derivatives dealer or end-user were to fail or
develop severe financial problems, regulators could use counterparty
credit exposure information to identify and prioritize the
institutions that would have to be contacted as part of mitigating a
crisis or resolving a failure.
--------------------
\13 Nontrading activities are further separated between contracts
whose values are marked to market for call report purposes and those
that are not.
BANK REGULATORS HAVE IMPROVED
THEIR OVERSIGHT
---------------------------------------------------------- Chapter 3:3
Bank regulators have improved their oversight examinations of bank
derivatives activities. They have improved their on-site
examinations by focusing on derivatives risk management and key
internal controls. They also have issued improved examiner guidance
that includes specific guidance on issues related to risk management,
trading, and derivatives activities. Further, they have developed
special units and training to enhance examiners' technical expertise,
conducted special studies, and increased the extent to which
technical and examination-related information is shared among
examiners.
BANK EXAMINATIONS MORE
CLEARLY FOCUSED ON
DERIVATIVES RISKS
-------------------------------------------------------- Chapter 3:3.1
On-site examinations remain regulators' primary means for assessing
the quality of management operations and internal controls. As part
of the examination process, regulators are to assess the adequacy of
internal control systems, specifically identify critical internal
control procedures, test these procedures, and evaluate the results
of these tests. For three of the seven major U.S. bank derivatives
dealers identified in our 1994 report, we compared the examinations
done by the Federal Reserve and OCC in 1994 to those they conducted
in 1993. We found that the 1994 examinations were more clearly
focused on the banks' derivatives risk-management and internal
control systems. The extent to which bank regulators had documented
the assessments they performed as part of their examinations also had
improved. In addition, we compared the 1994 examinations of two of
the banks to examinations conducted in 1992 and found the 1994
examinations were generally more comprehensive.
Using bank examination guidance and G-30 recommendations as criteria,
we identified elements we believe are vital to an effective
risk-management system.\14 We then determined how bank examiners
reviewed compliance with those elements. Although examiners reviewed
the internal control systems at the seven banks, we found that the
extent of internal control testing conducted as part of these
examinations was generally limited. Federal Reserve and OCC bank
examiners confirmed that they do not extensively test internal
controls during on-site examinations. They told us that one of the
reasons they limit their internal control testing is that such
testing is done by the banks' internal and external auditors.
According to an OCC official, it is the regulators' job to make sure
that internal and external auditors perform internal control testing.
However, a Federal Reserve official acknowledged that more extensive
internal control testing may be necessary and stated that Federal
Reserve staff are considering using statistical sampling in their
examinations. Supplemental guidance issued by the Federal Reserve in
May 1996 stated that the degree of testing conducted during an
examination is to depend on the quality of management practices and
the materiality of the activities or functions being reviewed.
In addition, bank regulatory officials told us that they review
certain key processes during every examination, including the
calculation of position valuations, credit approval, adherence to
internal position limits, management reporting, and audit coverage.
Bank regulatory officials also said they concentrate examiner
resources on intensive reviews in those areas where they believe
significant weaknesses exist.
We found that bank examiners used FDICIA-required internal control
assessment reports to varying degrees in the examination process.\15
Examiners can use the work of management and auditors to supplement
their examination procedures as long as they adequately review the
work. Examiners at one bank had reviewed the internal control
assessment reports and had followed up with bank personnel to
determine whether the deficiencies identified in the assessments had
been corrected. Examiners at five of the banks had reviewed the
internal control assessments but did not use them extensively in
conducting their examinations. Examiners at the seventh bank said
that the internal control assessment reports did not contain any more
information than they obtained from other sources and thus were not
used. A Federal Reserve official noted some bank personnel had
credited the requirement for accelerating the pace of internal
control improvements at their banks.
We found that examiners at all seven banks reviewed internal audit
reports, followed up on internal audit report findings, and assessed
the qualifications of the banks' internal audit staff. However, we
found no evidence that bank examiners had extensively reviewed the
workpapers and supporting materials for the internal audit reports.
For example, at three of the banks, we found no evidence that
examiners had reviewed internal audit workpapers during the 1994
examinations. At the other four banks, we found that examiners had
looked at only selected internal audit workpapers. Similarly,
examiners noted when external auditors had done relevant work, but we
found no evidence that examiners reviewed external auditors'
workpapers during these examinations. Such reviews could be an
important means for determining the adequacy and scope of the work of
internal and external auditors. In addition, auditors' workpapers
may provide useful information not included in their reports, which
cover only material weaknesses. Since our review of these
examinations, bank regulators have undertaken efforts to improve
cooperation between external auditors and examiners and have
attempted to identify areas in which examiners could better use the
work of external auditors, including external audit workpapers.
--------------------
\14 The elements include risk management, senior management and board
oversight, capital requirements, internal audits, and control over
sales practices.
\15 The 1994 examinations we reviewed were the first examinations
completed under FDICIA, which also requires management to annually
assess and report on the effectiveness of internal controls over
financial reporting. FDICIA further requires an external auditor
attestation of management's assertions about the adequacy of
controls, which is publicly available.
BANK REGULATORS ISSUED NEW
AND UPDATED EXAMINATION
GUIDANCE
-------------------------------------------------------- Chapter 3:3.2
Since our 1994 report, OCC and the Federal Reserve issued various
types of detailed guidance, which focused on supervising and
examining bank risk-management and internal control systems. Bank
regulators told us that most of the guidance issued since our 1994
report simply formalized the approach and procedures that bank
examiners had used for some time. Regulators told us they had been
moving away from a product-oriented examination approach to a more
risk-oriented approach, which is reflected in the guidance issued
since 1994. In addition to issuing more detailed guidance and
examination procedures for risk management, the Federal Reserve and
OCC issued guidance on sales practices,\16
structured notes, FCM activities, and trading activities in emerging
markets. OCC unveiled its "supervision by risk" program, which it
considers to be a departure from traditional supervision because of
its forward-looking nature that focuses on the quality of
risk-management systems. The Federal Reserve issued supplemental
guidance on risk-focused examinations.
--------------------
\16 This guidance is being examined as part of ongoing GAO work.
OCC EXAMINATION GUIDANCE
FOCUSES ON BANK RISK
MANAGEMENT
------------------------------------------------------ Chapter 3:3.2.1
Between May 1994 and August 1996, OCC issued new and expanded
guidance to its examiners. In May 1994, OCC issued answers to
commonly asked questions about BC 277.\17 In July 1994, OCC issued
additional guidance to national bank examiners and banks about the
market and liquidity risks associated with structured notes. In
October 1994, OCC issued detailed guidance and comprehensive
examination procedures to national banks and examiners to accompany
BC 277.
In November 1995, OCC issued specific guidance for examinations of
CFTC-registered FCMs that are operating subsidiaries of commercial
banks. According to an OCC official, the guidance was an outgrowth
of concerns created by the failure of Barings due to the activities
of its FCM affiliate. The underlying risks associated with FCM
activities are not new to banking, although their measurement and
control can be more complex than other traditional banking
activities. The guidance informs examiners about what controls
should be in place, including the role of a bank's board of directors
and senior management in developing internal control policies and
procedures and risk-management systems. The guidance also identifies
nine categories of risk on which examiners should focus.\18 Examiners
are also to focus on board of director oversight of the bank's FCM
activities by outlining what directors and management must do to
ensure adequate oversight of FCM activities. The guidance should
help to reinforce the importance of sound risk management and
adequate internal controls to bankers, because failure to comply
could be considered an unsafe and unsound practice.
In recent years, OCC has been incorporating risk-management
assessments into its examination activities. In December 1995, OCC
issued examiner guidance on its revised approach to supervision that
is designed to expand, enhance, and standardize the way examiners
evaluate national banks with assets of at least $1 billion. This
approach, supervision by risk, focuses on evaluating the quantity of
risk exposure in an institution and determining the quality of the
risk-management system in place to control that risk. To achieve
more comprehensive examinations, OCC used the same nine categories of
risk identified in the November 1995 guidance for FCM activities.
Bank examiners are to use risk profiles prepared for each bank to
focus attention on the most serious concerns in a bank. According to
the Comptroller of the Currency, supervision by risk will help OCC do
a better job of responding to current and future risks to banks and
the U.S. financial system. He also noted that this proactive
approach is a major departure from the traditional transactional
approach or more recent approaches, which examined how banks handled
past levels of risk.
Also, in December 1995, OCC issued additional guidance to examiners
on emerging market countries' products and trading activities.
According to an OCC official, "trading and investment in the emerging
countries makes this one of the fastest growing global financial
markets." The examiner guidance includes information on written
policies and procedures, country exposure, country exposure limits,
aged or stale-data inventory controls, compensation, and separation
of functions.
--------------------
\17 BC 277, "Risk Management of Financial Derivatives" (Oct. 1993),
is guidance that outlines specific components of risk management and
generally includes the role of senior management and board oversight;
management of various risks; and discussions of relevant legal
issues, capital adequacy, and accounting.
\18 The nine categories of risk include credit risk, interest rate
risk, liquidity risk, price risk, foreign exchange risk, transaction
risk, compliance risk, strategic risk, and reputation risk.
THE FEDERAL RESERVE'S
EXAMINATION GUIDANCE ALSO
FOCUSES ON RISK
MANAGEMENT
------------------------------------------------------ Chapter 3:3.2.2
The Federal Reserve also issued new and expanded guidance to its
examiners. In March 1994, the Federal Reserve issued a new
comprehensive examination manual that addressed trading activities.
It included more extensive instructions on evaluating internal
control systems than previous guidance. In August 1994, the Federal
Reserve issued examination guidance on structured notes, highlighting
their risks and the need for examiners to ensure that institutions
are using them according to their investment policies and procedures.
In addition, in March 1995, the Federal Reserve issued "Evaluating
the Risk Management and Internal Controls of Securities and
Derivative Contracts Used in Nontrading Activities." It included
specific guidance for examiners on evaluating the risk-management
practices used by banks for securities and derivatives contracts of
nontrading activities and stressed the importance of an active board
and senior management.
In November 1995, the Federal Reserve issued new guidelines on rating
the adequacy of risk-management processes and internal controls.
Examiners were instructed to give sufficient weight to the importance
of internal controls and risk management when evaluating management
under the bank and bank holding company rating systems. In 1996,
according to Federal Reserve officials, examiners began giving a
formal supervisory rating to the adequacy of a bank's risk-management
processes, including internal controls. Under the bank regulators'
Uniform Financial Institutions Rating System, commonly referred to as
the CAMEL rating system--which assesses capital adequacy, asset
quality, management, earnings, and liquidity--regulators would give
risk management and internal controls significant weight when
evaluating management on a scale from 1 (strong) to 5
(unsatisfactory). The guidance stressed the fundamentals of sound
internal controls discussed previously in this report. In July 1996,
FFIEC requested comments on proposed changes to the existing CAMEL
rating system that included increasing the emphasis on the quality of
risk management in each component and possibly adding a new, sixth
component to specifically address market risk sensitivity. Unlike
the Federal Reserve guidance on CAMEL ratings, the FFIEC proposal, if
adopted, would be used by all bank regulators.
In May 1996, the Federal Reserve issued additional examination
guidelines on "Risk-Focused Safety and Soundness Examinations and
Inspections." The guidance outlines the risk-focused examination
process. The Federal Reserve noted that this is a dynamic process
because the procedures focus on
"assessing the types and extent of risks to which a banking
organization is exposed, evaluating the organization's methods
of managing and controlling its risk exposures, and ascertaining
whether management and directors fully understand and are
actively monitoring the organization's exposure to these risks."
BANK REGULATORS HAVE TAKEN
ACTIONS TO INCREASE
EXPERTISE, CONDUCTED SPECIAL
STUDIES, AND IMPROVED
INFORMATION SHARING
-------------------------------------------------------- Chapter 3:3.3
In addition to issuing revised examination guidance, bank regulators
have developed special units or expertise to broaden their technical
capability, conducted special studies, and enhanced information
sharing. OCC officials told us that in June 1994, they established a
Risk Analysis Division to, among other things, assist examiners in
evaluating the models used by banks to measure and analyze risk.
Analyzing the integrity of bank value-at-risk models is increasingly
important to regulators because these models are now used to
incorporate market risk from trading activities into the risk-based
capital calculation. Focusing on banks with over $20 billion in
assets, OCC officials from the Risk Analysis Division told us that
they accompany examiners during on-site bank examinations and
communicate with examiners on an ongoing basis and with bank
personnel as needed.
We found that Federal Reserve examiners also performed technical
analysis as part of their examinations. For example, Federal Reserve
examiners performed a detailed, technical analysis of one bank's
pricing model for mortgage-backed securities. On the basis of their
analysis, examiners suggested several improvements to the model,
including discussing weaknesses in the model's use of a particular
mathematical technique. These types of examination activities are
critical in light of changes to the Basle Accord to incorporate
market risk using internal bank models.
Bank regulators also conducted special studies to improve their
oversight of derivatives and trading activities. For example, in May
1994, OCC staff completed a study that compared the methodologies
that active bank derivatives dealers use to measure market risk
exposure.\19 This study summarized the banks' market risk-measurement
practices and made several recommendations for improving examiner
supervision and evaluation of bank risk-management systems. In
December 1995, staff from various bank regulators issued a report on
an examination of the trading activities of commercial banks.\20 The
report addressed the growing importance of trading activities and
trading revenues at major U.S. banks. It also addresses concerns
raised by financial regulators, Congress, and others that trading
activities could pose undue risk to both individual banks and the
banking system in general. Specifically, the report noted that
concerns had been raised about the volatility of trading revenues
compared to other banking activities and the possibility of trading
activities producing sizeable and sudden losses. Federal Reserve
officials told us they were interested in putting trading activities
"in the same light as other banking activities." The study found that
between June 1984 and June 1995, trading activities resulted in less
volatility to dealer banks' earnings than lending activities and that
trading revenues were consistently positive for the major dealer
banks.\21
Bank regulators also have taken steps to improve information sharing
among examination staff engaged in derivatives and trading activities
work. OCC officials told us they hold regular meetings of staff
involved with capital markets and periodic conferences where
information is shared. Federal Reserve officials also indicated that
they conduct information and training sessions for their capital
markets examiners at least every 6 months. In addition, in June
1994, the Federal Reserve formed the Capital Markets Coordinators
group, which consists of senior Federal Reserve officials, to meet
with staff three times a year to discuss current capital markets
policy and examination issues.
--------------------
\19 "Market Risk Measurement and Evaluation" (May 1994), Alfred P.
Crumlish and Roger Tufts.
\20 "Trading Activities at Commercial Banks," (Dec, 1995), a paper
prepared by the staffs of OCC, FDIC, and the Federal Reserve.
\21 Of the quarterly reports filed during this time frame by the
seven largest bank dealers as of June 1995 (Bank of America NT&SA;
Bankers Trust Company; Citibank, NA; Chase Manhattan Bank, NA;
Chemical Bank; Morgan Guaranty Trust Company; and Nationsbank, NA
Carolinas), six instances occurred in which a bank had a loss from
trading activities for the quarter, and one bank accounted for four
of these instances.
THE FEDERAL RESERVE TOOK A
DERIVATIVES- RELATED
ENFORCEMENT ACTION
---------------------------------------------------------- Chapter 3:4
Bank regulators have the authority to implement enforcement actions
against an institution that fails to comply with laws and
regulations.\22 On December 4, 1994, the Federal Reserve Bank of New
York entered into a formal written agreement with Bankers Trust New
York Corporation, a bank holding company, and two of its subsidiaries
concerning leveraged derivatives.\23 This was the first enforcement
action taken by the Federal Reserve against a banking organization
for its derivatives activities.
The agreement required Bankers Trust to take action in eight areas
related to its leveraged derivatives business. Items addressed
included enhancing management and supervision, strengthening internal
audits, and ensuring that each customer has the capacity to
understand the nature and characteristics of any leveraged
derivatives transaction entered into with Bankers Trust. The
agreement also specified that Bankers Trust hire outside counsel that
is acceptable to the Federal Reserve Bank of New York to assist
Bankers Trust in reviewing (1) its method for allocating the revenues
and expenses of its leveraged derivatives business among Bankers
Trust and its affiliates and (2) its compliance with firewalls
related to corporate separateness.\24 In addition, the agreement
required special counsel to review any employee conduct related to
the leveraged derivatives business that does not comport with bank
policy or applicable law and determine whether disciplinary action is
appropriate. As of August 1, 1996, the agreement remained in
place.\25
--------------------
\22 Regulators use both formal and informal enforcement actions.
Formal actions are legally enforceable, and regulators can use them
to compel banks to take actions to address supervisory concerns.
Formal actions range from issuing cease and desist orders and
ordering the suspension, removal, or prohibition of individuals from
bank operations to assessing civil money penalties and entering into
formal agreements with banks. Formal actions are authorized by
statute. Therefore, if banks do not consent to a formal action or
fail to comply, regulators may enforce the action through
administrative or legal proceedings. Informal actions include
agreements reached through memorandums of understanding, commitment
letters, and board resolutions.
\23 Leveraged derivatives transactions are defined in the agreement
as "derivative transactions (i) where a market move of two standard
deviations in the first month would lead to a reduction in value to
the counterparty of the lower of 15 percent of the notional amount or
$10 million, and (ii) for notes or transactions with a final exchange
of principal, where counterparty principal (rather than coupon) is at
risk at maturity, and (iii) for coupon swaps, where the coupon can
drop to zero (or below) or exceed twice the market rate for that
market and maturity, and (iv) for spread trades that include an
explicit leverage factor, where a spread is defined as the difference
in the yield between two asset classes."
\24 Firewalls describe the legal separation of banking and
broker/dealer operations within a financial institution.
\25 In July 1996, independent counsel completed its report on Bankers
Trust.
CONCLUSIONS
---------------------------------------------------------- Chapter 3:5
Bank regulators have improved their oversight of derivatives
activities through expanded risk-based capital standards, more
extensive information-reporting requirements, and additional
supervisory guidance and procedures. These improvements were
consistent with the recommendations in our May 1994 report. The
Federal Reserve staff's proposed pre-commitment approach could
fundamentally change the way the capital requirement for market risk
is calculated. Shifting the onus of capital determination to banks
could help better ensure that capital reflects current market
conditions and the latest measurement methodologies. However,
regulators would have to continue to closely scrutinize the bank's
risk-management and control systems and carefully craft regulatory
penalties that would deter undercapitalization but would not be so
excessive as to compromise profitability.
Information-reporting requirements continue to be one of the primary
ways regulators monitor bank activities, including derivatives. The
expanded call report requirements that include separate reporting of
notional/contract amounts for exchange- traded and OTC contracts and
related revenue data should enhance bank regulators' oversight
capabilities. Although bank regulators now collect more
derivatives-related information than they have in the past, they
still do not routinely collect and analyze industrywide information
on individual counterparty credit exposures. Such information could
help regulators monitor potential problems and respond to financial
emergencies.
The Federal Reserve and OCC's examination guidance that focuses on
risk management and internal controls should help promote sound
internal controls. Bank regulators' efforts to increase staff
expertise, conduct various studies, and expand information sharing
should help improve examiners' abilities to oversee the derivatives
activities of banks.
Chapter 4 MAY 1994 REPORT SUMMARY
FINDINGS
SEC's regulatory jurisdiction pertains only to activities related to
securities. Therefore, SEC does not regulate affiliates of
broker-dealers whose activities involve products that are not
securities and who are not registered as broker-dealers. Like SEC,
CFTC's authority does not apply to a firm's entire organizational
structure. State insurance regulators do not directly oversee the
financial condition of affiliates of insurance companies that are OTC
derivatives dealers. Derivatives dealer affiliates of insurance
companies are subject to minimal reporting requirements and no
capital or examination requirements.
Five major U.S. broker-dealers that we identified were conducting
their OTC derivatives dealing in one or more affiliates outside the
entity regulated by SEC or CFTC. We identified three OTC derivatives
dealers that were affiliates of U.S. insurance companies. These
eight OTC derivatives dealers constituted a rapidly growing component
of the derivatives markets.
RECOMMENDATIONS
We recommended that Congress require federal regulation of the safety
and soundness of all major U.S. OTC derivatives dealers. We said
the immediate need was for Congress to bring the unregulated OTC
derivatives activities of securities firm and insurance company
affiliates under the purview of one or more of the existing federal
financial regulators and to ensure that derivatives regulation is
consistent and comprehensive across regulatory agencies.
SEC AND CFTC OTC DERIVATIVES
OVERSIGHT HAS IMPROVED, BUT
INSURANCE REGULATORS' OVERSIGHT
REMAINS UNCHANGED
============================================================ Chapter 4
Since our May 1994 report, SEC and CFTC have taken several steps to
improve their oversight of the major OTC derivatives dealers that
were affiliates of securities firms. First, CFTC adopted
risk-assessment rules that allow it to receive periodic information
on certain FCM affiliates. Second, DPG's framework for voluntary
oversight, which was developed in conjunction with SEC and CFTC,
represented an important first step in the evolution of oversight of
the major OTC derivatives dealers that are affiliates of U.S.
broker-dealers. Third, SEC continued its efforts to explore and
evaluate whether capital standards should be modified in light of
activities in the derivatives market. In 1995, CFTC began similar
efforts to reevaluate its capital standards to determine whether the
current method of measuring capital requirements has kept pace with
the changing financial environment. Fourth, SEC and CFTC took
enforcement actions involving derivatives activities. Although these
were positive steps for oversight of securities and futures firms,
oversight of insurance companies' derivatives dealer affiliates
remained unchanged.
CFTC IMPLEMENTED
RISK-ASSESSMENT RULES
---------------------------------------------------------- Chapter 4:1
On December 31, 1994, CFTC implemented risk-assessment rules that
allow it to collect information to assess the risks posed by the
activities of FCM affiliates that pose material risks to the FCM.\1
CFTC consulted with SEC, which had adopted similar information
risk-assessment rules in 1992, and other financial regulators to
develop its risk-assessment rules. The CFTC risk-assessment rules
require FCMs to provide certain information about their holding
company and affiliates.\2 Organizational charts and information on
risk-management policies are to be provided once with periodic
updates as needed, and financial statements are to be provided
annually. The rules provide CFTC with the authority to seek
additional information as necessary. CFTC and SEC officials credited
information acquired from their risk-assessment rules, along with
other information available to them, with enabling them to determine
whether U.S. firms had any large exposures to Barings. (See chs. 2
and 6 and app. I for additional discussion about Barings.)
CFTC deferred implementing final risk-assessment rules for reporting
information on (1) noncustomer accounts, (2) financial position and
other information relating to an FCM's material affiliates, and (3)
the occurrence of triggering events.\3
However, in May 1996, CFTC incorporated certain of these proposed
triggering events into its rule on early warning requirements. For
example, the new rule requires FCMs to report to CFTC when a 20
percent or greater reduction in their net capital occurs.\4
CFTC was still considering implementation of the balance of the
deferred risk-assessment proposal as of August 1996.
--------------------
\1 The risk-assessment rules generally apply to FCMs that hold
customer funds of $6,250,000 or greater, maintain adjusted net
capital in excess of $5,000,000, or are clearing members of a
contract market.
\2 CFTC's risk-assessment rules provide exemptive provisions for
entities that are subject to the regulatory oversight of other
domestic and foreign regulatory bodies.
\3 In its proposed final rule, CFTC identified eight events that
could have triggered ad hoc reporting.
\4 CFTC Rule 1.12 established financial early warning reporting
requirements for FCMs and introducing brokers that are designed to
provide advance notice of financial or operational problems. In
addition to incorporating the 20-percent reduction in net capital
early warning requirement, CFTC also incorporated three additional
early warning requirements applicable to all FCMs. FCMs are also to
report (1) a planned reduction in excess adjusted net capital of 30
percent or more 2 business days prior to the reduction, (2) a margin
call that exceeds an FCM's excess adjusted net capital that remains
unanswered by the close of the business day following the issuance of
the call, and (3) whenever excess adjusted net capital is less than 6
percent of the maintenance margin required to support positions of
noncustomers carried by the FCM unless the noncustomer itself is
subject to CFTC's minimal financial requirements for an FCM or SEC's
minimum requirements for a securities broker-dealer. These reporting
requirements harmonize CFTC's early warning reporting requirements
with industry self-regulatory organizations.
THE DPG FRAMEWORK PROVIDES FOR
VOLUNTARY OVERSIGHT
---------------------------------------------------------- Chapter 4:2
DPG member firms, in coordination with SEC and CFTC, developed a
self-regulatory framework to address public policy issues raised by
the OTC derivatives activities of "unregulated affiliates of
SEC-registered broker-dealers and CFTC-registered FCMs." DPG's
voluntary self-regulatory framework consists of four interrelated
components. The first component, which is discussed in chapter 2,
outlines management controls. The second component is a series of
quantitative reports that cover credit risk exposures and related
information associated with OTC derivatives activities.\5 The third
component consists of an approach for estimating credit and market
risk exposures associated with OTC derivatives activities and an
approach for evaluating those risks in relation to capital. The
fourth component offers guidelines governing relationships with
nonprofessional counterparties. As noted in the framework, this
initiative is considered part of a process, not a single event. As
DPG member firms and SEC and CFTC gain insights, they anticipate
further refinements to the framework. Although the DPG framework is
an important step in the evolution of oversight of the major OTC
derivatives dealers that are affiliates of U.S. broker-dealers, it
does not close the regulatory gaps that exist for these OTC dealers.
--------------------
\5 The DPG framework defines OTC derivative products for enhanced
reporting purposes as interest rate, currency, equity, and commodity
swaps; OTC options; and some currency forwards.
THE VOLUNTARY FRAMEWORK
PROVIDES ADDITIONAL
INFORMATION TO SEC AND CFTC
-------------------------------------------------------- Chapter 4:2.1
DPG firms voluntarily provide information on their unregulated OTC
derivatives affiliates that was not required under SEC and CFTC
risk-assessment rules. Since 1995, reporting DPG member firms have
provided SEC and CFTC quarterly reports on (1) credit concentrations
(specific information on individual counterparty exposures), (2) the
credit quality of their portfolios, (3) net revenue data, and (4)
consolidated volumes of derivatives activity.\6 SEC and CFTC had
received all agreed-upon reports from the five reporting DPG firms
through year-end 1995.\7 SEC and CFTC officials said that these
reports augment the information they receive through their
risk-assessment rules and other financial and position information
and that the reports are being analyzed and integrated into their
risk assessments of broker-dealers and FCMs. These reports, like the
information collected by SEC and CFTC under their risk-assessment
rules, are confidential and not publicly available.
The credit concentration reports that the reporting DPG firms
provided were based on their affiliates' top 20 current net credit
exposures by counterparty.\8 The firms provided the information
without identifying individual counterparties, but SEC and CFTC can
request the names when necessary. For each of the top 20 current net
credit exposures, the firms also reported information on the net
replacement value, gross replacement value, and potential additional
credit exposure. According to SEC, the DPG firms' reported
replacement value information is enhanced by the notional/contract
values they report under the risk assessment rules. SEC believes
this will provide a better understanding of the risks that the firms
incur and their level of trading. However, a CFTC official told us
that unnamed counterparty disclosures may not be useful in a market
crisis situation when it may be difficult to contact firms quickly.
The five reporting DPG firms also have provided separate quarterly
reports on the overall credit quality of their portfolios that
includes information on the net exposure, aggregate net replacement
value, and gross replacement value for all counterparties in the
portfolio. The first report is segmented by credit rating category
and industry. The other report is segmented by country for the top
10 geographic exposures. This type of information could be a useful
monitoring tool if it identified potential vulnerabilities from
geographic and industry concentrations. However, industry segments
designated by the International Swaps and Derivatives Association
(ISDA) for reporting purposes may be too broad to identify credit
concentrations within specific industries.\9 SEC and CFTC officials
acknowledged that the specific industry segments were not as useful
as they could be because they are so broad, but they said that this
is the type of issue they intend to evaluate in revising the DPG
framework.
The DPG firms also provided a report to SEC and CFTC on monthly net
revenue data--trading profit/loss less interest and dividend
income/expense. The report included OTC derivatives and related
activities either by generic product type or by business unit
categories, incorporating one or more of the product types. The
generic product types consisted of four categories: interest rate
products, currency and foreign exchange products, equity derivatives,
and commodity derivatives. Such periodic revenue data can be useful
for regulators when they are monitoring a firm's risk profile.
Further, the firms provided a report on the consolidated
notional/contract amount of outstanding OTC derivatives transactions
and current net credit exposures. This report was segmented by
product for the holding company group of which the unregulated OTC
derivatives affiliate was a member.
--------------------
\6 As discussed in chapter 2, CS First Boston is not required to
submit information to SEC or CFTC because it has an OTC derivatives
affiliate that is regulated by the Bank of England. However, SEC
officials told us that under their risk assessment rules, they
receive copies of quarterly financial reports that the affiliate
files with the Bank of England.
\7 SEC and CFTC officials told us that they had received all
agreed-upon reports through August 1996.
\8 Current net exposure equals the replacement value, less the effect
of legally enforceable netting and application of collateral.
\9 The DPG framework uses ISDA-designated segments, which are ISDA
members and non-ISDA members. These are broken down by corporates,
financial institutions, government/supranationals, and others.
THE DPG FRAMEWORK SUGGESTED
HOW TO ESTIMATE CAPITAL AT
RISK BUT DID NOT ESTABLISH
CAPITAL STANDARDS
-------------------------------------------------------- Chapter 4:2.2
The third component of the framework--evaluating risk in relation to
capital--has two parts. First, it suggests a way to estimate market
and credit exposures associated with OTC derivatives activities.
Second, it advocates an approach for evaluating those risks in
relation to capital. According to the DPG framework,
"capital-at-risk" estimates are imperfect measures of potential
losses associated with market and credit risks.\10
However, it noted that managers and supervisors can use them to gauge
capital adequacy and have agreed to report the estimates periodically
to SEC and CFTC.
Although DPG firms' estimates of capital at risk for market and
credit risks are not intended to be capital standards, the estimates
incorporate an approach similar to the one used by bank regulators in
calculating capital to incorporate market risk. The capital-at-risk
estimate is to be generated by the DPG reporting firm's proprietary
model, as is the value-at-risk estimate used by U.S. bank regulators
for certain capital calculation purposes. Although DPG used an
approach for estimating capital at risk for market risks similar to
the bank regulators' value-at-risk approach, it rejected the use of a
multiplier to link capital at risk to capital levels. Moreover, DPG
firms rejected the use of add-ons to estimate potential future credit
risk because the add-on amounts are based on notional/contract
amounts, which they do not consider to be meaningful measures of
risk. (See ch. 3 for a discussion of such calculations.) The DPG
framework used a combination model- and formula-based approach to
estimate credit risk. DPG firms consider this to be an interim
approach for estimating current and potential credit risk. They
noted in the framework that they anticipate cooperating with requests
by SEC and CFTC to compute potential credit risk using other
methodologies.
The DPG member firms developed minimum standards and audit and
verification procedures to ensure that performance characteristics of
all models used to estimate capital at risk for market risk are
broadly similar and rigorous. Because the potential for risk of loss
beyond the capital-at-risk estimate exists, DPG firms agreed to
supplement these estimates with other potential loss estimates
resulting from defined stress scenarios. The framework also outlines
a common approach to audit and verify technical and performance
characteristics because it allows the DPG firms to use proprietary
models that may be unique. SEC and CFTC have received annual reports
from the DPG reporting firms that summarized external auditors'
reviews of these models. However, because no generally accepted
criteria for modeling exist that would allow an external auditor to
assess compliance, the reports contained no opinions. SEC and CFTC
have been working with the DPG firms on how best to resolve this
issue.
In the second part of the framework's capital-at-risk component, the
DPG firms advocate, for a transitional period, an approach for
evaluating market- and credit-risk estimates in relation to capital
levels. In an evaluation of the adequacy of existing capital levels
at DPG-member affiliates, the framework advocates an oversight
approach that encourages regulators and senior managers to take into
account the following factors: the firm's structure, internal
control and risk management systems; quality of management; risk
profile and credit standing; actual daily loss experience; ability to
manage risks as indicated by the firm's ability to perform and
document stress and contingency analysis; and overall compliance with
the framework's policies and procedures. The DPG firms anticipate
that as experience is gained with the overall DPG framework, and
depending on the evolution of thinking and policies among regulators
internationally, this approach may require further refinement or
modification.
--------------------
\10 Capital at risk, as defined by DPG, is the maximum loss expected
to be exceeded once in every 100 weekly intervals.
DPG OFFERS GUIDELINES FOR
COUNTERPARTY RELATIONSHIPS
-------------------------------------------------------- Chapter 4:2.3
The DPG framework also provides guidelines for its members'
relationships with nonprofessional counterparties. The guidelines
address a number of subjects, including promotion of public
confidence; provision of generic risk disclosure statements;
clarification of the nature of the relationship between professional
intermediaries and nonprofessional counterparties; and preparation of
marketing materials, transaction proposals, scenario or other
analyses, and valuations and quotations. The DPG firms agreed to
provide new nonprofessional counterparties with a written statement
identifying the principal risks associated with OTC derivatives
activities and clarifying the nature of the relationship between
parties. We are not discussing issues involving counterparty
relationships, known as sales practices issues, in detail in this
report, because we are addressing them in ongoing work.
GAPS IN REGULATION OF
SECURITIES AND FUTURES OTC
DERIVATIVES DEALER
AFFILIATES REMAIN
-------------------------------------------------------- Chapter 4:2.4
The DPG framework is a positive step toward having some federal
oversight of large OTC derivatives dealers that are affiliates of
broker-dealers or FCMs. However, compliance with the reporting
requirements is voluntary and has been limited to the five reporting
DPG member firms. Furthermore, neither SEC nor CFTC has explicit
authority to enforce operational changes, conduct routine
examinations, or impose capital requirements for the major OTC
derivatives dealers that are affiliates of U.S. broker-dealers or
FCMs.
Through the DPG framework, the five reporting firms voluntarily
report periodic information to SEC and CFTC or have agreed to make
available to them certain information upon request. According to
SEC, these five firms accounted for over 90 percent of the total
derivatives notional/contract value for all U.S. securities
derivatives dealers in 1995. The DPG information provided to SEC and
CFTC is consistent with our 1994 report recommendation on information
reporting. However, the reporting is voluntary, and the framework
contains no provisions for addressing noncompliance. Withdrawal of a
DPG member firm's endorsement of the framework, or its failure to
provide the information agreed upon in a timely manner, could leave
SEC and CFTC without this information at critical times or for a
large part of the market. SEC and CFTC officials told us that their
oversight of the parent securities and futures firms and the threat
of damage to a firm's reputation provide an incentive for DPG members
to adhere to the framework.
SEC AND CFTC CONTINUED EFFORTS
TO REVISE CAPITAL STANDARDS
---------------------------------------------------------- Chapter 4:3
SEC and CFTC have continued efforts to revise their capital
standards. SEC officials stated that they were continuing to explore
and evaluate whether their capital rules should be modified in light
of activities in the derivatives markets and in the OTC market in
particular. Likewise, CFTC was in the initial phases of reviewing
its capital standards and is considering whether its minimum capital
standards have kept pace with the changing financial environment. An
additional consideration in revising capital standards is that
existing capital standards may create incentives for some
broker-dealers and FCMs to conduct certain activities through their
unregistered affiliates to avoid capital requirements that apply only
to registered broker-dealers and FCMs. For example, under current
SEC and CFTC capital requirements, payments that are due a
broker-dealer or FCM on interest rate swaps, which are deducted from
the firm's net worth, are the equivalent of a 100-percent capital
requirement. However, if these swaps were conducted in an
unregistered affiliate, they would not be subject to capital
requirements.
SEC, with CFTC cooperation, is also exploring whether proprietary
models can be incorporated into the capital calculation process. DPG
firms use proprietary (internal) models in their capital-at-risk
estimates, and regulators plan to monitor the results of these
estimates in evaluating whether proprietary models can be used
effectively to determine capital adequacy. SEC officials told us
that they monitored closely the development of the Basle Accord
amendment incorporating market risk into international bank capital
standards.
In September 1995, CFTC hosted a roundtable discussion on various
issues related to capital requirements. Issues discussed included
the purposes of capital requirements, the types of business that
should be covered and the degree to which they should be covered, the
way risk should be measured, and the way quality of capital should be
determined. In addition to reviewing the need for specific revisions
to existing capital standards, CFTC identified potential longer term
projects that included developing a new risk-based capital standard
and aggregating SEC and CFTC capital requirements for firms
registered as both broker-dealers and FCMs.
SEC AND CFTC TOOK ENFORCEMENT
ACTIONS AGAINST DEALER AND
END-USER ACTIVITIES
---------------------------------------------------------- Chapter 4:4
SEC and CFTC have the authority to take enforcement actions against
institutions that fail to comply with the laws and regulations they
are responsible for enforcing.\11 SEC and CFTC have worked together
and individually to bring actions against dealer and end-user
activities involving derivatives. As a result of the four
enforcement actions we reviewed, SEC and CFTC collected a total of
$12.25 million in civil penalties.
--------------------
\11 Their enforcement authorities include court injunctions;
temporary restraining orders; and various administrative proceedings
and sanctions (such as assessment of civil monetary penalties,
censure, suspension and revocation of registration, and issuance of
cease and desist orders).
SEC AND CFTC TOOK ACTIONS
AGAINST A BROKER-DEALER
-------------------------------------------------------- Chapter 4:4.1
On December 22, 1994, BT Securities Corporation settled separate
administrative proceedings with SEC and CFTC and agreed to pay a fine
of $10 million. Both proceedings involved the sale of derivative
products by BT Securities to Gibson Greetings, Inc. According to
CFTC's action, BT Securities, a broker-dealer registered with SEC,
also acted as a commodity trading advisor subject to CFTC
jurisdiction because of its advisory relationship with Gibson. SEC
and CFTC both highlighted their cooperative effort in bringing an
action against BT Securities and said that they were sending a strong
message that SEC and CFTC will work together to police the market
against fraud involving derivatives.
In the SEC proceeding, BT Securities, without admitting or denying
the findings, consented to issuance of an SEC order finding that it
caused reporting violations by Gibson and violated antifraud
provisions of federal securities laws. SEC also found that BT
Securities failed to supervise their employees.\12 The violations
stemmed from OTC derivatives contracts BT Securities sold to Gibson.
The reporting violations were connected with Gibson's 1992 and 1993
financial statements filed with SEC. In preparing those statements,
according to SEC, Gibson relied on valuations of its derivatives
transactions provided by BT Securities. These valuations understated
Gibson's losses by more than 50 percent from the values recorded on
Bankers Trust Company's books.\13 The SEC finding concerning fraud
violations involved two derivatives contracts BT Securities sold to
Gibson that SEC found were securities within the meaning of the
federal securities laws.\14 The finding stated that representatives
of BT Securities made material misrepresentations and omissions in
the offer and sale of these securities.
To avoid potential short-term dislocation of OTC derivatives markets
and direct regulatory consequences for OTC derivatives dealers, SEC
issued a temporary exemptive order concurrent with the order citing
reporting and antifraud violations of BT Securities. The exemptive
order noted that the complexity and rapid proliferation of derivative
instruments raised questions in the industry regarding the proper
statutory and regulatory designation of certain OTC contracts. These
concerns were compounded by a trend among dealers to conduct a range
of OTC derivatives activities in unregistered entities. To provide
certainty to participants in the OTC derivatives market concerning
their registration obligations, the exemptive order provided relief
from broker-dealer registration in connection with certain
transactions involving individually negotiated, cash-settled OTC
options on debt securities or groups of indexes of such securities.
The transactions included were those that (1) are documented as swap
agreements and (2) satisfy the terms of CFTC's swap exemptions. The
exemption was retroactive to June 6, 1934, the date of the enactment
of the Securities Exchange Act of 1934, and was to expire September
30, 1995. SEC subsequently extended this order to September 30,
1996.\15
In the CFTC proceeding, BT Securities, without admitting or denying
the allegations, consented to the issuance of a CFTC order finding
that BT Securities violated the antifraud provision of the Commodity
Exchange Act related to commodity trading advisors in connection with
swaps sold to Gibson. From November 1991 to March 1994, BT
Securities and Gibson entered into a series of derivatives
transactions, all of which were swaps. Over time, the derivatives BT
Securities sold to Gibson became increasingly complex, risky, and
intertwined. Many had leverage factors that caused Gibson's losses
to increase dramatically with relatively small changes in interest
rates. CFTC found that representatives of BT Securities had entered
into an advisory relationship with Gibson sufficient to cause BT
Securities to have become a commodity trading advisor with respect to
its derivatives transactions with Gibson. Further, CFTC concluded
that BT Securities defrauded Gibson in violation of the Commodity
Exchange Act.
In addition to the civil penalty, SEC and CFTC required BT Securities
to cease and desist from violating securities and futures laws and
hire an independent consultant to conduct a review of the firm's OTC
derivatives business. They also required BT Securities to adopt
recommendations that the independent consultant made.
--------------------
\12 Subsequent to the December 1994 BT Securities case, SEC took
administrative actions against two former BT Securities employees
involved in the violations.
\13 Bankers Trust Company, a bank affiliate of BT Securities, was the
counterparty to each derivative product that BT Securities sold to
Gibson. Bankers Trust Company maintained on its books certain
information relating to derivatives transactions with Gibson.
\14 In its proceeding, SEC found that a Treasury-linked swap sold to
Gibson was a cash-settled put option based on the spread between the
price of a Treasury security and the arithmetic average of the bid
and offered yields of a Treasury note. Another transaction, a
knock-out call option sold to Gibson, was a cash-settled call option
based on the yield of a U.S. Treasury security. According to SEC's
proceeding, Gibson entered into several amendments to the
Treasury-linked swap and knock-out call option proposed by Bankers
Trust, and each "was a security within the meaning of the federal
securities laws."
\15 See SEC Release No. 34-36270, CFR, Sept. 22, 1995 (Vol. 60,
No. 188).
SEC TOOK ENFORCEMENT ACTION
AGAINST AN END-USER
-------------------------------------------------------- Chapter 4:4.2
In October 1995, SEC settled administrative proceedings against
Gibson Greetings, Inc., and two of its senior officers. SEC found
that they violated or caused violations of the securities laws in
connection with derivatives transactions between Gibson and BT
Securities. Without admitting or denying any wrongdoing, Gibson and
the two officers consented to entry of an order requiring them to
permanently cease and desist from committing or causing any
violations of the reporting and books and records provisions of
federal securities laws. SEC found that in 1993 Gibson engaged in a
series of derivatives transactions with BT Securities that, for
accounting purposes, amounted to trading or speculation. According
to SEC, those transactions should have been recorded at market value
with changes recognized through the income statement, but instead
they were deferred. As a result, Gibson's quarterly reports on SEC's
Form 10-Q\16 for the first three quarters of 1993 failed to disclose
gains and losses from derivatives to shareholders. SEC also found
that Gibson failed to have adequate books, records, and internal
controls concerning its derivatives transactions.
--------------------
\16 A quarterly report required by SEC of companies with listed
securities.
CFTC TOOK ENFORCEMENT ACTION
AGAINST AN FCM
-------------------------------------------------------- Chapter 4:4.3
On July 27, 1995, MG Refining and Marketing (MGR&M) and MG Futures,
Inc., (MGFI) agreed to pay $2.25 million in civil penalties to settle
a CFTC complaint that they violated the Commodity Exchange Act and
various CFTC regulations.\17 MGFI is an FCM, a member of the New York
Mercantile Exchange, and a commodity trading advisor registered with
CFTC. According to the enforcement action, CFTC found that material
inadequacies in internal control systems at MGFI, as well as the
risks associated with its overall business, including its futures
positions, threatened the financial condition of MGFI. CFTC also
found that MGFI failed to notify it of these material internal
control inadequacies and further failed to file certified financial
reports required by CFTC regulations. MGFI and MGR&M agreed to
settle without admitting or denying any of the findings. According
to a CFTC official, the $2.25 million civil penalty against MGFI and
MGR&M represents the largest fine assessed for violations not
involving fraud in CFTC's history. In addition to the fine, MGFI
must comply with additional requirements, which include providing
certified financial statements, establishing an interim special
oversight committee, reforming inadequate internal controls,
reporting on internal control improvements, providing an
implementation plan, and providing a report by independent auditors
on its internal controls.
According to the settlement agreement, from at least December 1991 to
December 1993, MGR&M also marketed, offered, and sold illegal
off-exchange energy product futures contracts.\18 Some market
participants were concerned that the language used in the agreement
might implicate contracts previously exempted by CFTC as swaps.
However, CFTC maintained that this enforcement case was a response to
a serious failure of MGR&M's internal controls, and it was not
intended to, nor did it, affect the legality or enforceability of
other contracts.
--------------------
\17 Metallgesellschaft, AG is the ultimate parent company of both
MGR&M and MGFI.
\18 CFTC deemed the contracts sold by MGR&M to be futures because
they contained all the essential elements of a futures contract.
They called for making or taking delivery of a commodity in the
future at a price or pricing formula based at initiation; they could
be satisfied either by delivery of the commodity or by engaging in an
offsetting transaction without delivery; and the purpose of the
transaction was primarily to speculate or hedge the risk of price
change in the commodity without actually acquiring the underlying
commodity. CFTC deemed the contracts to be illegal because futures
contracts, unless specifically exempted, must be traded on an
exchange recognized by CFTC.
STATE INSURANCE REGULATORY
OVERSIGHT REMAINS UNCHANGED
---------------------------------------------------------- Chapter 4:5
Although the financial results of derivatives dealer affiliates are
part of consolidated insurance company financial reports to
regulators, these affiliates continue to have no capital or
examination requirements. Although the volume of derivatives
activities of insurance companies was small compared to that of the
top seven bank dealers (see ch. 1), the volume of their activities
was measured in billions of dollars and increased at a greater rate
than either banks or securities firms in 4 of the 5 years that we
analyzed. Given the large asset size of these institutions, adequate
oversight remains important because of the systemic implications of a
loss at any large dealer and the potential loss to policyholders.
State insurance departments, not federal regulators, are responsible
for monitoring insurance companies both headquartered and licensed to
operate in the state. However, state insurance regulators do not
directly oversee the financial condition of affiliates of insurance
companies that are OTC derivatives dealers. As we reported in 1994,
OTC derivatives dealer affiliates of insurance companies are subject
to minimal reporting requirements, continue to have no capital
requirements, and are not examined. According to insurance
regulators from Delaware, New Jersey, and New York, they have made no
changes in their oversight of derivatives since our 1994 derivatives
report. Insurance regulators in these states said that they continue
to receive audited consolidated financial statements for the parent
company or the holding company of the insurance company and that this
information also includes the activities of the derivatives dealer
affiliate.
NAIC, an advisory group that comprises insurance regulators from the
50 states, the District of Columbia, and 4 U.S. territories, has
been actively revising its suggested policies and procedures to
improve derivatives disclosures and examinations. However, NAIC's
proposals are not binding, and each state decides the extent to which
they will be applied. Further, the three states that supervise
insurance companies with derivatives dealer affiliates have no
statutory authority over the affiliates. Thus, even if the states
adopt the NAIC proposals, the resulting requirements would apply only
to the insurance companies, not to their derivatives dealer
affiliates.
NAIC included new derivatives disclosure requirements in its
recommended standard annual financial statement.\19 NAIC suggested
that these requirements be effective with the December 31, 1994,
statement prepared by regulated insurers. NAIC has also changed its
Financial Examiners Handbook to provide better guidance to state
insurance examiners on what to look for when dealing with
derivatives. Further, NAIC has made changes that affect accounting
for, and valuation of, derivatives to the Accounting Practices and
Procedures manuals and the Securities Valuation Office Purposes and
Procedures manuals, both used by state insurance departments. The
NAIC Life Risk-Based Capital Working Group is also considering
refinements to the formula used to calculate capital requirements,
which would better account for derivative products. Finally, the
NAIC Invested Asset Working Group, a study group that issues guidance
on invested assets of insurance companies, provides ongoing
monitoring of insurers' derivatives activity.
--------------------
\19 The standard annual statement is an annual report of the
financial condition of insurance companies required to be filed with
the various state insurance commissioners.
CONCLUSIONS
---------------------------------------------------------- Chapter 4:6
SEC and CFTC have made efforts to police the markets against fraud
involving derivatives as demonstrated by the enforcement actions they
have taken against derivatives dealers and end-users. SEC and CFTC
have also taken positive steps, consistent with the recommendations
in our 1994 report, to address gaps in the oversight of OTC
derivatives activities conducted through unregulated affiliates of
broker-dealers and FCMs. For example, CFTC's risk assessment rules
should provide better information for CFTC to monitor the financial
condition of FCMs. More importantly, SEC and CFTC have begun to
receive expanded information reported voluntarily by the five
reporting DPG members about their unregulated affiliates that are OTC
derivatives dealers. This information should allow SEC and CFTC to
better oversee the five DPG reporting firms and monitor them for
potential problems. Although the DPG framework is an important first
step in the evolution of oversight for the major OTC derivatives
dealers that we identified in our 1994 report, its voluntary nature
does not provide regulators authority to enforce operational changes
they might recommend. We also note that neither SEC nor CFTC has the
authority to put in place examination and capital requirements for
the unregulated affiliates of broker-dealers and FCMs.
Insurance companies' OTC derivatives dealer affiliates remain
virtually unregulated. To the extent that states adopt the new NAIC
proposals, derivatives disclosures and examinations for insurance
companies may improve. However, because the states do not directly
oversee insurance companies' derivatives dealer affiliates, the NAIC
proposals will not apply to them.
Chapter 5 MAY 1994 REPORT SUMMARY
FINDINGS
Accounting rules for derivatives, particularly those used for hedging
purposes by end-users of derivatives, were incomplete and
inconsistent and had not kept pace with business practices. FASB
standards directly addressed only two of the four basic types of
off-balance sheet derivatives--futures and forwards. No specific
accounting rules had been established by FASB for swaps or options.
In the absence of accounting rules for these derivatives, accounting
practices of derivatives market participants had been shaped by
common industry practice and by the adaptation of existing rules for
similar financial products.
We found that in practice, derivatives used for trading purposes were
recorded at market value, while derivatives used for hedging purposes
were recorded consistent with the item being hedged, either at market
value or at cost.\1 If the hedged item was recorded at cost, then
gains or losses from changes in the market value of the derivatives
were deferred until the related gains or losses on the hedged item
were realized, which we referred to as deferral hedge accounting. If
the hedge operated as planned, the income statement effects of the
derivative product and the hedged item would theoretically offset
each other. However, we found that determining whether a hedge was
operating effectively and thus qualified for hedge accounting was
difficult, not only because of the complexities involved but also
because of confusion about the definition of hedging. Some believed
that hedging meant activities to reduce, or neutralize, exposure to
risk of loss from changes in market conditions, while others believed
that hedging also encompassed activities that adjust risk to take
advantage of anticipated changes in market conditions. Since
existing accounting practice allowed for deferral of gains and losses
from derivatives activities designated as "hedging," we stated that
the broadening of the definition of hedging to include risk
adjustment enabled inappropriate deferral of hedge gains and losses.
With regard to disclosure of derivatives activities in financial
statements, we reported that two existing FASB disclosure standards
required disclosure of information about the extent and nature of an
entity's financial instruments, including derivative products, with
off-balance-sheet risk of accounting losses and about fair values\2
of financial instruments. We reviewed the 1992 annual reports of 10
large U.S. bank holding companies with significant derivatives
activity and found these institutions were generally complying with
these standards, although some variances in the extent and methods of
disclosures existed. A proposed disclosure standard, which was
expected to be issued by the end of 1994, required additional
disclosures about derivatives and their fair values. The proposed
standard also contained amendments to the prior two disclosure
standards and included certain optional disclosure requirements.
Although the proposed standard was an improvement over the existing
requirements, it was our view that there were additional disclosures
that would provide financial statement users with a more complete
understanding of derivatives.
We concluded that market value accounting is ultimately the best
solution to accounting for all financial instruments, including
derivatives, and would result in financial statements being almost
completely transparent concerning the effectiveness and impact of
financial risk management activities. However, we also recognized
that development of a new market value accounting model would take
time and thus might not be feasible in the short term because
authoritative accounting standards were needed immediately.
RECOMMENDATIONS
As a step forward, we recommended that FASB proceed expeditiously to
issue the exposure draft on disclosures of derivatives and fair value
of financial instruments. To more effectively deal with accounting
and disclosure issues, we also recommended that FASB proceed
expeditiously to develop and issue comprehensive and consistent
accounting rules for derivatives activities. As the best conceptual
approach to accomplish this, we recommended that FASB consider
adopting a market value accounting model for all financial
instruments, including derivative products.
--------------------
\1 We use the term "market value" to refer to the amount at which an
item could be exchanged between willing parties.
\2 FASB uses the term "fair value" to avoid the implication that the
standards apply only to items traded on active secondary markets.
ACCOUNTING AND DISCLOSURE ISSUES
CONTINUE TO BE OF CONCERN
============================================================ Chapter 5
To address accounting practices for derivatives hedging activities
since our 1994 report, we reviewed 12 banks and thrifts that were
end-users of derivatives. Our review of these 12 institutions showed
that inadequate accounting standards for derivatives hedging
activities continued to be a major unresolved problem that adversely
affected the quality of information available to users of financial
statements. Further, in the case of several entities that reported
major losses from investment activities involving securities with
derivatives-like characteristics, we found that the application of
historical cost accounting rules for investment securities allowed
them to delay recording those losses in the financial statements. We
continue to believe that the adoption of comprehensive market value
accounting for all financial instruments would resolve many of the
accounting problems with derivatives and investment securities.
FASB, GASB, and SEC have taken steps to address these issues. FASB
has issued a disclosure standard that requires specific disclosures
about futures, forwards, swaps, options, and other financial
instruments with similar characteristics. FASB also issued a
proposed standard that would require all derivatives, including
investment securities with derivatives-like characteristics, to be
recorded at fair value on the balance sheet. In addition, GASB
issued a proposed standard that would require state and local
governmental entities to record all investment securities at fair
value. Although these proposed standards would help resolve many of
the accounting issues we identified, they do not require
comprehensive market value accounting for all financial instruments.
Therefore, they would not resolve problems surrounding the use of
historical cost accounting for other types of financial instruments.
In addition, neither FASB nor GASB proposed or adopted standards
requiring disclosure of market risk. Such disclosure is key to
understanding the impact of interest rate and other market changes on
derivatives and other financial instrument holdings. SEC issued
proposed reporting requirements that include disclosure of market
risk. However, the proposal, if adopted, would be required only for
public companies.
HEDGING PRACTICES OF BANKS AND
THRIFTS VARIED CONSIDERABLY AND
WERE SOMETIMES SPECULATIVE
---------------------------------------------------------- Chapter 5:1
Our review of the derivatives accounting practices at 12 end-user
banks and thrifts showed that such practices were inconsistent and,
in some cases, inappropriate. The problems we found centered around
the use of deferral hedge accounting, whereby gains and losses from
these derivatives activities are not recorded in income as they
occur. We found that more than half of the institutions used
deferral hedge accounting for risk-adjusting or, at least in one
case, purely speculative, derivatives activity that was based on
anticipated market movements.\3 We believe that deferral hedge
accounting should be limited to activities intended to decrease an
entity's exposure to risk of loss and should not be used when an
entity uses derivatives to attempt to profit or speculate on market
movements. Only 5 of the 12 institutions used deferral hedge
accounting appropriately for derivatives activities designed to
neutralize their exposure to interest or foreign exchange rate risk.
Seven used deferral hedge accounting for derivatives activities
designed to adjust rather than neutralize their risks and therefore,
in our view, inappropriately delayed recording gains and losses on
these transactions.
Each of the 12 banks and thrifts we selected for review engaged in
activities using derivatives that they defined as "hedging."\4 Each
of the institutions also used deferral accounting for these
designated hedging activities. However, we found that the hedging
objectives for the group of five risk-reducing institutions differed
from those of the group of seven risk-adjusting institutions. The
criteria used by these 12 institutions to justify hedge accounting,
while reportedly based on the limited accounting standards that do
exist for derivatives, also varied significantly.\5 The specific
hedge objectives and related criteria of selected institutions in our
sample are described in appendix VII.
The hedging objective of all five risk-reducing institutions was to
neutralize the impact of potential loss from changes in interest or
foreign exchange rates on their operating income. For example, some
employed a hedging strategy to lock in a spread between interest
earned on assets and interest paid out on liabilities. Under this
type of strategy, changes in the market values of the assets and
liabilities involved, when adjusted by changes in market values of
the derivatives used as a hedge, would generally be offset, thereby
neutralizing the effect of rate changes on the institutions' overall
financial position. Changes in the market values of assets and
liabilities carried at historical cost are not recorded until they
are sold. The offset from changes in the market values of the
derivatives is accomplished by similarly deferring any realized hedge
gains and losses on the derivatives. The deferred hedge gains and
losses would generally be amortized over time and recognized as an
adjustment to net interest income related to the underlying assets
and liabilities being hedged.\6
Any changes in net interest income caused by changes in interest
rates would be offset by amortization of the related hedge gains and
losses.
The other seven institutions in our sample used strategies they
labeled as hedging that were risk-adjusting activities based on
anticipated market movements. For example, if an institution's
management believed interest rates were going to decline, they would
use derivatives to adjust their exposure to interest rates so that
they could profit from a decline in rates. If rates increased rather
than declined, such a strategy would generally result in losses for
the institution. In either case, neither the changes in market
values nor the impact on net interest income from the derivatives
would be offset by corresponding changes in the market values or net
interest income from the assets or liabilities purportedly being
hedged. In other words, the institutions used the derivatives to
shift their exposure to changes in interest rates rather than to
protect against such changes. Because deferral hedge accounting was
applied by these institutions, the gains or losses from these types
of risk-adjusting activities were deferred and not recorded in income
until a later time.
In some cases it may be appropriate for institutions to position
themselves to take advantage of expected changes in interest rates.
However, we believe that the resulting gains and losses from these
activities should not be afforded deferral hedge accounting.
Deferral of such gains and losses can result in large accumulations,
particularly of losses, that either get deferred in the balance
sheet, with no income statement recognition, or do not show up in the
financial statements (as is usually the case with swaps) until the
derivatives position is closed. The use of market value accounting
for derivatives and related financial instruments would preclude such
inappropriate accumulation of losses because changes in their market
values would be recognized in income as they occurred.
--------------------
\3 Examples of institutions' use of deferred hedge accounting are
included in appendix VII.
\4 For purposes of examining these 12 institutions, we limited our
review to their off-balance sheet derivatives activities, primarily
futures, forwards, options, and swaps. We did not specifically
examine their accounting practices for securities with
derivatives-like properties, such as structured notes or CMOs.
\5 Existing accounting standards for derivatives address only futures
and some types of forwards. These standards are outlined in appendix
VI.
\6 Hedge accounting for interest rate swaps differs in that the net
interest differential paid or received on the swap is amortized into
income over the applicable interest period. However, the changes in
market value of the swap itself are not recorded on the financial
statements.
ACCOUNTING PRACTICES FOR
INVESTMENT SECURITIES WITH
DERIVATIVES-LIKE
CHARACTERISTICS RESULTED IN
DELAYED RECOGNITION OF LOSSES
---------------------------------------------------------- Chapter 5:2
Some major losses reported by state and local government entities, a
credit union, and others have been the result of investments in
securities with characteristics similar to those of derivatives.
Changes in market value of these securities can be amplified by
leveraging features that can cause entities holding large portfolios
to experience severe losses in market value from changes in interest
rates. These market value losses are often not recorded by the
entity because accounting rules allow many investment securities to
be carried at historical cost. In particular, accounting practices
followed by state and local governments allow virtually all
securities to be carried at historical cost. Further, accounting
rules do not require disclosures about the potential effects of
changes in interest rates on the market value of the investment
portfolio. By recording investment securities at historical cost and
not disclosing market risk, entities leave financial statement users
without information about the effects of changing market conditions,
which could impede their ability to make informed business decisions.
FASB-ISSUED STANDARDS
REQUIRE ACCOUNTING FOR
INVESTMENT SECURITIES ON THE
BASIS OF ENTITY INTENT
-------------------------------------------------------- Chapter 5:2.1
In May 1993, FASB issued SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities, in response to concerns
about the use, by some securities holders, of historical cost
accounting for investments that were regularly sold and traded.\7
SFAS No. 115 permits some investment securities to be carried at
historical cost on the basis of the intent and ability of an entity's
management to hold the instruments to maturity, but other securities
are to be carried at fair value. Although SFAS No. 115 does not
apply to derivatives, it does apply to investment securities that
have derivatives-like characteristics, such as structured notes and
CMOs. As stated in our December 1992 comment letter to FASB on the
exposure draft for SFAS No. 115, we continue to believe that the
standard is too subjective and difficult to verify. Market value
accounting for all debt and equity securities would eliminate the
judgmental nature of SFAS No. 115 and would provide for early
exposure of portfolio declines.\8 Although market value accounting
has been criticized because it can cause earnings volatility based on
temporary changes in market values, we believe this volatility, if it
occurs, reflects the realities of the marketplace.
We believe that a market value approach to investment securities and
related liabilities and hedging instruments would help expose
activities that threaten an entity's viability and facilitate more
timely corrective actions. In contrast, management's ability to
account for investment portfolios and related activities at
historical cost has allowed some managers to avoid recognition of
problems until they become so severe that they require drastic
action. An example of the dangers of such use of historical cost
accounting is illustrated by the major losses of Cap Corp.
As discussed in chapter 2 and appendix I, market conditions in 1994,
compounded by an aggressive investment and funding strategy, resulted
in large declines in the values of CMOs held by Cap Corp. In the
fall of 1994, many member credit unions began withdrawing shares they
held in Cap Corp. To avoid recording the losses on its CMO
portfolio, Cap Corp funded these withdrawals with additional
borrowing rather than selling some of its CMO portfolio. Once these
borrowings resulted in violation of regulatory borrowing limits, Cap
Corp was forced to liquidate some of these investments at substantial
losses to fund credit union member withdrawals. Yet, Cap Corp
continued to record the vast majority of its portfolio at historical
cost, apparently taking advantage of the subjective criteria of SFAS
No. 115 that allow entities to carry such securities at cost if they
have the ability and intent to hold them to maturity. As of
September 30, 1994, Cap Corp's internal reports showed that over 95
percent of its portfolio was carried at historical cost, which was
approximately $35 million greater than the market value of these
securities at that time. Had earlier recognition of these market
value losses occurred in Cap Corp's financial reports, the negative
effects of its investment strategy would have surfaced sooner,
perhaps in time for remedial action that could have averted its
failure.
--------------------
\7 The requirements of SFAS No. 115 are outlined in appendix VI.
\8 As discussed in appendix VI, SFAS No. 107 requires entities to
disclose the fair value of all financial instruments either in the
body of the financial statements or the related footnotes. However,
we do not believe disclosure of these values effectively communicates
the financial impact of changes in the market value of the financial
instruments because it does not result in the changes in the market
values being reflected in the financial condition and results of the
entities' operations.
SPECIFIC ACCOUNTING
STANDARDS FOR INVESTMENTS
HELD BY STATE AND LOCAL
GOVERNMENTS DO NOT EXIST
-------------------------------------------------------- Chapter 5:2.2
As of September 30, 1996, no specific GASB standards existed that
established rules for accounting for most types of investments held
by state and local government entities.\9 While GASB Statement No.
3, Deposits With Financial Institutions, Investments (Including
Repurchase Agreements), and Reverse Repurchase Agreements, provides
guidance for investment and other disclosures by government entities,
we believe disclosures are no substitute for accounting rules that
determine how the investments should be recorded in the financial
statements. In practice, investment securities are usually recorded
and carried on the books at their original cost, unless it is clear
that the original cost cannot be recovered. The lack of accounting
standards can result in state and local governments avoiding the
recording of losses in market value until well after the book value
is permanently impaired.
In Orange County, CA, for example, despite rapidly decreasing values
(see ch. 2 and app. I), the county's entire pool of securities was
carried at historical cost. This masked the volatility and riskiness
of the investments the County Treasurer was making. The severe
decline in the value of the portfolio became apparent when the county
experienced a severe liquidity squeeze caused primarily by margin
calls. The county experienced substantial losses thereafter as it
liquidated portions of its investment portfolio. Up until this
point, the county continued to carry the portfolio at historical
cost.
As with Cap Corp, had earlier recognition of market value losses been
required, the county may have taken remedial action because the
negative effects of the investment strategy would have been made
clear. Also, as discussed later in this chapter, required
quantitative disclosure of the market risk being taken on investment
securities would have provided further warning of the sensitivity of
Cap Corp's and Orange County's investment portfolios to future
changes in interest rates. The following sections discuss standards
proposed by FASB, GASB, and SEC that if adopted would help resolve
many of the accounting and disclosure inadequacies regarding
derivatives and other investment activities.
--------------------
\9 An exposure draft entitled "Accounting and Financial Reporting for
Certain Investments and for External Investment Pools" was issued by
GASB on March 13, 1996. The provisions of this exposure draft are
summarized later in this chapter.
FASB'S PROPOSED STANDARD IS A
POSITIVE STEP TOWARD ADDRESSING
PROBLEMS IN ACCOUNTING FOR
DERIVATIVES AND SIMILAR
INSTRUMENTS
---------------------------------------------------------- Chapter 5:3
In June 1996, after considering and rejecting numerous proposals over
many years, FASB issued an exposure draft of a proposed standard,
Accounting for Derivative and Similar Financial Instruments and for
Hedging Activities. The proposed standard provides an approach to
accounting for derivatives and similar financial instruments that
would require entities to record such instruments in the balance
sheet as assets or liabilities measured at fair value. The
accounting for gains and losses resulting from changes in the fair
value of derivatives would depend on the entity's intended use of the
derivatives. The proposed standard has many advantages over current
practice and would help eliminate the types of inappropriate
practices we noted in our review of the 12 institutions. However,
strong opposition to the proposed standard exists that is due, in
part, to the fact that it eliminates much of the flexibility in
current practice and does not easily accommodate macro-type hedging
strategies.\10 As we have previously stated, we believe the only
viable solution to macrohedging issues, and the solution overall, is
comprehensive market value accounting for all financial instruments.
FASB's proposed standard is a step toward this solution.
--------------------
\10 Macrohedging is hedging of an entire portfolio as opposed to
individual assets or liabilities. Often this is accomplished by an
entity's hedging its net exposure to changes in interest rates or
other market factors.
SUMMARY OF FASB'S PROPOSED
STANDARD
-------------------------------------------------------- Chapter 5:3.1
FASB's proposed standard, which is described in detail in appendix
IX, applies to traditional derivatives, such as futures, forwards,
options, and swaps, and other financial instruments with
derivatives-like characteristics. The proposed standard would
require all derivatives to be recorded as either assets or
liabilities in the balance sheet at their fair value. The accounting
for gains and losses resulting from changes in the fair value of the
derivatives would depend on the reason for the use of the
derivatives.
For derivatives designated as hedges of changes in fair value of
existing assets or liabilities, or contractually committed
transactions (fair value hedge), the gain or loss would be recognized
in earnings along with the offsetting gain or loss on the hedged
item. For derivatives designated as hedges of cash flows from
forecasted (i.e., expected but not committed) transactions (cash flow
hedge), such as expected future inventory purchases, the gains or
losses on the derivatives would be reported as a component of equity,
called other comprehensive income.\11
Cumulative gains or losses on the derivatives would be moved from
other comprehensive income to earnings on the preestablished date
that the forecasted transaction was projected to occur. In the case
of derivatives not designated as hedges, the gain or loss would be
recorded in earnings, as is the current practice.
The proposed standard specifies a number of criteria that must be met
for derivatives to qualify as fair value or cash flow hedges. These
criteria are more restrictive than those used in current practice and
are likely to limit the types of activities that qualify for hedge
accounting under the proposed standard. All of these criteria are
discussed in appendix IX, and a discussion of selected criteria
follows.
For a derivative to qualify as a fair value hedge, formal
documentation of the hedging instrument, the hedged item, and the
risk being hedged must exist, and the use of the derivative must be
consistent with the entity's established policy for risk management.
In addition, the item being hedged must be specifically identified as
a single asset or liability or a portfolio of similar items sharing
common characteristics; the hedged item must be reliably measurable
at fair value, and changes in the fair value must be expected to be
substantially offset by changes in the derivative; and the hedged
item individually must present an exposure to price changes that
could affect reported earnings.
The criteria for a cash flow hedge also require that formal
documentation of the hedging instrument, the hedged item, and the
risk being hedged exist and that the use of the derivative be
consistent with the entity's established policy for risk management.
In addition, for a cash flow hedge, the forecasted transaction must
be probable, be part of an established business activity, and
represent an exposure to price changes that could affect reported
earnings. Further, the net cash flows from the derivative must be
expected to substantially offset all of the changes in net cash flows
of the hedged forecasted transaction that are attributable to the
risk being hedged.
The proposed standard also includes specific disclosure requirements
for derivatives and similar financial instruments. For all
derivatives, each entity is required to distinguish among derivatives
designated as fair value hedges, cash flow hedges, hedges of the
foreign currency exposure of a net investment in a foreign
operation,\12 and all other derivatives. The entity must disclose
-- its objectives for holding or issuing the instruments,
-- the context needed to understand those objectives,
-- its strategies for achieving those objectives, and
-- the notional or contract amount of the derivatives when
necessary for an understanding of the objectives.
For derivatives designated as hedges, the entity must provide
-- a description of the entity's risk-management policy for such
hedges, including a description of the items whose risks are
being hedged and the classes of derivatives used to hedge those
risks;
-- the amount of gains or losses on the derivatives and the items
being hedged, if applicable, that were recognized in earnings
during the reporting period as well as a description of where
those gains and losses and the related hedged items are reported
in the financial statements; and
-- the cumulative amount of derivatives gains or losses that have
not yet been recognized in earnings and a description of where
they are reported in the financial statements.
In addition, for fair value hedges, the entity must also disclose the
amount of gains and losses recognized in earnings when performance
under a hedged-firm commitment is no longer probable. For cash flow
hedges, the entity also must disclose the designated reporting
periods in which the forecasted transactions are expected to occur
and the deferred amounts to be recognized in earnings.
--------------------
\11 Comprehensive income is defined as the change in equity of a
business entity during a period from transactions and other events
and circumstances from nonowner sources. It includes all changes in
equity during a period except those resulting from investments by
owners and distributions to owners. Other comprehensive income
represents all components of comprehensive income other than net
earnings.
\12 See appendix IX for discussion of this type of hedge.
PROPOSED STANDARD HAS MANY
ADVANTAGES OVER CURRENT
PRACTICE
-------------------------------------------------------- Chapter 5:3.2
The proposed standard has many advantages over current hedge
accounting practices. For example, as outlined in appendix VI,
current accounting standards for derivatives address only certain
types of derivative instruments, while the proposed standard applies
to all derivatives and to financial instruments with characteristics
similar to derivatives. Derivatives held by end-users for hedging
purposes are currently not reflected on the balance sheet. Under the
proposed approach, all derivatives would be recorded as assets or
liabilities in the financial statements and measured at fair value.
Under existing hedge accounting, gains and losses on a qualifying
derivative hedging instrument are deferred to offset the change in
value of the underlying asset or liability being hedged (the hedged
item). These changes in fair values are not recorded in earnings.\13
Under the proposed standard, gains or losses on a derivative used as
a fair value hedge would be included in earnings, and offsetting
losses or gains on the hedged item would be accelerated and
recognized in earnings in the same period. Accelerating the gain or
loss on the hedged item generally has the added benefit of adjusting
the historical cost amount of that asset or liability toward its fair
value.\14
FASB's proposed standard would help eliminate the inappropriate uses
of deferral hedge accounting that we noted among the 12 institutions
we reviewed (see app. VII). Many of these institutions incurred
large declines in the values of their derivatives, which were not
reflected in their financial statements. Had the proposed standard
been in place, such derivatives would have been required to be
reported on the balance sheet at fair value; the related losses would
have been reflected in the financial statements, either in earnings
or in other comprehensive income.
We also note in appendix VII that the 12 institutions varied widely
in their application of hedge criteria. For example, they differed
significantly in how they determined whether there was high
correlation between changes in the market value of a derivative and
changes in market value of the underlying hedged asset or
liability--a requirement under current hedge accounting. Under the
proposed standard, calculating correlation becomes essentially
unnecessary since both hedge and nonhedge gains and losses are
required to be reported in earnings.\15 An ineffective hedge would
result in little or no offsetting losses or gains from the hedged
item, with the net accounting effect being the same as if the
derivative had not been designated as a hedge. In addition, the
proposal requires discontinuance of hedge accounting if a hedge fails
to meet any of the previously listed criteria.
There also are inconsistencies in the hedge criteria established in
the current standards. For example, as described in appendix VI,
SFAS No. 52 and SFAS No. 80 differ in the allowed use of hedge
accounting for anticipated, or forecasted, transactions. The
proposed standard would eliminate such inconsistencies by
establishing one set of standards for all derivatives and superseding
prior standards that caused such inconsistencies.
--------------------
\13 Any realized gain or loss on the derivative is deferred and added
to the basis of the underlying asset or liability being hedged on the
balance sheet.
\14 The amount of gain (or loss) accelerated is limited to the lesser
of the loss (or gain) on the derivative or the unrecognized gain (or
loss) on the hedged item occurring subsequent to the inception of the
hedge. Therefore, the adjusted value of the hedged item will not
reflect its actual fair value to the extent that the gains or losses
on the hedged item exceed those of the derivative.
\15 As previously discussed, cash flow hedge gains and losses are
initially reported in comprehensive income but flow through to
earnings on the projected date of the forecasted transaction.
PROPOSED STANDARD WOULD NOT
ACCOMMODATE MACROHEDGING
-------------------------------------------------------- Chapter 5:3.3
The 12 institutions in our sample used both micro- and macrohedging
strategies.\16 These strategies are described in detail in appendix
VII. FASB's proposed standard requires derivatives to be designated
as a hedge of a specific asset, liability, or forecasted transaction
or as a hedge of a portfolio of similar assets or liabilities.
Because of this, the proposed standard generally does not easily
accommodate macrohedging. As many institutions currently use
macrohedging strategies, the limitations imposed on such strategies
under the proposed standard have caused concern and opposition to the
proposed approach. In our sample institutions, eight used
macrohedging strategies. Of those eight, six were risk-adjusting
rather than risk-reducing strategies. As previously discussed, we do
not believe risk-adjusting strategies should qualify for special
hedge accounting treatment. The proposed standard would help
eliminate the ability of entities to inappropriately use hedge
accounting for risk-adjusting strategies; however, it would also
limit the ability to use hedge accounting for valid macrohedging
risk-reducing strategies.
We believe the only viable solution to these macrohedging issues is
comprehensive market value accounting of all financial instruments,
because it is the only reliable way that offsetting gains and losses
in the portfolio and in the derivative instruments can be matched up.
Under comprehensive market value accounting, the results of any
hedging strategies would be clearly reflected in earnings. Effective
risk-reducing macrohedging strategies would generally result in
minimal volatility in earnings, while macrohedging risk-adjusting
strategies would often result in significant earnings fluctuations.
However, we recognize that adoption of a market value accounting
model would require the resolution of significant implementation
issues and therefore may not be a feasible solution in the short
term. Officials from most of the 12 banks and thrifts in our sample
told us they were opposed to market value accounting for all
financial instruments. They expressed concerns about how to
determine market values for financial instruments with no ready
market, the treatment of intangible assets, and the overall
volatility in the financial statements that may result from temporary
shifts in the financial markets. They also indicated that it would
be very burdensome to determine market values for commercial loan
portfolios on a regular basis. These and other issues will need to
be addressed before full market value accounting can be feasibly
implemented.
--------------------
\16 A microhedge requires linking qualifying derivatives to
particular assets or liabilities, while a macrohedge is not
necessarily related to identifiable assets or obligations but instead
hedges the entity's net risk exposure.
COMPREHENSIVE MARKET VALUE
ACCOUNTING WAS CONSIDERED BY
FASB BUT NOT ADOPTED
-------------------------------------------------------- Chapter 5:3.4
On the basis of our review of FASB Board minutes leading up to the
issuance of the proposed standard as well as the background
information accompanying the proposed standard, nearly all FASB
members said that, ultimately, a comprehensive market value approach
for all financial instruments is the most conceptually sound solution
to the problems surrounding derivatives and other financial
instruments that FASB has been grappling with for years. In
developing the proposed standard, FASB made several fundamental
decisions about how to account for derivatives. One of those
decisions was that fair value is the most relevant measure for all
financial instruments and the only relevant measure for derivatives.
In the background information accompanying the proposed standard,
FASB acknowledged its belief that fair values for financial assets
and liabilities provide more relevant and understandable information
than cost or cost-based measures and that with the passage of time,
historical prices become irrelevant. It also acknowledged that a
fair value approach would have been simple and readily understandable
to financial statement users, would have increased comparability for
identical balance sheet positions between entities, and would have
eliminated the need for special accounting for hedges of financial
instruments.\17
In further reviewing the background information, we noted that in
keeping with this belief, FASB considered measuring all financial
instruments at fair value in the proposed standard. Some FASB
members indicated that changing the accounting model so that all
financial instruments are carried at fair value is the only
conceptually consistent solution to hedging issues. However, a
number of FASB members chose not to pursue such a model for various
reasons. In general, many FASB members did not believe that this
could be accomplished in one step. Some FASB members were concerned
that a substantial amount of time would be needed to fully address
and agree upon the implementation issues of such a model. These
include conceptual issues about the valuation of financial assets and
liabilities and the reliability of measuring the fair value of some
financial instruments. In addition, some FASB members were concerned
about the significant impact the requirement would have on financial
reporting practices. Because many preparers of financial statements
oppose FASB's proposed requirement that all financial instruments be
measured at fair value and because pressure exists to present a
solution to the long-standing derivatives problem, FASB opted to
develop an interim solution. However, this interim solution is also
facing much resistance due, in part, to the reduced flexibility that
entities would have compared with accounting practices used under
limited existing standards.
--------------------
\17 A fair value approach for financial instruments would not,
however, have addressed the need for special accounting for fair
value hedges of nonfinancial assets and liabilities and would not
accommodate the current practice of hedging forecasted transactions.
SOME IMPROVEMENTS MADE IN
DERIVATIVES DISCLOSURES, BUT
ENHANCEMENTS ARE NEEDED
---------------------------------------------------------- Chapter 5:4
Current derivatives disclosures are specifically dictated by SFAS No.
119, Disclosure About Derivative Financial Instruments and Fair Value
of Financial Instruments, which was effective for fiscal years ending
after December 15, 1994.\18 Although this statement will be
superseded by the proposed standard, it continues to be in effect
until the proposed standard, if adopted, becomes effective. The
effective date of the proposed standard is expected to be for fiscal
years beginning after December 15, 1997. We believe that although
SFAS No. 119 is an improvement over prior disclosure requirements,
it does not provide for adequate disclosure of the nature and risks
of derivatives activities.
We reviewed the disclosure practices of 37 banks and thrifts that
were active in the derivatives market and found that they generally
made disclosures beyond those required by SFAS No. 119. These
additional disclosures were prompted, in part, by SEC's request for
more disclosures about derivatives by public companies. These
SEC-requested disclosures, as well as subsequent formally proposed
disclosure requirements by SEC, were in response to the shortfalls in
SFAS No. 119. However, the SEC disclosure requirements, if adopted,
would apply only to public companies, thus leaving other derivatives
market participants without adequate disclosure requirements. FASB's
new proposed standard would fill some, but not all, of this void.
--------------------
\18 Disclosure requirements of two other standards also affect
derivatives disclosures. These two standards, SFAS No. 105
Disclosure of Information About Financial Instruments With
Off-Balance-Sheet Risk and Financial Instruments With Concentrations
of Credit Risk; and SFAS No. 107, Disclosures About Fair Value of
Financial Instruments, are discussed in appendix VI.
FASB'S CURRENT DISCLOSURE
REQUIREMENTS HAVE IMPROVED
BUT COULD BE ENHANCED
-------------------------------------------------------- Chapter 5:4.1
FASB issued a disclosure standard for derivatives, SFAS No. 119, in
October 1994. This standard requires disclosures about futures,
forwards, swaps, options, and other financial instruments with
similar characteristics.\19 It amends two previously existing
disclosure standards, SFAS No. 105 and SFAS No. 107, for financial
instruments. The required disclosures and the amendments are
summarized in appendix VI. Although SFAS No. 119 will be superseded
by the proposed standard, if adopted, it continues to be in effect
through the end of 1997.
To obtain information on actual derivatives disclosure practices, we
reviewed the 1993 and 1994 annual report disclosures of 37 banks and
thrifts that were active in the derivatives market.\20 In general,
these disclosures complied with generally accepted accounting
principles at that time, including SFAS No. 119 requirements, which
were effective for fiscal years ending after December 15, 1994.
The one exception to this general level of compliance was the
disclosure of the impact of derivatives with leverage features. Only
2 of the 37 institutions provided detailed disclosure about the
impact of leveraged instruments, 8 others disclosed that they did not
hold any such instruments, and 27 provided no disclosure. FASB also
found a similar lack of disclosure of the impact of leveraged
derivatives in its December 1995 report on derivatives disclosures in
1994 annual reports.\21 FASB reported that only 4 of 27 entities
reviewed--17 financial institutions and 10 large derivatives
dealers--clearly acknowledged the use of derivatives with leverage
features. This overall lack of disclosure may have occurred because
derivatives with leverage features were not held by the institutions
reviewed, or the institution determined they were not material and
thus did not disclose them. However, the lack of disclosure may also
have resulted from the fact that the requirement is contained in a
footnote of SFAS No. 119 and may have been overlooked. We noted
that guidance provided by some accounting firms for financial
statement preparers did not address the requirement for disclosures
on leveraged instruments.
The majority of institutions that we reviewed disclosed information
beyond that required by SFAS No. 119, including quantitative market
risk information and further distinctions among types of activities.
Only 10 institutions, however, provided specific information on the
criteria used to justify hedge accounting.
We continue to support FASB's efforts to improve derivatives
disclosures. However, additional disclosures not required by SFAS
No. 119 but voluntarily provided by some institutions would provide
investors more detailed and timely explanations of the risks of
firms' derivatives activities. These include
-- quantification of interest rate or other market risks of
derivative products and related financial instruments (SFAS No.
119 encourages but does not require such disclosures),
-- further distinctions among types of derivatives,
-- the impact of using deferral hedge accounting on the reported
balance sheet and income statement amounts, and
-- the criteria used by an entity to justify deferral hedge
accounting.
The disclosure requirements in FASB's proposed standard discussed
earlier would address some but not all of these additional needed
disclosures. Specifically it would require distinguishing the types
of activities that derivatives are being used for and the impact of
derivatives activities on the financial statements. In addition, it
would standardize the criteria used to justify hedge accounting. SEC
has also taken steps, which are discussed in the following sections,
that would address all of the additional needed disclosures.
--------------------
\19 SFAS No. 119 does not apply to commodity contracts or structured
notes.
\20 We also compared derivatives disclosure practices of major bank
dealers with those of major securities firm and insurance company
dealers and found that the banks had the most extensive disclosures
(see app. VIII).
\21 Special Report: Review of 1994 Disclosures About Derivative
Financial Instruments and Fair Value of Financial Instruments
(Financial Accounting Standards Board, Dec. 1995).
SEC HAS REQUESTED ADDITIONAL
DISCLOSURES
-------------------------------------------------------- Chapter 5:4.2
In 1994, SEC specifically requested its public companies to provide
certain disclosures in an effort to improve annual report disclosures
of derivatives activities. The disclosures requested by SEC included
-- a discussion of the nature of trading activities, including the
business purpose of trading, the tolerable risk levels, and the
types of contracts traded;
-- the amount of trading income recognized in the income statement
for each major type of financial instrument;
-- a disaggregated description of outstanding derivatives contracts
held for end-user activities, including a description of the
type, amount, expected maturity, and fair value of each class of
contract;
-- a reconciliation of the notional or contract amounts of
derivatives held for end-user activities from the beginning of
the period to the end of the period for each income statement
presented;
-- the amount of deferred gains and losses from hedging or risk-
adjusting activities and the expected amortization of such
amounts on a period-by-period basis; and
-- the impact of derivatives activities on net interest income (for
financial institutions or insurance companies) or income from
continuing operations (for commercial and industrial entities)
for each period for which an income statement is presented.
Figure 5.1 indicates the number of institutions in our sample of 37
banks and thrifts that provided SEC-requested disclosures in their
1993 (prior to request) and 1994 (after request) annual reports. As
shown, a number of institutions significantly improved their
derivatives disclosures as a result of SEC's request. The additional
disclosures provided useful information for a reader of an entity's
financial statements to better understand its derivatives activities.
Figure 5.1: SEC-Requested
Disclosures
(See figure in printed
edition.)
Source: GAO review of institution annual reports.
SEC ISSUED PROPOSED
DISCLOSURE REQUIREMENTS
-------------------------------------------------------- Chapter 5:4.3
In continuing its efforts to improve derivatives disclosure
practices, SEC reviewed the 1993 and 1994 annual reports of about 500
public companies. As a result of these reviews, SEC staff concluded
that although SFAS No. 119 had a positive effect on the quality of
disclosures, further requirements were needed.
In December 1995, SEC released for comment proposed derivatives
disclosure requirements for public companies to supplement SFAS No.
119. The proposed requirements are intended to clarify and expand
disclosures about public companies' accounting policies for
derivative products. They also would require disclosure outside the
financial statements of qualitative and quantitative information
about market risk inherent in derivatives and other financial
instruments.\22
SFAS No. 119 requires entities to disclose the related accounting
policies used to account for their derivatives. However, SFAS No.
119 does not provide an explicit indication of what entities must
disclose in their footnotes on accounting policies. SEC's proposal
would require registrants to distinguish between accounting policies
for trading derivatives and those for derivatives used for other
purposes. It would require disclosure of each method used to account
for derivatives by type, the hedge criteria required to be met for
each accounting method used, the accounting method used if the
criteria are not met, the accounting method for terminated
derivatives or terminated hedges, and when and where derivatives and
their related gains and losses are reported in the financial
statements. It also would extend those requirements to commodity
derivatives.
SEC's proposed quantitative and qualitative disclosures are to
provide information outside the financial statements about the impact
of changes in interest or other market rates on the registrants'
financial results. The proposal provides three alternatives for
quantitative disclosures, with the expectation that registrants are
to develop quantitative disclosures that best reflect the market risk
inherent in their business activities. The proposed qualitative
information about market risk would include a discussion of the
public companies' primary market risk exposures as they existed at
the end of the current reporting period. It would also include the
way the public companies managed these exposures. In general, this
disclosure would include a description of the objectives, strategies,
and instruments used to manage the exposures. SEC expects that
consensus on the most effective way to portray market risk will
evolve on the basis of industry practice.
We believe that the SEC proposed requirements for enhanced
qualitative and quantitative disclosures effectively address the
shortfalls of SFAS No. 119. FASB's proposed standard includes
similar qualitative disclosure requirements but does not adequately
address the quantitative market risk disclosure. Disclosure of
market risk continues to be optional under FASB's proposed
standard\23 and is not addressed in GASB standards. We believe this
is an important disclosure for all entities. However, because SEC
requirements apply only to public companies, not all entities would
be required to disclose market risk without a change in FASB's and
GASB's standards.
--------------------
\22 The SEC proposal pertains to derivatives and other financial
instruments with similar characteristics. It defines derivatives as
futures, forwards, swaps, and options. It defines other financial
instruments as including investments, loans, structured notes,
mortgage-backed securities, indexed debt instruments, interest-only
and principal-only obligations, deposits, and other debt obligations.
\23 The optional disclosure about market risk is included as an
amendment to SFAS No. 107 under the proposed standard.
GASB PROPOSED STANDARD
ADDRESSES ACCOUNTING FOR
INVESTMENTS
---------------------------------------------------------- Chapter 5:5
In response to the Orange County bankruptcy filing and other large
investment securities losses reported by state and local governmental
entities, GASB issued a proposed standard in March 1996 that provides
accounting and disclosure requirements for investments. The
investments included under the proposed standard are interest-earning
investment contracts; all debt and equity securities, purchased
options, stock warrants, and stock rights with readily determinable
fair values; and investments in mutual funds and investment pools.
With limited exceptions, the proposed standard requires that all
investments be valued at fair value. However, investments purchased
with remaining maturities of 90 days or less could be valued at
amortized cost subject to certain general restrictions. The proposed
standard also would require that governmental entities recognize all
changes in fair value in the operating statement (or other statement
of activity). In addition, the proposed standard would require that
the valuation of investment pool participations be based on the pool
type. Participants in SEC-registered mutual funds would value their
position at current share price and disclose the investment type as
an SEC-registered mutual fund. Participants in any pool that is not
SEC-registered (whether administered by a government or not) would
normally value their position at the fair value per share of the
pool's underlying investments.
GASB has scheduled the issuance of the final standard during the
fourth quarter of 1996. In conjunction with this project, we have
encouraged GASB to consider requiring disclosures that quantify
market risk. Even if investments are reported at market value, such
disclosure is needed because it provides information about the
sensitivity of those market values to future changes in interest
rates.
The proposed standard does not address accounting for off-balance
sheet derivatives, and no GASB standards currently address this
issue. As state and local governmental entities are increasing their
involvement with derivatives, it is essential that standards are
developed to avoid inconsistent and potentially inappropriate
accounting practices for these activities. By extending the market
value accounting principle to derivatives, GASB's proposal would
include comprehensive market value accounting for virtually all
financial instruments used by state and local governments. We have
also advised GASB, in a letter dated March 15, 1996, of our views on
this matter.
CONCLUSIONS
---------------------------------------------------------- Chapter 5:6
Serious shortcomings in accounting standards continue to be exposed
as entities experience major losses from market-sensitive financial
instruments, with seemingly little warning. Such losses are often
allowed to build without being recorded in an entity's financial
statements, because the use of the historical cost accounting model
does not require such losses to be recorded. In our 1994 report, we
recommended that FASB consider adopting a market value accounting
model for all financial instruments, including derivatives. This
recommendation is even more important today, for both FASB and GASB,
as unexpected losses from investment securities as well as
derivatives have caused financial disasters for various entities and
a deterioration of investor confidence.
FASB's proposed standard is a significant step in the right
direction. For the first time, all derivatives would be recorded in
the financial statements at their fair values. Accelerating
recognition of the offsetting gains or losses on underlying assets or
liabilities and adding them to the basis of these assets or
liabilities would also have the effect of adjusting their historical
cost toward their fair value.
FASB's inclusion in its proposed standard of financial instruments
with characteristics similar to derivatives is also a major positive
step. However, FASB has yet to address the problems with the use of
historical cost accounting for other financial instruments. It also
does not effectively deal with accounting for macrohedging
activities. These issues will be resolved only when a comprehensive
market value accounting model is adopted for all financial
instruments.
We recognize that problems exist in adopting a market value
accounting model for all financial instruments. In addition, many
financial statement preparers oppose this approach. We also
recognize that it will take time to develop and gain acceptance for a
new accounting model and that some type of short-term solution is
needed. Therefore, we support FASB's proposed standard as a
reasonable interim accounting solution. As part of this interim
solution, bolstering disclosure requirements for derivatives and
other financial instruments with similar risks, as has been proposed
by SEC, would help provide forewarning of potential losses from these
types of instruments. However, we continue to believe that market
value accounting for all financial instruments would more readily
respond to the need for financial information that reflects the
realities of today's volatile financial markets.
Chapter 6 MAY 1994 REPORT SUMMARY
FINDINGS
In each of the seven countries we reviewed (Australia, France,
Germany, Japan, Singapore, Switzerland, and the United Kingdom), we
found that major OTC derivatives dealers were subject to regulation.
However, regulators in two countries--Australia and
Switzerland--acknowledged that derivatives activities by some
financial institutions were not subject to direct regulation. All of
the regulators obtained some information about derivatives on a
monthly or quarterly basis to assess the volume and risks of
derivatives activities, but some regulators collected more detailed
information than others. Four of the seven countries--Australia,
Japan, Singapore, and the United Kingdom--had different capital
requirements for banks and securities firms. In France, Germany, and
Switzerland, financial institutions conducting securities activities
must also be licensed as banks, requiring all institutions to meet
bank capital requirements. Capital requirements for banks in these
countries met the Basle requirements, but some regulators had placed
additional requirements on banks conducting derivatives activities.
International coordination efforts were generally mixed. Among the
most important efforts were the projects to develop minimum capital
standards for banks and securities firms. Bank regulators
successfully created international capital standards for credit risk,
but market risk requirements were not final. Although efforts to
develop international capital standards for securities firms had been
under way since 1987, securities regulators had not agreed on certain
aspects of the standards. The lack of agreement among the securities
regulators prevented the harmonization of international capital
standards for both banks and securities firms. International
accounting organizations had also proposed new accounting and
disclosure standards.
RECOMMENDATION
We recommended that U.S. financial regulators provide leadership in
working with industry representatives and regulators from other major
countries to harmonize disclosure, capital, and legal requirements,
including netting enforceability, and examination and accounting
standards for derivatives.
EFFORTS TO IMPROVE INTERNATIONAL
COORDINATION CONTINUE
============================================================ Chapter 6
U.S. banking, securities, and futures regulators have been working
with their international counterparts, primarily through the Basle
Committee on Banking Supervision and the Technical Committee of
IOSCO, to improve regulatory harmonization and coordination and have
addressed many of the issues raised in our 1994 report. Further,
like U.S. regulators, regulators in the six countries we contacted
had taken or proposed steps to enhance their oversight of
derivatives, through a variety of approaches. Barings' failure
directly resulted in various written agreements and guidelines to
ensure that all concerned parties have access to the information they
need. Barings' failure also focused regulators' attention on the
need to formalize international coordination.
INTERNATIONAL COORDINATION
EFFORTS HAVE CONTINUED
---------------------------------------------------------- Chapter 6:1
Since our May 1994 derivatives report was issued, international
banking, securities, and accounting organizations have undertaken
major initiatives intended to improve derivatives regulation. The
Basle Committee on Banking Supervision and IOSCO have undertaken
initiatives that address risk management for OTC derivatives, public
disclosure of market and credit risks, and regulatory reporting of
derivatives activities. The Basle Committee on Banking Supervision
also amended international banking capital standards to include
broader recognition of bilateral netting agreements, to adjust the
calculation of potential future credit exposures, and to incorporate
market risk from trading activities into the risk-based capital
calculation for internationally active banks. However, harmonizing
capital standards for securities firms has, so far, been
unsuccessful. The International Accounting Standards Committee
(IASC) approved a new international accounting standard that
addresses disclosure and presentation of derivatives activities.\1
--------------------
\1 IASC was formed in 1973. Its role is to contribute to the
establishment of sound, internationally comparable accounting
principles, especially in developing countries. Professional
accountancy groups of about 50 countries are members. However,
national standards-setting bodies are independent of IASC and under
no obligation to adopt international accounting standards as a
requirement within their countries.
INTERNATIONAL INITIATIVES
HAVE ADDRESSED RISK
MANAGEMENT, PUBLIC
DISCLOSURE, AND REGULATORY
REPORTING
-------------------------------------------------------- Chapter 6:1.1
Since May 1994, international coordinating bodies, such as the Basle
Committee on Banking Supervision and IOSCO working groups, have
issued numerous discussion papers, recommendations, and guidelines
specifically related to derivatives. These initiatives addressed the
need for overseeing the risk-management process, ensuring adequate
public disclosure, collecting information on the global derivatives
market, harmonizing regulatory reporting, and providing supervision.
These voluntary initiatives represent international efforts to
enhance and harmonize the regulation of derivatives activities as
financial markets become more closely linked and international
barriers are removed.
In July 1994, the Basle Committee on Banking Supervision and the
Technical Committee of IOSCO issued guidelines for regulators on
supervising risk-management systems of banks and securities firms
involved in OTC derivatives activities.\2 Although the specifics of
these guidelines differ, banking and securities regulators share the
common objective of promoting sound internal risk- management
practices for managing OTC derivatives. Both sets of guidelines
focus on the role of regulators in determining how best to promote
the development of sound management control policies and procedures
in the banks and securities firms they regulate. The guidelines draw
on the best practices of IOSCO and the Basle Committee on Banking
Supervision member countries.
In September 1994, a Working Group of the Euro-currency Standing
Committee of the Central Banks of the Group of Ten countries released
a discussion paper on public disclosure of market and credit risks.\3
The paper discusses the need for sufficient information about the
risks and returns of derivatives to ensure that investors and
counterparties can make informed investment decisions. It warns that
if a disconnect exists between the actual trading and risk-management
activities of derivatives dealers and what is disclosed to investors,
capital misallocation and the potential for heightened market
distress can result.\4
The paper also discusses the possible role of adequate disclosure in
correcting and adjusting risk-management procedures.
In February 1995, a working group established by the central banks of
the Group of Ten countries issued a report that identified existing
derivatives information-reporting requirements of central banks.\5
The report is part of a larger international effort of regulators to
develop a framework for improved regular monitoring of the size and
structure of the global derivatives markets. The report identified a
broad range of information that bank regulators need and made
recommendations about how they should collect this information.
The report recommended two interrelated ways for regulators to
collect information that could be used to monitor global OTC
derivatives activities. One of these recommendations was for
regulators to conduct occasional surveys of a large number of
participants. BIS conducted the first survey of derivatives market
activity in 26 countries in April 1995. (We discuss some of the
results of this survey in ch. 1.) The second recommendation was for
regulators to develop a system of regular derivatives market
reporting limited to primary institutions. The survey data would be
used by regulators to determine the size and distribution of the
global derivatives market. Adequate data such as those provided by
this survey are vital if regulators are to understand the global
financial environment in which regulated institutions operate. In
July 1996, a working group developed a proposal for regular
collection of derivatives information on a global basis, which is to
be implemented at the end of 1997.\6
In May 1995, the Technical Committee of IOSCO and the Basle Committee
on Banking Supervision issued a joint framework on regulatory
reporting.\7 The framework consisted of two parts. The first part
was a catalogue of data identified as important for an evaluation of
derivatives risks that could be used by regulators as they continue
to expand their information-reporting requirements. The second part
was a subset of information that should be collected at a minimum for
all large internationally active banks and securities dealers that
have substantial derivatives activities. If this framework was
implemented, harmonization of information reporting among regulators
could improve along with oversight of the global derivatives market.
The recommended framework encourages regulators to draw on
information that banks and securities firms generate for internal
purposes to limit the regulatory burden. The catalogue of
information identified by the committees revolved around four broad
areas: credit risk, market risk, liquidity risk, and earnings.
According to the joint framework, periodic information in those four
broad areas should include current credit exposure, potential credit
exposure, credit enhancements, concentration of credit risk,
counterparty credit quality, market liquidity risk, funding risk,
value-at-risk, trading activities, nontrading activities, unrealized
or deferred losses, and valuation reserves and actual credit losses.
While many regulators may already collect some of the information
called for in the framework, others do not. In the United States,
SEC and CFTC receive detailed quarterly information on the top 20 net
credit exposures for individual counterparties from 5 of the 6 firms
included in DPG. (See ch. 4.) However, U.S. bank regulators do not
collect comparable information on a routine basis.
The framework also lists a subset of information that regulators
should collect at a minimum for large internationally active banks
and securities firms with significant derivatives activities. This
information covers broad risk categories (such as interest rate or
foreign exchange risk) by type of contract (such as swaps or
forwards). According to the framework, regulators should also
collect information on the purpose for holding derivative products,
such as trading versus nontrading, as well as information on
notional/contract amounts, market values, potential credit exposure,
counterparty credit quality, and past-due amounts.
In July 1995, the Tripartite Group of Banks, Securities, and
Insurance Regulators issued a report titled "The Supervision of
Financial Conglomerates."\8 The report focuses on supervisory issues
and capital adequacy. It identifies broad areas of agreement among
participating regulators from the three groups and makes
recommendations on ways to improve the supervision of financial
conglomerates. It also identifies areas that regulators should focus
on in the future. These areas include developing a groupwide
perspective on capital adequacy; fostering intensive cooperation
among regulators responsible for different entities within a
conglomerate; and addressing the need for regulators to obtain
adequate information on the conglomerate's structure. The report
also identifies numerous other issues, such as regulators' ability to
access information about nonregulated entities within a conglomerate.
In November 1995, the Basle Committee on Banking Supervision and the
Technical Committee of IOSCO issued a joint report on the public
disclosure of trading and derivatives activities of a sample of large
banks and securities firms worldwide.\9 The report compared 1993 and
1994 annual report disclosure of trading and derivatives activities
in 79 of the largest, internationally active banks and securities
firms in the Group of Ten countries. The Basle Committee on Banking
Supervision and IOSCO found general improvements and significant
voluntary innovation in the annual report disclosures. However,
despite encouraging advances in disclosure practices, they found that
"many institutions" continued to disclose very little about their
trading and derivatives activities. The report recommended that
banks and securities firms disclose additional qualitative
information about their risks and management controls and their
accounting and valuation models. It also recommended greater
quantitative disclosure of market activity, credit risk, market
liquidity, market risk, and earnings information. While these
recommendations were aimed at banks and securities firms, the Basle
Committee on Banking Supervision and IOSCO "hope that other financial
institutions and non-financial companies with significant trading and
derivatives activities will consider the concepts and recommendations
presented in the report."
--------------------
\2 These guidelines were: "Risk Management Guidelines For
Derivatives," the Basle Committee on Banking Supervision, July 1994;
and "Operational and Financial Risk Management Control Mechanisms For
Over-the-Counter Derivatives Activities of Regulated Securities
Firms," the Technical Committee of IOSCO July 1994.
\3 "Public Disclosure of Market and Credit Risks by Financial
Intermediaries," prepared by a Working Group of the Euro-currency
Standing Committee of the Central Banks of the Group of Ten
countries, Sept. 1994.
\4 The paper states that during periods of market stress, lack of
information transparency can cause rumors alone to impair a firm's
market access and funding.
\5 "Issues of Measurement Related to Market Size and Macroprudential
Risks in Derivatives Markets," prepared by a working group
established by the central banks of the Group of Ten countries, Feb.
1995.
\6 "Proposals For Improving Global Derivatives Market Statistics,"
prepared by a working group established by the Euro-currency Standing
Committee of the Central Banks of the Group of Ten countries, July
1996.
\7 "Framework for Supervisory Information about the Derivatives
Activities of Banks and Securities Firms," the Basle Committee on
Banking Supervision and the Technical Committee of IOSCO, May 1995.
\8 The Tripartite Group was formed in 1993 at the initiative of the
Basle Committee on Banking Supervision to address issues relating to
the supervision of financial conglomerates. It consists of bank,
securities, and insurance regulators from 12 countries. The group
defines a conglomerate as "any group of companies under common
control whose exclusive or predominant activities consist of
providing significant services in at least two different sectors
(banking, securities, insurance)."
\9 "Public Disclosure of the Trading and Derivatives Activities of
Banks and Securities Firms," joint report by the Basle Committee on
Banking Supervision and the Technical Committee of IOSCO, Nov. 1995.
INTERNATIONAL BANK CAPITAL
STANDARDS WERE AMENDED TO
RECOGNIZE ADDITIONAL TYPES
OF RISK
-------------------------------------------------------- Chapter 6:1.2
International bank supervisors' efforts to expand risk-based capital
standards have produced positive results. In December 1994, U.S.
and foreign bank regulators amended the Basle Accord to recognize
legally enforceable bilateral netting agreements for risk-based
capital purposes. Previously, banks were restricted to netting only
obligations denominated in the same currency and due on the same
date. The amendment allows banks to net together all obligations on
their derivatives contracts with each counterparty with whom they
have entered into legally enforceable netting agreements. In
addition, in April 1995, bank regulators amended the Basle Accord to
allow broader recognition of legally enforceable bilateral netting
agreements in the calculation of capital for potential future credit
exposure amounts. The amendment also expanded the coverage and
increased the maximum level of credit conversion factors used to
calculate the add-on amount. (See ch. 3 for additional detail on
implementation in the United States.)
In addition to finalizing amendments to the Basle Accord on netting
and expanding the conversion factors, the Basle Committee on Banking
Supervision continued to work on incorporating market risk from
trading activities into risk-based capital calculations for large
internationally active banks in major countries. In January 1996,
the Committee amended the Basle Accord to incorporate market risks.
Specifically, this amendment addressed interest rate and equity-price
risk in trading activities and foreign-exchange risk and commodities
risk throughout a bank. As stated in the amendment, the new capital
standards for market risk should be implemented by the Group of Ten
supervisory authorities by year-end 1997, at the latest. In
implementing this amendment's capital standards requirement for
market risk, central banks can allow the reporting banks to use
either a standardized model or their internal model; those banks
wishing to use their own models are required to adhere to certain
standards.\10 Regulators also are to play a role in ensuring that the
internal models used by banks are adequately measuring market risk.
The Committee also incorporated backtesting requirements and
established a framework for regulators to use when interpreting the
results of backtesting. (See ch. 3 for details.)
--------------------
\10 As discussed in chapter 3, U.S. bank regulators require that
banks use their internal (proprietary) model.
EFFORTS TO DEVELOP COMMON
APPROACHES TO INTERNATIONAL
CAPITAL STANDARDS FOR
SECURITIES FIRMS HAVE
CONTINUED
-------------------------------------------------------- Chapter 6:1.3
International efforts to develop common minimum capital standards for
securities firms, which have been ongoing since 1987, have not
produced final results. IOSCO issued a report in June 1995 that
discussed the use of value at risk by securities firms. The report
proposed that IOSCO conduct additional joint work with the Basle
Committee on Banking Supervision to test value-at-risk models for
calculating capital for market risk. It also recognized the growing
importance of these models for securities firms and the need to
explore further the possibility of using such models for capital
purposes. However, IOSCO did not set a timetable to incorporate the
use of models to calculate market risk for capital standards. The
reasons it cited for not rushing such development included (1) the
lack of data regarding the reliability of models in practice; (2) the
importance of appropriate market risk capital for securities firms;
and (3) the need to await the results of current initiatives, such as
DPG in the United States.
IASC ISSUED AN ACCOUNTING
STANDARD ON DISCLOSURE AND
PRESENTATION OF FINANCIAL
INSTRUMENTS
-------------------------------------------------------- Chapter 6:1.4
In March 1995, the IASC Board approved International Accounting
Standard 32, Financial Instruments-Disclosure and Presentation. The
new standard applies to all types of entities and covers most types
of financial instruments, including derivatives.\11 It requires that
entities subject to its standards provide information about, among
other things, accounting policies and methods applied, the entities'
exposure to interest rate risk and credit risk from financial assets
and liabilities, and the fair value of financial assets and
liabilities.
The standard provides financial statement preparers with considerable
latitude to tailor the format in which information is provided. It
also encourages enterprises to provide a discussion of the extent to
which they use financial instruments, the associated risks, and the
business purposes served. The new standard, effective for financial
statements covering periods beginning on or after January 1, 1996,
should provide financial statement users better information about the
derivatives activities of the preparers.
--------------------
\11 International Accounting Standard 32 does not deal with the
recognition and measurement issues covered in an exposure draft on
financial instruments previously issued by IASC, as the IASC Board
has decided those issues require further work.
DERIVATIVES REGULATION
CONTINUED TO VARY GLOBALLY
---------------------------------------------------------- Chapter 6:2
Although differences remained in their oversight of derivatives, each
of the 11 regulators we contacted in 6 different countries had taken
action or had plans underway to enhance their oversight activities
since 1994. These enhancements were consistent with the
recommendations we made to U.S. financial regulators in our 1994
report. Regulators in three of the six countries expanded the amount
of information they collected on a regular basis. Regulators in all
six countries had made revisions to or planned to revise their
capital standards to better address the risks derivatives pose. The
regulators had also expanded oversight of or guidance for the risk
management of derivatives. They also noted that efforts to improve
accounting and disclosure guidance for derivatives were ongoing in
their respective countries.
FOREIGN REGULATORS EXPANDED
INFORMATION COLLECTED TO
ASSESS THE EXTENT AND RISK
OF DERIVATIVES ACTIVITIES
-------------------------------------------------------- Chapter 6:2.1
As with U.S. regulators, some foreign regulators had begun to
collect more information on derivatives for regulatory reporting
purposes. As described in table 6.1, we found that regulators in
three of the six countries had expanded their required regulatory
reporting. In Japan, regulators now receive information on contract
amounts and counterparty risk amounts monthly for certain types of
derivatives. In Singapore, banks are now required to provide a
monthly breakdown by product type, volume, and profit/loss.
Previously, they were required to provide only a combined total for
exchange-traded and OTC derivatives. In the United Kingdom, the Bank
of England, as a result of the EU Capital Adequacy Directive (CAD),
required new reporting forms to capture market risk, as well as other
risks on all trading instruments--cash and derivatives.\12 The
Securities and Futures Authority Ltd. (SFA) also changed its
reporting standards as a result of CAD. Regulators in the other
three countries were in the process of reviewing, or had plans to
improve, their regulatory reporting requirements.
Table 6.1
International Changes to Reporting
Requirements
Country Changes in reporting requirements
---------------------- ----------------------------------------------
Australia No changes; however, reporting requirements
are under review.
Germany No changes, but reporting requirements are
likely to be reviewed in the near future in
connection with CAD.
Japan Detailed information on forward rate
agreements (contract amounts and counterparty
risk amounts) are now to be collected monthly
as part of the capital adequacy report.
Additional information is also to be reported
monthly on forward rate agreements and yen
interest rate swaps.
Singapore Banks are now required to report monthly to
their bank regulator the notional/contract
amount of their derivatives transactions by
type of product, volume, and profit/loss. In
addition, Singapore is reviewing its reporting
system to capture information in a more
standardized format.
Switzerland Reporting requirements for market risk are
likely to be reviewed with the implementation
of new capital requirements for market risk.
United Kingdom The Bank of England introduced new reporting
forms to cover market risk when CAD was
implemented on January 1, 1996. SFA replaced
its position and counterparty risk document
and started collecting from some firms more
detailed information on the breakdown of
profit and loss accounts/turnover from trading
activities. By year-end 1997, SFA plans to
require reports to be made of all transactions
in all financial instruments (cash and
derivatives). Eventually, this will include
reporting the identity of counterparties.
----------------------------------------------------------------------
Source: Compiled from information provided by Australia, the
Australian Securities Commission and the Reserve Bank of Australia;
Germany, the Deutsche Bundesbank and the Federal Banking Supervisory
Office; Japan, the Bank of Japan and the Ministry of Finance;
Singapore, the Monetary Authority of Singapore; Switzerland, the
Federal Banking Commission; and the United Kingdom, the Bank of
England, the Securities and Investments Board, and SFA.
--------------------
\12 CAD sets out the minimum capital requirements for credit
institutions and investment firms for the market and other risks
associated with their trading activities.
CAPITAL REQUIREMENTS HAVE
EVOLVED AS REGULATORS
ATTEMPTED TO ADDRESS
ADDITIONAL TYPES OF RISK
-------------------------------------------------------- Chapter 6:2.2
International efforts to standardize capital requirements have
continued with some countries' capital standards covering more types
of risks than others, depending on the type of institution.
According to Australian officials, their securities and futures
regulator was in the process of reviewing its capital standards,
which may result in changes to better address the risks that
derivatives pose. In Germany, the central bank plans to implement
CAD. In Japan, regulators amended capital standards to reflect the
changes to the Basle Accord concerning bilateral netting and the
calculation of potential future credit exposure. Following Barings'
failure, Singapore's regulators further tightened the capital
requirements for futures brokers. Singapore is in the process of
changing its capital requirements for futures brokers from the
present system that is based on amounts of customer-segregated funds
to a risk-based system in which the regulatory capital maintained
should better reflect the risks of positions carried by futures
brokers. Effective February 1995, Switzerland revised its capital
requirements to bring them in line with the Basle Accord, in general,
and to introduce the methods for calculating credit risk equivalents
of off-balance sheet items and bilateral netting. The United Kingdom
implemented CAD, which resulted in new market risk capital
requirements for banks. SFA said that securities and futures firms
in the U.K. had been subject to market risk capital requirements for
at least 10 years.
NEW INTERNATIONAL GUIDANCE
RESULTS IN EXPANDED FOCUS ON
RISK MANAGEMENT
-------------------------------------------------------- Chapter 6:2.3
In all of the countries we contacted, at least one regulator had
expanded oversight of or guidance for risk management involving
derivatives activities. In Australia, although no new programs were
initiated by its securities regulator, securities firms were
encouraged to adopt the G-30 recommendations on derivatives risk
management. In December 1994, the Reserve Bank of Australia
implemented a new program of on-site visits to banks to focus on how
the banks measure their market risks. In Germany, the central bank
started a program of (1) on-site inspections to review
risk-management models for capital purposes; and (2) inspections of
trading activities, including derivatives. Its Federal Banking
Supervisory Office also issued minimum requirements for trading
activities of credit institutions.
In Japan, the Bank of Japan took further measures to set up its
on-site examination function to assess banks' risk. For example, it
introduced an overall credit exposure review system, which includes
derivatives, and established a "Risk Assessment Team" to support the
on-site examinations. In April 1995, Singapore's bank regulator
issued specific new guidance to banks on ensuring adequate risk
management. In Switzerland, the Swiss Bankers Association's "Risk
Management Guidelines for Trading and the Use of Derivatives" became
effective on July 1, 1996. Although the Swiss Bankers Association is
purely self-regulatory, the Federal Banking Commission has decided
that external auditors have to ensure a bank's compliance with these
guidelines and report on it in their annual reports to the Federal
Banking Commission.
In the United Kingdom, the Bank of England established a team of
experts in 1994 before implementing CAD to review the models that
banks wish to use in calculating capital requirements. The Bank of
England uses detailed questionnaires followed by on-site visits to
assess the models and their control environment. SFA already had a
similar team that reviewed options and swap pricing models at
securities firms. In fall 1994, SFA reorganized the division that
monitors compliance with its rules to enhance oversight into five
specific groups.\13 It now focuses more detail on monitoring the
specific risks proposed by each type of business. In 1995, the U.K.
Securities and Investments Board, along with the U.S. SEC, announced
a joint initiative to conduct in-depth studies of financial,
operational, and management controls used by selected securities
firms that conduct significant cross-border derivatives and
securities activities.\14
--------------------
\13 The five groups are: (1) firms that deal mainly in commodities
and exchanges traded futures;(2) multinational firms that deal in all
types of financial instruments; (3) merchant banks and corporate
finance firms; (4) private client stock brokering firms; and (5)
other institutional brokers and firms led or regulated by, for
example, the Bank of England.
\14 This joint initiative builds on the March 1994 joint statement
previously issued by SEC, CFTC, and the Securities and Investments
Board. The initiative identified several areas where regulators can
cooperate in their oversight of the OTC derivatives market. By
year-end 1995, several joint reviews had been conducted.
EFFORTS TO IMPROVE
ACCOUNTING AND DISCLOSURE
GUIDANCE ARE ONGOING
-------------------------------------------------------- Chapter 6:2.4
All of the regulators we contacted noted that efforts to improve
accounting and disclosure guidance are ongoing in their respective
countries. In Australia, current disclosure standards are being
reconsidered by the Australian Accounting Standards Board. In
Germany, reporting for derivatives has been further improved by
banks, especially through disclosure of value-at-risk estimates that
were introduced in Basle Committee on Banking Supervision and IOSCO
Technical Committee papers. In Japan, legislation was passed that
enabled financial institutions and securities companies to use
current value accounting for trading securities and derivatives. In
July 1996, regulators in Japan issued a "Ministerial Ordinance,"
which makes all derivatives transactions subject to disclosure
requirements. In April 1995, regulators in Singapore issued guidance
that required commercial and merchant banks to disclose the nature,
material terms and conditions, and derivatives risks in their
risk-disclosure statement. In Switzerland, by revising the Swiss
Banking Ordinance, regulators adapted accounting and disclosure
requirements to improve derivatives coverage. In addition,
regulators now require Swiss banks to provide replacement cost and
notional/contract values for all off-balance-sheet items, including
derivatives. Regulators also required banks to provide written
comments on business policies and risk management.
In the United Kingdom, new disclosure standards, effective January 1,
1995, require U.K.-listed companies to include in their financial
statements acknowledgement by the board of directors that they are
responsible for internal controls, an explanation that internal
controls offer no absolute assurance against misstatement or loss, a
description of key procedures established to provide effective
internal control, and confirmation that the effectiveness of internal
controls has been reviewed. Directors are also required to comment
when internal control weaknesses have resulted, among other things,
in material losses. In addition, a statement of recommended
accounting practice on derivatives was published for banks in
February 1996. This sets out recommendations on the accounting
treatment and disclosure of derivatives in U.K. banks' accounts.
The Accounting Standards Board also published proposals designed to
lead to a new code on disclosure for other companies, as well as
banks, by 1998.
BARINGS' FAILURE ILLUSTRATED
THE IMPORTANCE OF INTERNATIONAL
COORDINATION AND SPARKED
COORDINATION EFFORTS
---------------------------------------------------------- Chapter 6:3
The Barings failure focused new attention on the potential for
systemic risk and the importance of international coordination.
Regulators concerned about containing Barings' losses closely
followed the unfolding crisis to determine whether the crisis would
spread. Barings' failure did not lead to widespread international
failures of other financial institutions. Although the crisis was
managed through informal coordination among regulators
internationally, Barings spurred additional efforts to enhance
international coordination. Futures regulators, acknowledging that
more formal coordination was needed, worked to develop the Windsor
Declaration, which outlines steps to improve international
coordination. Likewise, the industry responded with the Futures
Industry Association's (FIA) Global task force on national and
cross-border issues related to the structure and operation of the
international markets for exchange-traded and/or cleared futures and
options. As a result of the Windsor Declaration and FIA task force
recommendations, futures exchanges, clearinghouses, and regulators in
many major countries signed companion agreements to share large
exposure information. In addition, U.S. clearing organizations
signed an agreement to promote greater cooperation and information
sharing among securities and futures clearing organizations.
THE WINDSOR DECLARATION WAS
A REGULATORY RESPONSE TO
BARINGS' FAILURE
-------------------------------------------------------- Chapter 6:3.1
Following the failure of Barings, regulatory authorities responsible
for supervising the world's major futures and options markets met in
May 1995 in Windsor, England. Regulators from 16 countries attended
the meeting hosted by the U.K. Securities and Investments Board and
the U.S. CFTC.\15 The regulators outlined steps they proposed to
take to improve (1) cooperation between market authorities; (2)
protection of customer positions, funds, and assets; (3) default
procedures; and (4) regulatory cooperation in emergencies. In
addition, the regulators agreed to
-- improve communication of information relevant to material
exposures and other regulatory concerns;
-- review and, as necessary, enhance the adequacy of existing
arrangements to minimize the risk of loss through insolvency or
misappropriation;
-- facilitate the liquidation and/or transfer of positions, funds,
and assets from failing members of futures exchanges; and
-- improve existing mechanisms for international cooperation and
communication among market regulators.
The regulators agreed that the work identified in the Windsor
Declaration should be coordinated through various working groups of
IOSCO's Technical Committee. IOSCO has been involved in follow-up
work relating to the areas identified by the regulators and has
issued reports on some of these issues. For example, in March 1996,
the Technical Committee issued the "Report on Cooperation Between
Market Authorities and Default Procedures."
--------------------
\15 Regulatory authorities from the following countries participated
in the meeting: Australia, Brazil, Canada, France, Germany, Hong
Kong, Italy, Japan, the Netherlands, Singapore, South Africa, Spain,
Sweden, Switzerland, the United Kingdom, and the United States.
THE FIA TASK FORCE
RECOMMENDATIONS WERE AN
INDUSTRY RESPONSE TO
BARINGS' FAILURE
-------------------------------------------------------- Chapter 6:3.2
The events surrounding the Barings failure prompted market
participants to consider certain national and cross-border issues
related to the structure and operation of the international markets
for exchange-traded and/or cleared futures and options. The FIA
Global Task Force on Financial Integrity was organized in March 1995
to address these issues. The task force included representatives of
major international exchanges/clearinghouses, brokers/intermediaries
(including FCMs and other brokers), and customers from 17
jurisdictions.
The objectives of the task force were similar to those of the
international regulatory authorities that issued the Windsor
Declaration in May 1995. The task force issued 60 recommendations
covering financial integrity issues; exchange/clearinghouse risk
assessment, reporting, and coordination; legal/regulatory issues;
risk management for exchanges/clearinghouses, clearing brokers, and
depositories; risk management for customers; risk management for
internal controls; legal relationships with brokers/intermediaries;
risk assessment of brokers/intermediaries; risk management of
exchanges/clearinghouses; and internal risk-management procedures.
According to FIA, the most significant of these issues included the
mechanisms that exist for protecting participants' assets; the
internal controls and risk-management procedures employed by
exchanges/clearinghouses, brokers/intermediaries, and customers; and
the communication of information regarding the activities of market
participants by exchanges/clearinghouses and regulatory authorities.
U.S. AND FOREIGN EXCHANGES
AND REGULATORS HAVE SIGNED
INFORMATION SHARING
AGREEMENTS
-------------------------------------------------------- Chapter 6:3.3
On March 15, 1996, 49 exchanges and clearing organizations signed a
multilateral information-sharing agreement on large exposures. On
the same date, 14 regulatory agencies signed a separate companion
information-sharing agreement. These agreements could help prevent
and manage another crisis similar to that created by the Barings
collapse.\16 The agreements were an outgrowth of recommendations
outlined in the Windsor Declaration and by the FIA task force.
Participating exchanges and regulators agreed to share information on
exposures to unusual risks of their common member firms. One
objective of the agreements is to reduce threats to the system by
enabling regulators to better monitor firms' exposures on multiple
markets to reduce threats to the system. As described by a CFTC
official, the agreements represent an unprecedented exercise in
cooperation among international futures exchanges, clearing
organizations, and regulators. However, some countries, such as
Switzerland and Japan, have legal restrictions preventing certain
regulators from signing such agreements. Therefore, these regulators
have not signed the agreement but may sign if the legal restrictions
can be overcome.
As written, the terms of the agreements could be triggered by a
number of events. For example, an exchange or regulator could
request details of a member firm's positions in various markets if
that firm has experienced a sizable reduction in its capital,
unusually large cash flows in its proprietary trading account or
those of its customers, or a concentration of positions in a
particular futures contract. However, concerns about protecting the
privacy of market participants and their activities in some countries
may limit the potential effectiveness of these agreements. Further,
exchanges have varying levels of controls and procedures; therefore,
the availability of information varies. Regulators have attempted to
address the legal and confidentiality concerns about exchanges
sharing information through their agreement, which contains
additional provisions that allow regulators to share information if
commercial or legal restrictions prohibit exchanges from acting. A
CFTC official noted that this is a critical component of the
regulators' companion agreement. However, in order for these types
of provisions to be effective, the exchanges must be willing to go to
their regulator to get the needed information to the appropriate
parties.
--------------------
\16 Since March 15, 1996, at least seven exchanges and one regulator
have signed on to the agreements.
U.S. SECURITIES AND FUTURES
CLEARING ORGANIZATIONS
AGREED TO GREATER
COOPERATION AND INFORMATION
SHARING
-------------------------------------------------------- Chapter 6:3.4
On September 7, 1995, clearing organizations for 19 stock, stock
options, and futures exchanges in the United States, called the
Unified Clearing Group, signed an agreement to foster greater
cooperation and information sharing among securities and futures
exchanges. According to the Chairman of CFTC, the information-
sharing agreement should enable trade clearing officials at major
U.S. financial markets to "better assess the risk carried by
brokerage firms that buy and sell exchange-listed futures,
securities, and stock options." According to the agreement, the
purpose of the Unified Clearing Group is to improve the clearance and
settlement process of securities and futures transactions; to ensure
that securities, futures, funds, and other collateral, which are in
the custody or control of members, or for which members are
responsible, are safeguarded; remove impediments that prevent prompt
and accurate clearance and settlement; and protect investors and
public interests. The group plans to meet as needed and to appoint a
task force on issues as they arise.
CONCLUSIONS
---------------------------------------------------------- Chapter 6:4
Consistent with recommendations in our 1994 report, U.S. and foreign
financial regulators, working independently and through various
committees and working groups, have issued guidelines and
recommendations that, if adopted by member countries, could help
harmonize risk management, disclosure, reporting, and accounting for
derivatives. However, many of these initiatives are not legally
binding and have not been adopted by all regulators. In addition,
most coordination among regulators still occurs informally. The
Barings crisis spurred efforts to improve international regulatory
coordination, primarily through formal information-sharing
agreements. While these agreements may result in greater information
sharing, their effectiveness depends on continued cooperation among
regulators and market participants, which may be hampered by issues
of privacy and confidentiality.
FLAWED CORPORATE GOVERNANCE
SYSTEMS CONTRIBUTED TO SIGNIFICANT
LOSSES
=========================================================== Appendix I
We reviewed four highly publicized losses from derivatives activities
in recent years. A common factor in each of these losses was a weak
corporate governance system that did not establish effective risk
management and internal controls. Frequently, those responsible for
corporate governance, including boards and senior management, did not
-- provide effective oversight of their entities' use of
derivatives and monitor the exposure these products represent;
-- ensure that effective risk-management and control policies and
procedures were established;
-- ensure that qualified personnel and comprehensive systems were
used to initiate derivatives activities and monitor their
exposure; or
-- ensure that comprehensive audits and reviews were conducted to
independently assess compliance with established policies,
limits, and controls.
As a result of these weaknesses, risks and exposures associated with
derivatives were not properly managed.
BANKERS TRUST AND ITS CLIENT,
GIBSON GREETINGS
--------------------------------------------------------- Appendix I:1
Bankers Trust had been known among federal regulators for the high
quality of its internal control systems over derivative products.
However, according to Federal Reserve Bank of New York officials,
when Bankers Trust started its new line of leveraged derivative
products, it did not treat this line as a new and riskier business
and, therefore, did not make any adjustments to its existing internal
controls. Subsequently, Bankers Trust's practices were questioned by
SEC and CFTC for possible violations of securities and commodities
laws related to these leveraged transactions, and Bankers Trust was
sued by several clients.
The regulators' inquiries revealed weaknesses in Bankers Trust's
risk-management and internal control systems, including improper
conduct in the marketing, offer, and sale of its leveraged
derivatives transaction business and failure to reasonably supervise
its employees involved in this business. In December 1994, Bankers
Trust entered into agreements with the Federal Reserve, SEC, and CFTC
to enhance internal controls to prevent future violations and to pay
a $10 million fine imposed jointly by SEC and CFTC.\1 In a public
release of the agreement with the Federal Reserve Bank of New York,
Bankers Trust noted that its control mechanisms needed to be
strengthened and agreed to correct them. These corrections included
enhancing its management and supervision process and establishing a
committee of its board of directors to monitor compliance with the
agreement.
The leveraged nature of Bankers Trust's derivatives contracts caused
one of its clients, Gibson Greetings, Inc., to incur losses that
multiplied quickly as interest rates rose in early 1994. Gibson
decided not to honor its obligations and sued Bankers Trust. SEC
investigated Gibson for possible violations of SEC reporting
requirements. The investigation showed that Gibson did not have
adequate internal controls associated with its leveraged derivatives
contracts. Flaws in Gibson's control environment, including a
failure by Gibson officials to establish proper accounting and
internal controls over its derivatives activities, allowed Gibson to
incur a reported loss of about $23 million.\2
Two Gibson officials initiated its derivatives investments by
purchasing interest rate swaps, intending to reduce Gibson's
borrowing costs. From November 1991 to March 1994, Gibson, through
Bankers Trust, entered into about 30 derivatives transactions,
including interest rate swaps and related restructurings that became
increasingly complex, risky, and intertwined. Many of the
derivatives had leverage factors that caused Gibson's losses to
increase dramatically with relatively small changes in interest
rates. Gibson's officials were not adequately experienced or trained
to fully understand derivatives. The derivatives background of
Gibson's primary official responsible for its derivatives activities
was limited to a few seminars focused on the use of derivatives and
on-the-job training obtained in working with Bankers Trust. Without
knowledge of derivatives and lacking systems to value them, Gibson
officials were unable to exercise controls over the acquisition of
the derivative products or to monitor whether these products were
serving the intended purpose of reducing Gibson's debt costs.
SEC's investigation also showed that the derivatives Bankers Trust
sold to Gibson were customized contracts that did not trade on any
market and thus were difficult to price. Gibson relied totally on
Bankers Trust to establish market values for use in preparing
Gibson's financial statements and periodic reports filed with SEC.
They did not use independent sources to verify the market values that
Bankers Trust provided. As a result, Bankers Trust representatives
were able to mislead Gibson about the value of the company's
derivatives positions by providing values that significantly
understated the magnitude of the losses. Gibson remained unaware of
the actual extent of its losses from derivatives transactions and
continued to purchase additional derivatives from Bankers Trust.
These conditions could not have existed had Gibson's board and
management exercised appropriate oversight of the company's
derivatives activities and insisted on having independent means to
determine the value of their derivatives holdings.
--------------------
\1 These agreements do not affect Bankers Trust's overall derivatives
business but are limited specifically to its leveraged derivatives
transactions activities.
\2 Subsequent litigation by Gibson against Bankers Trust reduced the
amount of its loss.
ORANGE COUNTY, CA
--------------------------------------------------------- Appendix I:2
Orange County managed a pool of about $7.5 billion for 187 separate
governmental agencies, including school, water and sewer districts,
and other municipalities, as well as about 400 individuals. The
County Treasurer managed the pool and historically reported high
interest earnings. The Treasurer's investment strategy stressed
yield over liquidity or security at a time when the county Board of
Supervisors faced increasing budgetary pressure to fund county
government services from investment earnings instead of tax
increases. The percentage of the budget generated from tax revenues
was declining. The Treasurer operated the investment pool with
little oversight from the Board of Supervisors.
From January 1991 to November 1994, the Treasurer substantially
increased risk by mismatching the investment pools' assets and
liabilities. He purchased volatile, long-term structured notes and
used short-term liabilities (reverse repurchase agreements) to fund
the purchases.\3 For example, as of November 30, 1994, the Orange
County investment pool included large investments in structured notes
that averaged nearly 4 years to maturity.\4 The Treasurer's strategy
made the investment pool even more vulnerable by entering into
reverse repurchase agreements at short-term rates. When combined
with the volatility of structured notes, this leveraging strategy
produced an investment portfolio highly sensitive to interest rate
movements. By November 30, 1994, an estimated $7.5 billion of
original investments in the pool had been leveraged to over $20
billion, a large portion of which was in inverse floaters. Overall,
from 1983 to late 1993, this strategy yielded greater returns than
most investment funds of the California State Treasurer and other
county treasurers.
As rates increased in 1994, the returns on long-term investments no
longer exceeded the cost of funds borrowed to acquire them. In
addition, the market values of the long-term investments that were
used as collateral declined. On December 6, 1994, the county did not
meet a substantial obligation under one of its reverse repurchase
agreements. This resulted in the liquidation of the county's
collateral. Other entities also began selling Orange County's
collateral subject to reverse repurchase agreements. These sales
resulted in about $1.7 billion in losses. The losses precipitated
Orange County's filing for bankruptcy.
Despite concerns about the county's investment activities and
questions about its ability to repay debt securities, which it had
also used to fund the investment pool, the Board of Supervisors
failed to carry out its public responsibilities to effectively
supervise the county's investment activities and to oversee related
debt offerings. The Board failed to require the County Treasurer to
submit monthly reports on changes in the County's investments, which
is required by California law, and failed to ensure that actions were
taken to prevent the recurrence of internal control weaknesses in the
Treasurer's office.
The county's investment losses were heightened by the control
weaknesses in the County Treasurer's office. Similar weaknesses were
noted in several County Auditor's reports issued over a period of
years before the bankruptcy filing, but these weaknesses continued to
occur. In one report, the Auditor characterized one of these
weaknesses as creating the perception of a loose control environment
and recommended that risky or unusual transactions be prudently
entered into with documented decisions made by an investment
committee and with advice, if appropriate, from County Counsel. This
lack of oversight allowed the Treasurer to invest in risky
transactions without accountability to other county officials.
Even though the County Auditor's reports on the Treasurer's office
were addressed to the Board of Supervisors, they were routinely
marked "not for Board agenda." As a result, the internal control
weaknesses in the Treasurer's office did not come up for public
discussion. Although questions have been raised in a report on
Orange County's bankruptcy filing about this and other practices of
the County Auditor, the Auditor's performance does not excuse the
county's Board and management from exercising their responsibility to
address control weaknesses and prevent their recurrence.
In other reports related to the county's budget, the County Auditor
also raised concerns about the county's reliance on investment income
to fund a significant portion of its budget and warned in one report
that it was not fiscally responsible to continue budgeting in this
manner. In addition, the Auditor had informed the Board that
investment income projections contained in the budget were based on
increased amounts of borrowing. Despite these warnings, on numerous
occasions the Board approved requests to issue bonds and notes
without public discussion. The Treasurer then used the bond proceeds
to increase the investment pool.
After the county's bankruptcy, an outside consultant studied the
internal controls and operational effectiveness of the Treasurer's
office and continued to identify weaknesses that in our judgment
contributed to the collapse of the county's investment pool. For
example, the consultant found that the county's investment policy did
not define a diversification strategy or establish limits on levels
of high-risk investments.
In January 1996, SEC reported that the Board lacked sufficient
information on the county's investment pool and the impact of the
Treasurer's investment strategy on both the county's financial
condition and its ability to repay investors. In addition, SEC found
that despite the Board's knowledge that the county's discretionary
budget was increasingly dependent on the pool's interest income and
that this income was connected to the county's increased debt
offerings, the Board failed to ensure that this material information
was disclosed to potential investors. SEC concluded that in
authorizing the offer and sale of debt in 1994, the Board failed to
meet its statutory responsibilities to ensure proper disclosure when
it approved the county's misleading disclosure documents.
Orange County's losses illustrate the vulnerability of state and
local governments to losses resulting from weaknesses in internal
controls. Without a responsible oversight body to develop and
implement policies governing the nature and extent of derivatives use
and to provide effective oversight of internal controls and
derivatives activities, entities have greater vulnerability to
significant losses. Both Orange County and the state of California
have instituted corrective actions. For example, the Board
established a Treasury Oversight Committee, which consists of five
financial experts, to assist the Board in improving accountability to
the public on county investments and evaluating internal controls in
the Treasurer's office. California enacted legislation requiring
local treasurers to have oversight committees, annual written
investment policies, and annual compliance audits. It also enacted
legislation restricting portfolios to certain types of investments.
--------------------
\3 A reverse repurchase agreement is an agreement in which the entity
transfers securities to the broker in exchange for cash and promises
to repay the cash plus interest in exchange for the same securities
at a later date certain or on demand by the broker.
\4 Many of these notes provided a rate of return that was equal to a
fixed rate minus a floating rate index. These notes are called
"inverse floaters" because, as interest rates go down, the amount of
interest they pay goes up. For example, if the fixed rate of
interest on the note is 32 percent, and the floating rate is the
multiple of 4 times LIBOR of 7 percent, the interest to be paid would
be 4 percent. If LIBOR goes down to 6 percent, the new interest rate
to be paid would be 8 percent.
CAPITAL CORPORATE FEDERAL
CREDIT UNION
--------------------------------------------------------- Appendix I:3
The Capital Corporate Federal Credit Union, which is known as Cap
Corp, was formerly one of the nation's largest corporate credit
unions. Over the 6-year period 1989 to 1994, Cap Corp invested an
increasing portion of its assets in CMOs in an apparent attempt to
increase the return paid to its member credit unions. Although Cap
Corp's investments in CMOs increased substantially during this 6-year
period, Cap Corp did not develop and implement a risk-management
system that was capable of effectively monitoring and responding to
rapid and unanticipated changes in CMO market values.\5 In
particular, Cap Corp lacked a financial model to test the overall
sensitivity of its investment portfolio to potential changes in
interest rates and was unable to react readily to the growing
mismatch between its assets and liabilities.\6 In January 1995, the
National Credit Union Administration placed Cap Corp into
conservatorship because it could not meet its financial obligations
to its members. As of February 1995, Cap Corp's losses totaled $61
million.
Cap Corp's board of directors not only failed to ensure that an
adequate risk-management system was established and functioning, it
also did not appear to adequately oversee Cap Corp's investment
activities. For example, virtually all responsibility for Cap Corp's
investment activities was delegated to an investment committee
comprising Cap Corp's senior management, and the board showed little
interest in the decisions this committee made. Until late 1993, the
committee did not maintain minutes of its meetings that would have
documented investment decisions. In late 1994, only after National
Credit Union Administration examiners insisted, minutes of the
investment committee were formally presented to the board on a
monthly basis. However, the board did not appear to discuss or
question the investment committee's strategy or activities.
In addition, the supervisory committee of the board of directors,
which was responsible for oversight of the audit function and related
review of internal controls, did not establish an internal audit
function at Cap Corp. Instead, the supervisory committee relied
solely on the annual financial statement audit performed by the
external auditor to provide information about the status of internal
controls. The objective of a financial statement audit is for an
external auditor to provide an opinion on the fairness of the
information appearing in the financial statements. Therefore, the
purpose of these audits is different from audits that focus on the
adequacy of internal controls. Although the annual external audit
may have contributed to the committee's oversight, it did not take
the place of a specific review of controls that an internal or
external auditor could have performed to ensure Cap Corp's compliance
with established policies and procedures. Without this type of
review, the Board of Directors did not have adequate information to
understand the seriousness of the risk associated with Cap Corp's
investment activities.
--------------------
\5 The market value of a CMO tends to be more volatile than
traditional corporate investments, such as U.S. Treasury
obligations, in part because changes in interest rates affect the
time pattern of mortgage prepayments. When interest rates rise,
people prepay mortgages at a slower rate, and the average maturity of
these assets lengthens.
\6 Financial modeling, including stress testing, is important because
it shows the sensitivity of asset and liability values to potential
changes in interest rates.
BARINGS PLC
--------------------------------------------------------- Appendix I:4
In February 1995, Baring Brothers & Co., Ltd, a British investment
bank owned by Barings PLC, collapsed after losing over $1 billion by
trading financial futures on exchanges in Singapore and Japan.
According to the British Board of Banking Supervision Inquiry,
Barings' management failed at various levels to institute a proper
system of internal controls; to enforce accountability for all
profits, risks, and operations; and to adequately follow up on a
number of warning signals over a prolonged period. For example, a
1994 internal audit report highlighted that one individual had an
excessive concentration of power and that this concentration was a
significant internal control weakness. That weakness allowed the
individual responsible for initiating trading transactions, often
referred to as "front" office activities, to also be responsible for
recording and reconciling these activities. The latter, referred to
as "back" office activities, also included settling any account
differences. Permitting one individual to be responsible for both
front and back office activities increases the likelihood that
unauthorized transactions could occur and go undetected. The
employee's unauthorized transactions were concealed by false trading
transactions and accounting entries, the submission of falsified
reports, and the misrepresentation of trading profitability. Despite
the seriousness of this lack of basic separation of duties, Barings'
management did not take any action or follow up on the internal audit
report.
The Banking Supervision Inquiry also showed that other warning signs
existed and were ignored by management. For a relatively risk-free
trading strategy to generate such apparently large profits should
have raised questions. Further, the trading activities required a
high level of funding. In early 1994, the employee had requested
some of the funds used to finance his trading positions from the bank
as loans to fund client positions. Because the employee requesting
the funds was responsible for both front and back office
transactions, he was able to conceal from Barings' credit department
the fact that he was characterizing the transactions as loans. Since
this department was not informed of the loans, it made no attempt to
verify whether any clients existed (none did). Barings' inattention
to key internal controls, such as the segregation of duties,
demonstrates its lack of effective corporate governance and a
generally weak overall control environment.
RESULTS OF GAO REVIEW OF KEY
INTERNAL CONTROLS AT 12 BANKS AND
THRIFTS
========================================================== Appendix II
We judgmentally selected a sample of 12 banks and thrifts that were
large end-users of derivatives to obtain an understanding of their
corporate governance, risk management, and internal controls.\1 At
each of the institutions, we discussed the formal assessment of
internal controls required by FDICIA, whether management perceived
benefits from these FDICIA requirements, and the reasons for their
perceptions. This appendix also discusses the extent to which
certain key controls over derivatives activities were designed into
these institutions' systems of internal controls.
Officials at most of the financial institutions told us that the
formal assessment was beneficial. Some officials told us the process
provided them an opportunity to thoroughly think through their
internal control structures or to heighten their awareness of
internal controls. Some of the officials noted that the process
identified areas needing improvement or increased their staffs'
awareness of the importance of controls. Although some officials
said that in its first year of application the process was either
costly or time-consuming, many others said that it will take less
time or effort in subsequent years to update the information
previously obtained.
To determine whether key internal controls related to derivatives
were designed into the internal control systems at the 12
institutions, we reviewed available documentation and discussed
specific controls with management, internal auditors, or regulatory
examiners.\2 The documentation included bank examination working
papers and, when available, internal control documentation related to
derivatives that had been prepared by management to satisfy FDICIA
requirements. We developed the list of key internal controls related
to derivatives after reviewing various guidance documents prepared by
market participants, regulators, and others. Most of the controls we
considered key were included in guidance issued by more than one of
these sources and were also contained in derivatives guidance issued
by COSO. However, our review did not evaluate or test the
effectiveness of the key internal controls at the 12 institutions.
Table II.1 summarizes the results of our review of key derivatives
controls in the system of internal controls at the 12 institutions.
For each key derivatives control, the table identifies the number of
institutions that (1) had designed the internal control into their
systems; (2) had designed the internal control into their systems,
but for which examiners or internal auditors had noted the need for
improvements; and (3) had incomplete data with which to verify that
the control was designed into the system.
Table II.1
Summary of Results at 12 End-User
Financial Institutions
Key Incomplete
control data to
designed verify
into that key
Key system/ control
control but was
designed improvemen designed
into ts still into
Key internal control system needed system
-------------------------------------------- ---------- ---------- ----------
The overall objective of the hedging program 9 1 2
is defined, and this objective is approved
by the board of directors.
Written policies clearly set risk limits and 6 6 0
are approved by management.
A committee meets regularly to oversee the 6 4 2
hedging program, report to the board of
directors, and maintain documentation of
its decisions and actions.
Trading limits are set for specific market 9 2 1
risks.
Credit limits are established for 8 4 0
counterparty exposure.
Policies exist to execute trades through 8 1 3
authorized brokers.
Policies exist to ensure that persons have 5 2 5
appropriate knowledge to manage derivatives
activities.
The board of directors has a policy to 8 3 1
ensure that sufficient capital is
maintained to support risk exposures.
Procedures are designed to segregate the 10 2 0
trading function from the credit function
in order to separate placing an order,
recording the transaction, and verifying
the confirmation of the trade.
Policies are established that authorize 11 1 0
separate employees to set hedge strategy,
change hedge strategy, change trading
limits, and execute trades.
Backup procedures exist when key employees 3 1 8
are absent.
Procedures exist to monitor risk limits and 7 3 2
exposures on a daily or regular basis.
A system of communication exists between the 8 0 4
back office management and senior
management concerning changes to hedging
strategies.
Established subsidiary accounting records 9 0 3
exist for futures contracts.
Procedures exist to periodically reconcile 9 1 2
subsidiary records to the general ledger.
Documentation exists to support (1) the 9 2 1
objective and strategy of each hedge; and
(2) key accounting information for options,
futures, and swaps transactions.
Sequential numbering of transactions is 6 0 6
used.
Procedures exist to require trade 9 1 2
verification by (1) agreeing executed trade
to broker's confirmation, (2) agreeing key
accounting data to broker's statements, and
(3) accounting for the sequence of numbered
transactions.
Internal audit function exists so that 8 1 3
periodic reviews of derivatives activities
and policies and procedures established by
management could be done.
Management receives reports on a regular 7 3 2
basis of the results of hedging and trading
activities.
--------------------------------------------------------------------------------
Sources include: OCC Banking Circular BC-277; Federal Reserve Board
Letter SR 93-69; Derivatives: Practices and Principles, Global
Derivatives Study Group, Group of Thirty, Washington, D.C., July
1993; An Integrated Bank Regulatory Approach to Derivatives
Activities, Institute of International Finance, May 1993; and Audits
of Savings Institutions, AICPA accounting and audit guide.
--------------------
\1 At the time of selection, the banks and thrifts had at least $1
billion in total assets and notional amounts of derivatives exceeding
25 percent of the amount of total assets. We selected at least two
institutions regulated by each of the four bank and thrift regulatory
agencies. We excluded the seven largest bank OTC derivatives dealers
discussed in our May 1994 report.
\2 Subsequent to our review of the 12 banks and thrifts, as discussed
in chapter 3, the Federal Reserve issued examination guidance stating
that the board of directors, as well as management, should approve
risk limits. See Federal Reserve Board Letter SR 95-17 (SUP),
"Evaluating the Risk Management and Internal Controls of Securities
and Derivatives Contracts Used in Nontrading Activities"; and Federal
Reserve Board Letter SR 95-51 (SUP), "Rating the Adequacy of Risk
Management Processes and Internal Controls at State Member Banks and
Bank Holding Companies."
PROTOTYPE GUIDELINES FOR ROLES AND
RESPONSIBILITIES OF BOARDS OF
DIRECTORS
========================================================= Appendix III
The following represent suggested guidelines for boards of directors
presented by GAO to SEC for its consideration in responding to the
recommendations in our May 1994 report. These guidelines were
accumulated from existing guidance issued in OCC Banking Circular
BC-277; Federal Reserve Board SR 93-69; the Canadian Deposit
Insurance Corporation's Interest Rate Risk Management paper; and The
CPA Letter article entitled "Questions About Derivatives," issued by
AICPA in July/August 1994.
Boards of Directors should
-- approve all significant policies and activities relating to
derivatives and related risk-management activities; and ensure
that these policies and activities are consistent with the
organization's broader business strategies, capital adequacy,
expertise, and the overall willingness to take risk.
Specifically, the boards should consider and approve
-- a description of the relevant financial products, markets, and
business strategies;
-- the costs of establishing sound and effective risk-management
systems and of attracting and retaining professionals with
expertise in derivatives transactions;
-- an analysis of the reasonableness of the proposed activities in
relation to the entity's overall financial condition and capital
levels;
-- an analysis of the risks that may arise from the activities;
-- the procedures the entity will use to measure, monitor, and
control risks;
-- the relevant accounting guidelines (the appropriateness of such
guidelines should be discussed with the external auditors as a
basis for approval); and
-- an analysis of any legal restrictions and whether the activities
are permissible.
In addition, Boards of Directors should
-- regularly reassess the adequacy of the financial condition of
the entity and the competency of designated professional
personnel to support the derivatives and related risk-management
activities;
-- regularly re-evaluate (at least annually) significant
derivatives and related risk-management policies and procedures;
-- approve any significant changes in derivatives activities;
-- review the appropriateness of established risk limits and
controls whenever significant changes occur in the size and
scope of the entity's activities or market conditions, or if the
entity experiences significant reductions in earnings or capital
that were not anticipated at the time the limits and controls
were established;
-- receive relevant information about credit exposure arising from
derivatives activities on a periodic and timely basis;
-- receive reports that accurately present the nature and level(s)
of risk taken and compliance with approved policies and limits;
-- ensure compliance with the risk-management program by receiving
sufficient information in periodic reporting by management and
internal and external auditors;
-- ensure that an internal audit function reviews risk operations
to ensure that the entity's risk-management policies and
procedures are being adhered to; and
-- conduct and encourage discussions between its members and senior
management, as well as between senior management and others in
the entity, regarding the entity's risk-management process and
risk exposure.
PROTOTYPE REPORT ON INTERNAL
CONTROLS OVER DERIVATIVES AND
RELATED RISK-MANAGEMENT ACTIVITIES
========================================================== Appendix IV
At SEC's request, we prepared this prototype report on internal
controls over derivatives activities to illustrate the kind of public
reporting we were recommending. This report describes an entity's
derivative products, the establishment of its risk limits and related
controls, and its involvement of the board of directors and the
board's audit committee. This report is only illustrative and could
well be shortened, simplified, or broadened to include a wider range
of important internal controls. We presented this report to SEC for
its consideration in responding to the recommendations in our May
1994 report.
As described further in Note XX to the financial statements, the
Company uses financial derivatives as an efficient way to manage
its various market risks, including adverse changes in interest
rates, foreign exchange rates, and commodity prices. The
Company uses derivatives to protect against price volatility in
the raw materials of the products it manufactures. In addition,
the Company uses derivatives and related risk-management
products to synthetically alter the interest rate and maturity
characteristics of its debt instruments to better match the
characteristics of the related assets being funded by those
instruments. In certain instances, the Company may use
derivatives to protect itself against foreign currency movements
in connection with its overseas operations. Derivative
instruments used include futures contracts, foreign exchange
forwards, options, and interest rate swaps.
The Company's Board of Directors has approved the
risk-management policies and procedures that management uses to
carry out its risk-management activities. These policies and
procedures reflect the Company's objectives to hedge virtually
all of its market risk exposure. However, the Board-approved
policy allows management to maintain nonhedged market risk
exposures not to exceed X percent of the Company's planned gross
profit.
Management has established a system of internal control to
provide reasonable assurance that the derivatives and related
risk-management policies and procedures are being carried out
and, in so doing, that reliable financial reporting of these
activities is achieved and that assets are protected from losses
due to unauthorized acquisition, use, or disposition of
derivatives. The control system for derivatives contains
self-monitoring mechanisms, including risk-management group
reporting directly to senior management and the Board of
Directors. As a result, actions are taken to correct
deficiencies as they are identified. However, an effective
internal control system, no matter how well designed, has
inherent limitations--including the possibility of the
circumvention or overriding of controls.
Management has assessed the operation of its control system for
derivatives as of December 31, 19XX, using the criteria for
effective internal control described in "Internal Control -
Integrated Framework" issued by COSO. The assessment included
an in-depth analysis of all departments of the Company
responsible for derivatives and related risk-management
activities. A separate task force consisting of members of
mid-level management and internal audit had overall
responsibility for the assessment and, at the conclusion,
reported to senior management. The documentation of the
assessment in the form of checklists, flowcharts, and
questionnaires provides evidence of this review. In addition,
the Company's independent auditors reviewed the assessment in
connection with their annual audit procedures but have not been
asked to express an opinion on the effectiveness of the system.
Management reviewed its assessment of the effectiveness of the
control system for derivatives, including the methodology used
to perform the assessment, with the Audit Committee of the Board
of Directors. Management also reviewed with the Audit Committee
all weaknesses identified in the assessment and the corrective
actions taken. All identified weaknesses were corrected as of
December 31, 19XX.
On the basis of the assessment described, Management believes
that as of December 31, 19XX, its approved policies and
procedures for risk management using financial derivatives are
being carried out and that they provide reasonable assurance
that published financial statements reliably report these
activities and that Company assets are safeguarded against loss
due to unauthorized acquisition, use, and disposition of
derivatives.
QUANTITATIVE STANDARDS FOR MARKET
RISK AMENDMENT
=========================================================== Appendix V
In September 1996, U.S. bank regulators issued a final rule to
incorporate market risk into risk-based capital standards for
internationally active dealer banks and bank holding companies with
significant trading activities. The final rule requires that, by
January 1, 1998, these banks use their internal (proprietary)
value-at-risk models to calculate the amount of regulatory capital to
be held for market risk. Banks have used these models primarily as
management tools to produce estimates for evaluating their trading
positions, limits, and strategies, rather than for evaluating capital
adequacy. The final rule imposes several qualitative and
quantitative requirements to adapt these models for regulatory
capital purposes.
The qualitative requirements include rigorous stress testing, an
independent risk control unit, active involvement of senior
management, and an independent review of the risk measurement system.
The quantitative requirements include
-- daily calculation;
-- an assumed holding period of 10 business days;\1
-- a 99 percent confidence level to estimate maximum loss;\2
-- allowance for correlations among broad risk categories (interest
rates, exchange rates, equity and commodity prices) only if
based on empirical analysis and if the regulator agrees that the
measurement system is
sound;\3
-- use of at least 1 year of historical data in the models of
future price and rate changes;\4
-- updates at least every 3 months of the underlying data used in
the models;
-- at least six different maturities of interest rates included in
the models of interest rates for each major currency;
-- all material risks measured by the bank's model; and
-- nonlinear price characteristics of options\5 adequately
addressed.
--------------------
\1 Most institutions assume a 1-day holding period in estimating
value at risk in their trading portfolios. That would cover the
amount of adverse price move that might be expected the next day. A
longer assumed holding period, such as 10 days, will generate a
larger potential price movement and therefore a larger value at risk.
Bank regulators do not expect banks to hold losing positions for that
period; instead they use the 10-day calculation as a way of ensuring
that banks' value-at-risk shows the potential impact of a stressful
shock, such as an instantaneous price move of a magnitude that
ordinarily might occur only over 10 days.
\2 This constraint establishes that the value at risk will be set on
the basis of an adverse rate or price movement large enough so that
in 99 out of 100 10-day periods, price moves are expected to be less
adverse than this.
\3 If two market prices or rates move in a clearly defined
relationship to each other, and if this relationship is stable, these
market prices or rates are said to have a defined numerical
correlation. As an example, if currency A and currency B always move
together, then a firm could reduce its value at risk by having an
asset position in one and a matching liability position in the other.
\4 Some banks use data from periods as short as 30 to 60 days, while
others use periods as long as several years. The regulators' 1-year
constraint is intended to make value-at-risk estimates more
comparable among banks.
\5 The relationship of the value of an option to the price of the
underlying is not constant, and banks' models must allow for the
different factors that move options prices.
CURRENT ACCOUNTING AND DISCLOSURE
STANDARDS FOR DERIVATIVES AND
RELATED FINANCIAL INSTRUMENTS
========================================================== Appendix VI
Accounting standards establish the rules that entities must follow in
recognizing and measuring transactions for reporting in the body of
the financial statements. Disclosure standards establish the rules
that entities must follow in providing additional information beyond
what is reported in the financial statements, usually in the
accompanying footnotes. Accounting and disclosure standards
promulgated by FASB are generally applicable to nongovernmental
entities, and those issued by GASB apply to state and local
governmental entities. FASB began a financial instruments project in
1986 to develop standards to aid in resolving financial accounting
and reporting issues about various financial instruments, including
derivatives. Standards affecting derivatives that have been issued
since the project began focus on disclosures. No new accounting
standards for derivatives have been issued since 1984. However, an
accounting standard for certain investments in debt and equity
securities was issued in 1993. There are no specific GASB
pronouncements that address accounting for derivatives held by state
and local governmental entities. The following is a discussion of
existing accounting and disclosure standards as well as other
guidance from authoritative sources.
ACCOUNTING REQUIREMENTS
-------------------------------------------------------- Appendix VI:1
Currently, two FASB statements prescribe specific accounting
requirements for derivative instruments:
-- Statement of Financial Accounting Standards (SFAS) No. 52,
Foreign Currency Translation, issued in 1981, applies to foreign
currency transactions including foreign currency futures,
forwards, and swaps.
-- SFAS No. 80, Accounting for Futures Contracts, issued in 1984,
applies to futures contracts, except foreign currency futures.
SFAS No. 52 allows the use of hedge accounting treatment, provided
the hedging instrument is so designated and is effective as a hedge
of a specific commitment or transaction, and the commitment is firm.
SFAS No. 80 allows the use of hedge accounting treatment provided
(1) the item to be hedged exposes the entity to price or interest
rate risk; (2) the hedging instrument and the hedged item, which may
be either an individual item or an identifiable group of essentially
similar items, are specifically identified by management and the
relationship between them is designated as a hedge; and (3) the
hedging instrument reduces the entity's exposure to price or interest
rate risk and continues to do so throughout the hedge period.
Some similarities exist in the hedge criteria specified in both
statements. For example, both require the specific hedging
instrument and the hedged item to be identified and designated as a
hedge, and both require an ongoing demonstration of effectiveness or
correlation to demonstrate the hedge is working as intended.
However, there are significant differences between the statements as
well. For example, SFAS No. 80 allows the use of hedge accounting
when the hedging instrument is designated against an anticipated
transaction, provided the significant characteristics and expected
terms of the anticipated transaction are identified and occurrence is
probable.\1 SFAS No. 52 allows hedging only against firm
commitments.\2 SFAS No. 80 requires the hedging instrument to reduce
the entity's overall exposure to interest rate risk, while SFAS No.
52 requires only reducing the risk of the designated hedged item. As
a result, these two statements do not provide consistent guidelines
to those seeking to apply them to instruments for which there are
currently no standards. Although FASB in the past had considered
undertaking a project focusing on reconciling both statements, due to
questions raised about the appropriateness of hedge accounting in
general, it decided instead to address hedging more broadly in its
ongoing hedge accounting project.
In May 1993, FASB issued SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities, in response to concerns
about the appropriateness of previous accounting practices in which
historical cost accounting was used for investments that were
regularly being sold and traded. Although SFAS No. 115 does not
apply to derivatives, it does apply to financial instruments that may
have derivatives-like characteristics. SFAS No. 115 requires most
investment securities to be classified in three categories and
accounted for as follows:
-- Debt securities that the entity has the positive intent and
ability to hold to maturity are classified as "held-to-maturity
securities" and reported at amortized cost.
-- Debt and equity securities that are bought and held principally
for the purpose of selling them in the near term are classified
as "trading securities" and reported at fair value, with
unrealized gains and losses included in earnings.
-- Debt and equity securities not classified as either
held-to-maturity or trading securities are classified as
"available-for-sale securities" and reported at fair value, with
unrealized gains and losses excluded from earnings and reported
in a separate component of shareholders' equity.
In addition, SFAS No. 115 requires that for securities classified as
available-for-sale or held-to-maturity, an entity must record in
income any declines in fair value that are deemed to be other than
temporary.
--------------------
\1 SFAS No. 80 defines an anticipated transaction as one that an
entity expects, but is not obligated, to carry out in the normal
course of business.
\2 A firm commitment is an agreement, usually legally enforceable,
under which performance is probable because of sufficiently large
disincentives for nonperformance.
DISCLOSURE REQUIREMENTS
-------------------------------------------------------- Appendix VI:2
Since the financial instruments project began in 1986, FASB has
issued three disclosure statements:
-- SFAS No. 105, Disclosure of Information About Financial
Instruments with Off-Balance-Sheet Risk and Financial
Instruments with Concentrations of Credit Risk, which applies to
all financial instruments with the stated risks;
-- SFAS No. 107, Disclosures About Fair Value of Financial
Instruments, which generally applies to all financial
instruments; and
-- SFAS No. 119, Disclosure About Derivative Financial Instruments
and Fair Value of Financial Instruments.
SFAS No. 105 and SFAS No. 107, which were issued in 1990 and 1991,
do not make a distinction between hedge versus nonhedge instruments.
SFAS No. 105 established requirements for all entities to disclose
information principally about financial instruments that have an
off-balance-sheet risk of accounting loss.\3 For all applicable
financial instruments, entities must disclose the extent, nature, and
terms of such instruments, including the credit and market risks they
carry, the potential accounting loss that may result from the credit
risk regardless of any offsetting collateral or security, and
information about the entity's collateral policy and program to
better indicate the extent of credit risk. In addition, entities are
to disclose all significant concentrations of credit risk arising
from all financial instruments.
SFAS No. 107 requires all entities to disclose the fair value of
financial instruments, both on-balance sheet and off-balance sheet,
for which it is practicable to estimate fair value, as well as the
method(s) and significant assumptions used to estimate the fair value
in either the body of the financial statements or the related
footnotes. If estimating fair value is not practicable, the standard
requires disclosure of descriptive information pertinent to
estimating the value of a financial instrument.
SFAS No. 119, issued in October 1994, established new disclosure
requirements and included revisions to SFAS No. 105 and SFAS No.
107. Specifically, for all derivative financial instruments, SFAS
119 requires disclosure of the following information either in the
body of the financial statements or in the accompanying footnotes:
-- the amounts, nature, and terms of derivative financial
instruments that are not subject to SFAS No. 105 because they
do not result in off-balance-sheet risk of accounting loss;
-- average fair value and net trading gains or losses for
derivative financial instruments held or issued for trading
purposes;
-- the objectives for holding or issuing derivative financial
instruments held other than for trading, the strategies for
achieving those objectives, and how the instruments are reported
in the financial statements; and
-- information about hedges of anticipated transactions, including
firm commitments, such as a description of the classes of
derivative financial instruments used to hedge those
transactions, the amount of hedging gains and losses deferred,
and a description of the transactions or other events that
result in recognition of the deferred gains or losses in
earnings.
The statement also amended SFAS No. 105 to require disaggregation of
information about financial instruments with off-balance-sheet risk
of accounting loss by class, business activity, risk, or other
category that is consistent with the way the entity manages those
instruments. Additionally, the statement amends SFAS No. 107 to
require that fair value information be presented without combining,
aggregating, or netting the fair value of derivative financial
instruments with the fair value of nonderivative financial
instruments and be presented together with the related carrying
amounts in the body of the financial statements, a single footnote,
or a summary table. SFAS No. 119 also encourages, but does not
require, quantitative information about market risks of derivative
financial instruments and other related assets and liabilities that
is consistent with the way the entity manages or adjusts those risks
and that is useful for comparing the results of applying the entity's
strategies to its objectives for holding or issuing the derivative
financial instruments.
--------------------
\3 SFAS No. 105 defines an off-balance-sheet risk of accounting loss
as the risk of loss beyond what is currently recognized in the
balance sheet due to credit and/or market risk directly resulting
from the rights and obligations of a financial instrument.
OTHER GUIDANCE
-------------------------------------------------------- Appendix VI:3
The accounting and financial reporting provisions of AICPA Audit and
Accounting Guides generally describe authoritative literature or
describe practices for a specific industry where no such literature
exists.\4 Although the guides describe existing principles and
practices, they do not establish accounting standards themselves.
One guide--Audits of Investment Companies--contains limited
information about the accounting for derivatives by those entities.
In general, this guide briefly describes current accounting practice
for derivatives by those entities for various derivative products.
Another guide, Audits of State and Local Governmental Units, contains
limited information on the accounting for investments of governmental
funds by these entities but does not specifically address
derivatives. A recently issued guide, Banks and Savings
Institutions, and a proposed guide, Audits of Brokers and Dealers in
Securities, contain more extensive discussion of derivatives and
related accounting and auditing guidance. AICPA anticipates issuing
the proposed guide in the fourth quarter of 1996.
Additional guidance on derivatives issues is contained in various
FASB Emerging Issues Task Force (EITF)\5 consensus positions
concerning hedge accounting. For example, EITF Issue No. 90-17,
Hedging Foreign Currency Risk with Purchased Options, addresses the
appropriateness of hedge accounting for purchased foreign currency
options under various circumstances and EITF Issue No. 91-1, Hedging
Intercompany Foreign Currency Risks, addresses whether intercompany
transactions present foreign exchange risk that may be hedged for
accounting purposes. Although EITF has dealt with a variety of
issues related to certain derivatives, it has not dealt with them
comprehensively. Instead, EITF decisions generally deal with
somewhat narrow accounting issues. Consequently, they do not provide
guidance that can be applied universally to derivatives or other
transactions.
In 1994 the GASB staff issued Technical Bulletin No. 94-1,
Disclosures About Derivatives and Similar Debt and Investment
Transactions, to address financial statement disclosures about
derivatives and similar transactions. Technical Bulletin No. 94-1
calls for certain disclosures if a governmental entity directly or
indirectly uses, holds, or writes (sells) derivatives or similar
transactions during the period covered by the financial statements.
These disclosures should explain the nature of the transactions and
the reasons for entering into them, including relevant discussion of
exposure to credit risk, market risk, and legal risk.
Although there are no authoritative accounting standards for
option-based derivatives, AICPA Issues Paper 86-2, Accounting for
Options, addresses issues related to the accounting for options.
However, the 1986 issues paper contains certain viewpoints that
differ from the conclusions in SFAS Nos. 52 and 80. For example,
the paper states that an option that hedges either an asset stated at
cost or a liability stated at proceeds cannot qualify for hedge
accounting. However, SFAS No. 80 permits hedge accounting for
futures contracts that hedge such assets or liabilities. The
advisory conclusions expressed in the issues paper are not
authoritative, and FASB has advised that the existing authoritative
accounting pronouncements should be followed.
--------------------
\4 Statement of Auditing Standards No. 69, The Meaning of Present
Fairly in Conformity with Generally Accepted Accounting Principles in
the Independent Auditor's Report, describes the hierarchy of sources
of established accounting principles that are generally accepted in
the United States. The highest category, officially established
accounting principles, includes all FASB and GASB statements, such as
SFAS Nos. 52 and 80. AICPA Industry Audit and Accounting Guides,
consensus positions of the FASB Emerging Issues Task Force, and GASB
Technical Bulletins are described in Statement of Auditing Standards
No. 69 as accounting principles but are lower in the hierarchy than
FASB and GASB statements. FASB maintains the responsibility for
setting principles with broad applications and thus limits the scope
of these additional sources. AICPA Issue Papers are listed in the
hierarchy as other accounting literature to be considered in the
absence of established accounting principles.
\5 FASB established EITF in 1984 to assist FASB in the early
identification of emerging issues affecting financial reporting and
of problems in implementing authoritative pronouncements. Its
membership consists of representatives from the major public
accounting firms as well as representatives of major associations of
preparers of financial statements, such as the Financial Executives
Institute and the Business Roundtable.
DERIVATIVES ACTIVITIES OF 12 BANKS
AND THRIFTS
========================================================= Appendix VII
This appendix describes the use of derivatives by the 12 end-user
banks and thrifts we reviewed as well as examples of the hedging
strategies of these institutions. The information that follows is
based on our analysis of bank examination workpapers, annual reports,
regulatory reports, and discussions with regulatory and institution
management and staff at each of the 12 institutions. We generally
obtained data for each institution as of December 31, 1993. In two
cases, however, we obtained detailed derivatives data as of the most
recent regulatory examination at those institutions. For
institutions F and K, data are as of September 30, 1994, and June 30,
1994, respectively.
EXTENT AND USE OF DERIVATIVES
------------------------------------------------------- Appendix VII:1
We found that while all 12 of the institutions we reviewed were using
derivatives for what they identified as end-user risk-management or
hedging activities,\1 most of them were also using derivatives for
dealing and for proprietary trading. As shown in figure VII.1, nine
institutions were using derivatives for dealing and/or proprietary
trading in addition to their hedging activities.
Figure VII.1:
Notional/Contract Amount of
Derivatives Held by Purpose of
Activity, as of December 31,
1993
(See figure in printed
edition.)
Note: Institutions H and J show combined dealing and trading
activities under "dealing."
Source: GAO analysis based on reviews of bank and thrift examination
reports and workpapers, internal and external financial reports, and
discussions with bank and thrift examiners and management.
Although all of the institutions were using derivatives for hedging,
the total notional/contract amount of derivatives used for hedging
was much less than that used for dealing and trading. Only 27
percent of the total notional/contract amount of derivatives held by
these 12 institutions was identified as being used for hedging
compared with 73 percent for dealing and/or trading. In all cases
the derivatives used for dealing and for trading were carried at
market value.
Figure VII.2 shows the extent to which these institutions used
interest rate derivatives versus their use of foreign exchange rate
instruments.
Figure VII.2:
Notional/Contract Amounts of
Interest and Foreign Exchange
Rate Derivatives, as of
December 31, 1993
(See figure in printed
edition.)
Source: GAO analysis based on reviews of bank and thrift examination
reports and workpapers, internal and external financial reports, and
discussions with bank and thrift examiners and management.
As a whole, 64 percent of the notional/contract amounts of the
derivatives held were interest rate derivatives, and 36 percent were
foreign exchange rate instruments. About 42 percent of the interest
rate derivatives were used for hedging, while less than 1 percent of
the foreign exchange rate derivatives were used for hedging purposes.
Only two institutions were hedging with foreign exchange rate
instruments. Institution H also used nominal commodity and equity
futures for dealing/trading.
As shown in figure VII.3, the institutions we reviewed used a variety
of derivative products.
Figure VII.3:
Notional/Contract Amount of
Derivatives by Type of
Contract, as of December 31,
1993
(See figure in printed
edition.)
Note: Institutions F, H, and J reflect combined futures and forwards
amounts under futures.
Source: GAO analysis based on reviews of bank and thrift examination
reports and workpapers, internal and external financial reports, and
discussions with bank and thrift examiners and management.
Swaps were the only type of derivatives used by all 12 institutions.
Despite this, about 57 percent of the total notional/contract amount
of derivatives held by these 12 institutions was in futures and
forwards, while 27 percent was in swaps and 15 percent in options.
This distribution was due in large part to the fact that most of the
derivatives held by the institutions in our sample were used for
dealing and/or trading purposes.
As figure VII.4 shows, interest rate swaps were clearly the
predominant derivative instruments that these institutions used
specifically for hedging purposes.
Figure VII.4:
Notional/Contract Amount of
Hedging Derivatives by Type of
Contract, as of December 31,
1993
(See figure in printed
edition.)
Source: GAO analysis based on reviews of bank and thrift examination
reports and workpapers, internal and external financial reports, and
discussions with bank and thrift examiners and management.
The widespread use of interest rate swaps for hedging is not
surprising because insured depository institutions are inherently
vulnerable to changes in interest rates, and swaps can be customized
to enable the institutions to better match the interest rate
sensitivity of their assets to their liabilities. As a group, 54
percent of these institutions' hedging instruments were interest rate
swaps, followed by interest rate futures at 31 percent. In contrast,
foreign exchange futures and forwards together accounted for almost
half of the total derivative instruments used for dealing and trading
purposes. Overall, 99 percent of the hedging instruments that the
institutions in our sample used were interest rate instruments, while
instruments used for dealing and proprietary trading were about
evenly split between interest rate and foreign exchange rate
products.
--------------------
\1 As discussed in chapter 5, some institutions used deferral hedge
accounting strictly for risk-reducing activities, while others used
deferral hedge accounting for risk-adjusting activities, which some
referred to as risk-management activities. Throughout this appendix,
we use the term hedging to refer to all transactions for which the
institutions are using deferral hedge accounting, where the
underlying asset or liability is carried at historical cost, whether
the activities are risk-reducing or risk-adjusting. Hedging or hedge
accounting also refers to situations where the derivative is used to
hedge an underlying asset or liability carried at market value.
HEDGING STRATEGIES
------------------------------------------------------- Appendix VII:2
The institutions we reviewed used a variety of hedging strategies to
manage their interest rate risk. Each institution's specific
strategy was unique because of factors such as the size and type of
the institution, the nature and mix of its assets and liabilities,
and its management's tolerance for risk and anticipation of market
movements.
RISK-ADJUSTING STRATEGIES
----------------------------------------------------- Appendix VII:2.1
Seven of the institutions we reviewed used a risk-management strategy
based on adjusting, but not necessarily reducing, their interest rate
risk exposure. In general, these institutions had limits on the
maximum acceptable level of risk; however, their managements were
free to adjust risk up or down within these limits. In some cases,
institutions' strategies were built largely upon speculation about
anticipated market movements. Following are selected examples of
institutions using risk-adjusting strategies.
EXAMPLE 1
--------------------------------------------------- Appendix VII:2.1.1
One institution used deferral hedge accounting for all of its
derivatives, even though its strategy for these derivatives was
primarily speculative. The institution was engaged in swaps that
required it to make interest payments based on a variable, or
floating, interest rate and receive payments based on a fixed
interest rate. These swaps, which were entered into in 1992 and
1993, were not being used to hedge particular assets or liabilities
but as a means of generating income at a time of declining interest
rates. These swaps were quite profitable for the institution at a
time when interest rates were falling, because they yielded a fixed
return while the payment obligation, which was based on a floating
interest rate, declined as interest rates declined.
In anticipation of interest rates rising, the institution entered
into caps and collars to protect its swap positions.\2 However, these
caps and collars were not to become effective until 1995, leaving
1994 exposed. As rates increased faster than expected in 1994, the
institution terminated some of its existing swaps and began investing
in swaps that required the institution to make fixed rate interest
payments while receiving floating rate interest payments in order to
limit its losses. Although the institution greatly increased its
investment in derivatives in 1994, the fair value of its portfolio
greatly decreased. On the basis of our review of the institution's
annual report footnote disclosures, the estimated fair value of its
derivatives fell during 1994 from a positive position at the
beginning of the year to a negative position by the end of the year.
As the institution used deferral hedge accounting on these
instruments, this decline in value was deferred and not recorded in
its 1994 financial statements.
--------------------
\2 Caps, floors, and collars are interest rate options that function
to protect the entity from interest rate fluctuations, although they
may also be used for speculation. A purchased cap protects the
holder from rate increases above the cap rate, and a purchased floor
protects the holder from rate decreases. A collar is the equivalent
of purchasing a cap and selling a floor, which allows an entity to
protect against rising rates while reducing the cost of buying the
cap by the premium the entity receives from selling the floor.
EXAMPLE 2
--------------------------------------------------- Appendix VII:2.1.2
This institution categorized the majority of its derivatives as
hedging instruments. However, upon closer examination it appeared
that virtually all of the hedging derivatives were being used to
circumvent compliance with SFAS No. 115, which specifies the
accounting treatment for certain security investments. Although the
institution's purpose for engaging in these swaps was not
speculative, we believe it was still an inappropriate use of hedge
accounting, since the institution had no intent to neutralize its
interest rate risk exposure.
This institution had a portfolio of fixed income securities that it
classified as available-for-sale (AFS). Under SFAS No. 115, such
securities are required to be measured at fair value, with unrealized
holding gains and losses reported in shareholders' equity. In late
1993, after SFAS No. 115 was issued, this institution began
implementing a series of swaps that required the institution to make
interest payments based on a fixed interest rate and receive payments
based on a floating interest rate. Institution management stated
these original swaps were being used to hedge the AFS securities, and
thus the institution used hedge accounting for these swaps. Since
SFAS No. 115 requires AFS securities to be marked to market value
through equity, the swaps were also recorded in this manner under
SFAS No. 80. By doing so, the changes in the market value of the
AFS portfolio were netted against the offsetting changes in the
market value of the swaps, resulting in little net balance sheet
impact.
The institution also entered into a series of offsetting swaps--in
some cases, simultaneously with the original swaps described
earlier--on which it was required to make interest payments based on
a floating interest rate and receive fixed rate interest payments.
However, it did not value these offsetting swaps at fair value and,
therefore, did not recognize the related gains and losses. Although
economically the institution was in virtually the same position it
would have been had it not entered into the original and the
offsetting swaps, the net accounting effect was to defer recognition
of the gains or losses on the AFS securities, thereby circumventing
SFAS No. 115. This was because the original swaps were marked to
market value, with the resulting gains and losses recorded in the
period incurred, while the gains and losses on the offsetting swaps
were deferred. According to information from the institution's 1994
annual report,\3 the estimated fair value of these offsetting swaps
declined in 1994 to a negative fair value. Since this decline in
value was deferred, it was not reflected in the bank's financial
statements.
--------------------
\3 All of the institutions discussed in our examples, except example
1, consolidated their financial statements into the annual reports of
their respective bank holding companies.
EXAMPLE 3
--------------------------------------------------- Appendix VII:2.1.3
In this example, the institution's hedging portfolio included
interest rate swaps, options (caps and floors), and futures. At the
time of our review, the institution's assets were repricing faster
than its liabilities, making it asset-sensitive.\4 Instead of using
derivatives with the goal of eliminating the mismatch as much as
possible, management opted instead to adjust the institution's
interest rate risk profile to create a liability-sensitive position
in order to take advantage of declining interest rates. Management
explained that it allowed the institution's interest rate risk
exposure to be adjusted up or down within a defined "band of risk."
Management was not required to neutralize risk but was allowed to
adjust it depending on anticipated market movements as long as the
institution's overall risk exposure remained within this band.
Specifically, it could adjust risk up or down provided its overall
interest rate risk exposure did not exceed a 5-percent negative
impact on net interest income over 12 months for a 100-basis point
movement in interest rates. This is an example of using derivatives
to adjust interest rate risk rather than to attempt to eliminate it.
To create the liability-sensitive position, the institution primarily
used interest rate swaps that required it to make interest payments
based on a floating interest rate and receive payments based on a
fixed interest rate, similar to the institution in example 1.
Although the institution's policy required designating these swaps
against specific asset and liability groups for hedge accounting
purposes, on an overall enterprise basis these swaps were actually
being used to create a planned asset/liability imbalance toward a
liability-sensitive position.\5 The estimated fair value of hedging
derivatives declined from a positive value at the end of 1993 to a
negative value at the end of 1994. This decline was deferred and not
reflected in the institution's financial statements. A portion of
this amount relates to the imbalance position and, therefore, was
inappropriately deferred.
--------------------
\4 For a given asset or liability, the repricing date is the next
date on which its rate could be reset or when the item would mature.
When more assets than liabilities reprice within a given period, the
entity is said to be asset-sensitive because the assets are more
vulnerable to changes in interest rates than the liabilities. This
situation generally presents an opportunity to earn more net interest
income in a rising interest rate environment. Conversely, when more
liabilities than assets reprice within a given period, a
liability-sensitive position results, which would generally be
beneficial in a declining interest rate environment.
\5 This type of overall adjustment of risk is referred to as
macrohedging, in contrast to microhedging, which requires designating
the hedging instrument against a specific asset or liability or group
of similar assets or liabilities.
EXAMPLE 4
--------------------------------------------------- Appendix VII:2.1.4
This institution's overall hedging objective was to limit its
interest rate risk exposure while allowing for imbalances that could
enable it to profit from favorable market conditions. For example,
in 1993 the institution purposely maintained a pricing imbalance
between its assets and liabilities in order to benefit from a
declining interest rate environment. Similar to the institution in
example 3, this institution also adjusted risk within specified
limits. Its allowable risk-adjusting activities were controlled by
limits on net interest revenue at risk and market value sensitivity
limits based on various interest rate scenarios. The institution's
controller stated this allowed the institution to take advantage of
rising and falling interest rates; however, he acknowledged that
there is no clear definition as to when a strategy moves from being
one of managing risk to one of speculation. This institution
disclosed in its 1994 annual report a decline in the market value of
its interest rate hedging derivatives. Since deferral hedge
accounting was being applied, this decline was not reflected in the
bank's financial results. A portion of this deferred amount related
to the imbalance position and, therefore, was inappropriately
deferred.
RISK-REDUCING STRATEGIES
----------------------------------------------------- Appendix VII:2.2
Five of the institutions we reviewed used risk-reducing hedging
strategies. The primary goal of these institutions' strategies was
to reduce overall interest rate risk exposure. As a result, these
institutions' strategies tended to be more conservative than the
risk-adjusting strategies institutions used and followed more closely
the hedging criteria specified in SFAS No. 80. Such risk-reducing
strategies demonstrate that, when used properly, derivatives are a
very useful and viable means of protecting an institution's exposure
to interest rate risk. Following are two examples of these
strategies.
EXAMPLE 5
--------------------------------------------------- Appendix VII:2.2.1
This institution's balance sheet was primarily naturally hedged; that
is, the interest rate risk of the assets offset the corresponding
interest rate risk of the liabilities. As a result, it did not need
to use derivatives extensively for hedging. Its hedging derivatives
included interest rate swaps that required the institution to pay
interest based on a fixed rate and receive interest payments based on
a floating interest rate. These swaps were being used to hedge a
portfolio of municipal securities. The rest of the swaps were
primarily basis swaps, which required a floating rate interest
payment while receiving a different, floating rate interest payment.
These were entered into in 1993 primarily to hedge specific prime
based loans.
EXAMPLE 6
--------------------------------------------------- Appendix VII:2.2.2
Over 80 percent of this institution's hedging instruments were
interest rate futures, with the remainder primarily interest rate
swaps. Bank management stated its strategy was one of "risk
elimination," as it had experienced financial difficulties in the
past and had made a conscious decision to maintain a very
conservative, controlled hedging environment.
This institution used both micro- and macrohedges for risk reduction.
It placed microhedges on all individual loans (assets) over a
pre-established threshold as they were made. All remaining loans
were then consolidated and hedged weekly. Then, the total
asset/liability pricing mismatch was calculated and hedged monthly.
Although this institution used a combination of micro- and
macrohedges, the macrohedges were of discrete segments of the
portfolio since most of the large items were already hedged before
the monthly mismatch was calculated and, therefore, the monthly
mismatch was relatively small. This institution maintained a very
active yet controlled hedging program that it said allowed it to
successfully neutralize its exposure to interest rate risk.
HEDGE CRITERIA
------------------------------------------------------- Appendix VII:3
As mentioned in chapter 5, most institutions used SFAS No. 52 and
SFAS No. 80 by analogy in formulating their own hedge criteria for
derivatives, even though these standards specifically apply only to
foreign currency transactions and futures contracts, respectively.
Despite their common basis in these standards, the institutions we
reviewed varied in their views and practices on what types of
transactions and strategies should be allowed to qualify for deferral
hedge accounting.
MACRO- VERSUS MICROHEDGES
----------------------------------------------------- Appendix VII:3.1
One view is that qualifying derivatives should be linked to
particular assets or liabilities, such as to residential mortgage
loans or variable rate deposits. Such a direct linkage between the
hedging instrument and the hedged item, which we refer to as a
microhedge, requires an entity to identify, designate, and hedge
specific items that it has identified as exposing the entity to
interest rate risk. Others maintain that the hedge contracts need
not necessarily be related to identifiable assets or obligations but
instead should be considered "macrohedges" of the entity's net
exposure. Both SFAS No. 52 and SFAS No. 80 require designation of
the hedge.
In developing SFAS No. 80, FASB concluded that, with respect to
futures contracts, hedge accounting should not be permitted for
macrohedges because without direct linkage there is no objective
method of gauging the effectiveness of the hedging instruments or
ultimately recognizing the hedge results in income. The 12
institutions we reviewed varied widely in their use of micro- and
macrohedges. While four institutions used solely microhedges in
their hedging programs, one used solely macrohedges, and seven used a
combination of micro- and macrohedges. Although management at some
of these institutions stated they were required to link the
derivatives to specific items in order to qualify for hedge
accounting treatment and did so for accounting purposes, the
derivatives were not being used to hedge the identified assets and
liabilities but instead were being used to hedge a net exposure on a
macro basis.
CORRELATION
----------------------------------------------------- Appendix VII:3.2
SFAS No. 80 requires that at the inception of the hedge and
throughout the hedge period, high correlation between changes in the
market values of the futures instrument and the hedged item shall be
probable so that the results of price or interest rate changes on the
hedging instrument will substantially offset those of the hedged
item. If high correlation has not occurred, the entity must cease
accounting for the contract as a hedge and recognize a gain or loss
for the amount that has not been offset. Similarly, SFAS No. 52
requires the designated foreign currency transaction to be effective
as a hedge of a specific foreign currency commitment. However,
neither SFAS No. 52 nor SFAS No. 80 specifies how correlation or
effectiveness is to be determined or the level or degree of
correlation required. As a result, the 12 institutions we reviewed
used a variety of different measures and criteria for determining
correlation. For example, one institution simply tracked changes in
the associated interest rate indexes, which can be done without
specific identification of assets and liabilities, while others used
various calculations depending on the type of derivative product
used. Some examined effectiveness monthly, others quarterly, still
others semiannually. Management at one institution stated that since
swaps are synthetic instruments, they do not have to meet any
correlation tests.
One objective of an ongoing test of correlation like that in SFAS No.
80 is to avoid a buildup of deferred hedging losses (or gains) that
are not counterbalanced with unrealized gains (or losses). Another
objective is to determine which hedges should be afforded hedge
accounting treatment. However, without reliable and consistent
standards for measuring correlation, these objectives may not be met.
The institution management we interviewed were mixed in their desire
for more definitive correlation guidance in any future hedge
accounting standards. Although some stated they felt more specific
correlation guidance was needed, they also said they feared such
guidance might be too restrictive and not allow the flexibility
needed to adjust to each institution's own unique situation.
Management at another institution added that although correlation
guidance was needed, poor guidance would be worse than no guidance at
all. For example, management stated that a minimum correlation
requirement, such as 80-percent correlation, without good guidance on
how to calculate it would be worse than no such requirement at all.
ANTICIPATED TRANSACTIONS
----------------------------------------------------- Appendix VII:3.3
One of the significant inconsistencies between SFAS No. 52 and SFAS
No. 80 is in the allowed use of hedge accounting for anticipated
transactions. As discussed in appendix VI, SFAS No. 52 only allows
hedging against firm commitments, which it defines as agreements that
are usually legally enforceable and for which performance is probable
because of sufficiently large disincentives for nonperformance.
However, SFAS No. 80 allows the use of hedge accounting, subject to
certain criteria, for instruments designated against anticipated
transactions.\6 It defines anticipated transactions as those an
entity expects, but is not obligated, to carry out in the normal
course of business. For example, a bank may anticipate issuing
certificates of deposit to replace certificates that will mature at a
future date. SFAS No. 119--which specifies disclosure
requirements--further adds to the conflict by defining anticipated
transactions to include both firm commitments and forecasted
transactions for which no firm commitment exists.
In practice, the results of applying the criteria of SFAS No. 80 for
hedges of anticipated transactions have been mixed. Disputes have
arisen about how well the characteristics and terms of certain
anticipated transactions have been and possibly can be identified in
advance. Others blamed the vague criteria for leading to cases of
inappropriate deferral of losses pending transactions that never
occurred or proved insufficiently profitable to offset the deferred
hedging loss.
At the 12 institutions we reviewed, management at half of the
institutions stated they did not hedge anticipated transactions,
while three said they did so on occasion, and three said they did so
regularly. However, part of the variance in their responses may be
due to the difficulty of defining an anticipated transaction. For
example, management at one institution viewed anticipated
transactions very broadly and stated virtually all of its hedging was
anticipatory. Management stated that hedges of deposits are
anticipatory because of assumptions that the deposits will remain
with the institution. At the same time, they stated that hedges of
loans are anticipatory because of assumptions that new loans will be
generated to offset loan payoffs and prepayments. However, other
institutions used derivatives to hedge similar assets and liabilities
and did not consider any of them to be anticipatory.
--------------------
\6 Under SFAS No. 80, hedge accounting treatment is allowed for
hedges of anticipated transactions provided the instruments meet the
hedge criteria, the significant characteristics and expected terms of
the anticipated transaction are identified, and the likelihood of the
anticipated transaction occurring is probable.
VOLUNTARY DISCLOSURE OF THE 15
MAJOR U.S. DERIVATIVES DEALERS IN
1994 ANNUAL REPORTS
======================================================== Appendix VIII
We reviewed the annual reports of the 15 major U.S. derivatives
dealers for fiscal year 1994 to compare their disclosure practices.
As noted in the text, these 15 firms included 7 banks, 5 securities
firms, and 3 insurance companies. We generally found that the banks'
disclosures were more extensive than those of securities firms and
insurance company dealers. The results are summarized in table
VIII.1.
We found that eight of the firms disclosed their internal estimates
of their value at risk in their derivatives trading activities.
Value at risk is the amount by which an institution's derivatives
trading portfolio could decline due to general market movements over
a given holding period, measured with a specified confidence level.
This group included all seven of the banks, one of the three
insurance companies, and none of the securities firms. These eight
firms also disclosed the holding periods and confidence levels that
defined their value-at-risk estimates, which may help users of annual
reports assess these figures. However, because these parameters
varied from firm to firm, they are not comparable among firms. Of
the eight firms that disclosed their value-at-risk estimates, six
provided information on their full trading activities, covering not
only their exposure to losses on derivatives trading but also losses
on trading of securities. It should be noted, however, that value at
risk is not a measure of the largest possible market risk loss the
firm could face in its trading activities. It is only a measure of
the expected maximum loss at the specified confidence level. Largest
potential losses are better estimated not by value at risk but by
stress tests. None of the major dealers disclosed the results of
their stress tests for their trading activities.
Six of the firms (four of the banks, one securities firm, and one
insurance company) revealed their actual gains and losses on their
trading activities, either as absolute dollar amounts or in
comparison to the firms' value-at-risk estimates. We counted only
those firms that disclosed daily or weekly information, that is,
information that is not mandatory and that is measured on a basis
comparable to value at risk. Mandatory reporting of quarterly or
annual trading revenues did not merit a "yes" entry in table VIII.1.
Table VIII.1
Voluntary Annual Report Disclosure
Potential
Value at Actual gains future Breakdown by
Institution risk\a and losses\b exposure\c credit quality\d
-------------- -------------- -------------- -------------- ----------------
BankAmerica yes no no yes
Corp.
Bankers Trust yes yes no yes
New York Corp.
The Chase yes yes no no
Manhattan
Corp.
Chemical yes yes no no
Banking Corp.
Citicorp yes no yes yes
First Chicago yes no yes no
Corp.
J.P. Morgan & yes yes no yes
Co., Inc.
The Goldman no no no no
Sachs Group,
L. P.
Lehman Bros. no no no yes
Merrill Lynch no yes no yes
& Co., Inc.
Morgan Stanley no no no yes
Group, Inc.
Salomon, Inc. no no no yes
American no no no yes
International
Group, Inc.
General Re yes yes no no
Corp.
The Prudential no no no yes
Insurance
Company of
America
--------------------------------------------------------------------------------
\a We entered a "yes" only if the firm provided quantitative
information on its exposure to losses on its trading risk. The
information was either in absolute dollar amounts or stated as a
dollar amount that was not exceeded, or as a percentage of equity,
allowing the reader to calculate a dollar amount.
\b We entered a "yes" only if the firm provided very specific
information; for example, monthly averages of daily figures, weekly
figures, or if it stated that losses did not exceed the quantified
value at risk.
\c A "yes" was entered if the firm presented its own estimate of this
item. U.S. bank call reports to the regulators contain a measure of
this, but it is merely the application of a regulatory formula, not
the bank's own estimation.
\d The firms grouped this information according to equivalent credit
ratings used by the major rating agencies. However, the
counterparties did not necessarily have these ratings from the rating
agencies themselves, because the ratings were the internal
assessments of the reporting dealers.
Source: 1994 annual reports.
Public companies in the United States are required to report their
current credit exposure on derivatives contracts. However, this
credit exposure could increase in the future if market rates or
prices moved in a way that increased expected payments from the
derivatives counterparties to the firms. Of the 15 major dealers,
only 2 (both of them banks) disclosed their estimates of the
potential future credit exposure on their derivatives contracts.
Credit exposure on derivatives, just as on traditional loans, poses a
risk of loss that varies depending on the soundness of the
counterparty. Ten of the major derivatives dealers provided at least
some information on the creditworthiness of their derivatives
counterparties. This group included four of the banks, four of the
five securities firms, and two of the three insurance companies. In
some cases this was simply a statement of the portion of the
counterparties that were equivalent to "investment grade," and others
provided a more detailed breakdown. No firm disclosed its exposure
to individual counterparties.
DESCRIPTION OF FASB'S PROPOSED
STANDARD
========================================================== Appendix IX
In June 1996, FASB issued an exposure draft of a proposed standard,
Accounting for Derivative and Similar Financial Instruments and for
Hedging Activities. The proposed standard applies to traditional
derivatives, such as futures, forwards, options, and swaps, as well
as certain financial instruments that do not meet the definition of a
derivative but have characteristics similar to those of derivatives,
such as leveraged instruments.\1 Throughout the proposed standard,
both derivative financial instruments and similar instruments
included in the statement are referred to collectively as
derivatives, and the proposed standard's requirements would apply to
both.
Under the proposed standard, which would be effective for fiscal
years beginning after December 15, 1997, all derivatives would be
recognized as either assets or liabilities in the balance sheet and
measured at fair value. The accounting for gains and losses
resulting from changes in the fair value of a derivative would depend
on the intended use of the derivative and resulting designation. All
derivatives would fall into one of the following four categories for
purposes of determining the accounting method for the gains and
losses:
(1) Fair value hedge: For a derivative designated as a hedge of the
institution's exposure to changes in the fair value of an asset,
liability, or firm commitment,\2 the gain or loss would be recognized
in earnings in the period of change together with the offsetting loss
or gain on the hedged item. Gains or losses on the hedged item would
be recognized in the period of change only to the extent of
offsetting losses or gains on the derivative.
(2) Cash flow hedge: For a derivative designated as a hedge of the
exposure to variable cash flows of a forecasted transaction,\3 the
gain or loss would be reported as a component of "other comprehensive
income" (component of equity) until the projected date of the
forecasted transaction.\4 On that date, the entity would recognize in
earnings the accumulated "other comprehensive income" for that
derivative.
(3) Foreign net investment hedge: For a derivative designated as a
hedge of the foreign currency exposure of a net investment in a
foreign operation,\5 the portion of the change in fair value
equivalent to a foreign currency transaction gain or loss would be
reported in "other comprehensive income," together with the
offsetting cumulative translation adjustment resulting from the
exposure per SFAS 52. Any remaining change in fair value would be
recognized in earnings.
(4) Nonhedge: For a derivative not designated as a hedge, the gain
or loss would be recognized in earnings in the period of change.
The proposed standard lays out the specific hedge criteria that must
be met in order for a derivative instrument to qualify for
designation as a fair value or cash flow hedge. The common hedge
criteria for these two types of hedges require that at inception of
the hedge, there must be formal documentation of the hedging
instrument, the hedged item, and the risk being hedged; the use of
the derivative must be consistent with the entity's established
policy for risk management; and the hedging instrument may not be a
net written option.\6 Furthermore, the combination of a net written
option and any other nonoption derivative cannot be designated as a
hedging instrument. To qualify as a fair value hedge, the following
additional criteria must also be met:
-- The hedged asset, liability, or firm commitment is specifically
identified as a single asset or liability, or a portfolio of
similar items sharing common characteristics, or a specific
proportion thereof.
-- The hedged item has a reliably measurable fair value, and
substantial changes in the fair value of the derivative are
expected, both at inception and on an ongoing basis, to offset
substantially the changes in the fair value of the hedged item
that are attributable to the risk being hedged.
-- The hedged item individually presents an exposure to price
changes that could affect reported earnings and can be allocated
any general reserves, deferred fees or costs, or purchase
premiums or discounts established for a group of items of which
the hedged item is a part.
-- The hedged item is not (1) a debt security that is classified as
held-to-maturity in accordance with SFAS No. 115, Accounting
for Certain Investments in Debt and Equity Securities; (2) oil
or gas in the ground, unmined mineral ore, an agricultural
product in the process of growing, or similar item; (3) an
intangible asset; (4) an investment accounted for by the equity
method; (5) mortgage servicing rights that have not been
recognized as assets in accordance with SFAS No. 122,
Accounting for Mortgage Servicing Rights; (6) a lease, as
defined in SFAS No. 13, Accounting for Leases; or (7) a
liability for insurance contracts written.
-- At inception, any variable cash flows related to the hedged item
are not being hedged as a cash flow hedge.
To qualify as a cash flow hedge, the common criteria and the
following additional criteria must be met:
-- The forecasted exposure is a transaction (an external event
involving the transfer of value between two or more entities),
probable, part of an established business activity, and presents
an exposure to price changes that could affect reported
earnings.
-- Both at inception and on an ongoing basis, the derivative
financial instrument is expected to have cumulative net cash
flows that will offset substantially the changes in cash flows
of the hedged forecasted transaction attributable to the risk
being hedged. In addition, the contractual maturity or
repricing date of the derivative is on or about the same date as
the projected date of the forecasted transaction.
-- The forecasted transaction is not the acquisition of an asset or
incurrence of a liability that will be measured at fair value
subsequent to acquisition or incurrence with changes in fair
value reported in earnings.
-- At inception, the variable cash flows being hedged do not relate
to an item being hedged as a fair value hedge.
The proposed standard also includes specific disclosure requirements
for derivatives and similar financial instruments. For all
derivatives, each entity is required to distinguish between
derivatives designated as fair value hedges, cash flow hedges, hedges
of the foreign currency exposure of a net investment in a foreign
operation, and all other derivatives. It must disclose
-- its objectives for holding or issuing the instruments,
-- the context needed to understand those objectives,
-- its strategies for achieving those objectives, and
-- the face or contract amount of the derivatives when necessary to
understand the objectives.
For derivatives designated as hedges, the entity must provide
(1) a description of its risk-management policy for such hedges,
including a description of the items whose risks are being hedged and
the classes of derivatives used to hedge those risks;
(2) the amount of gains or losses on the derivatives and the items
being hedged that were recognized in earnings during the reporting
period, and a description of where those gains and losses and the
related hedged items (if applicable) are reported in the financial
statements; and
(3) the cumulative amount of unamortized derivatives gains or losses
that have not yet been recognized in earnings and a description of
where they are reported in the financial statements.
In addition, for fair value hedges the entity must also disclose the
amount of gains and losses recognized in earnings when performance
under a hedged firm commitment is no longer probable. For cash flow
hedges, the entity must also disclose the designated reporting
periods in which the forecasted transactions are expected to occur
and the deferred amounts to be recognized in earnings.
For derivatives not designated as hedges, the entity must disclose
(1) a description of the purpose of the activity; and (2) the amount
of gains and losses on the derivatives arising from the activity
during the reporting period disaggregated by class, business
activity, risk, or other category consistent with the management of
that activity, and a description of where those gains and losses are
reported in the financial statements. If the disaggregation is other
than by class, the entity shall also describe for each category the
classes of derivatives from which the gains and losses arose.
The proposed standard amends SFAS Nos. 52 and 107; supersedes SFAS
Nos. 80, 105, and 119; and modifies or nullifies related EITF
consensus positions as follows:
-- SFAS No. 52, Foreign Currency Translation, is amended primarily
to eliminate duplicate coverage of foreign currency derivatives
between the two Statements, eliminate the allowability of
deferral hedge accounting, and update the definition of
derivatives consistent with the definition provided for in the
proposed standard.
-- SFAS No. 107, Disclosures About Fair Value of Financial
Instruments, is amended primarily to include commodity-based
contracts in the definition of derivatives, update the
definition of fair value, and incorporate portions of SFAS Nos.
105 and 119--which are superseded--into the proposed standard.
Specifically, requirements for disclosure about concentrations
of credit risk are incorporated from SFAS No. 105, and
encouraged disclosure about market risk of all financial
instruments is incorporated from SFAS No. 119 into the proposed
standard.
--------------------
\1 As part of its proposed standard, FASB developed a working
definition of a derivative financial instrument, including the
characteristics of such instruments. Of note, FASB has also included
nonfinancial commodity-based instruments in the definition, which
FASB had not considered as financial instruments in the past.
\2 A firm commitment is a contract that obligates two unrelated
parties to make an exchange and specifies the price and quantity to
be exchanged.
\3 A forecasted transaction is one that the entity anticipates but is
not obligated to carry out, such as future sales or the anticipated
acquisition of inventory.
\4 FASB also issued an exposure draft of another proposed standard,
Reporting Comprehensive Income, in June 1996. The specific reporting
requirements for derivatives hedging gains and losses in
comprehensive income would be determined by this proposed standard.
\5 For foreign net investment hedges, an entity may designate a
foreign currency-denominated nonderivative financial instrument (in
addition to those nonderivative leveraged instruments included in the
scope of this proposed standard) as a hedge of the foreign currency
exposure of a net investment in a foreign operation.
\6 The proposed standard states that a combination of options entered
into contemporaneously (for example, a collar), whether freestanding
or embedded in a derivative, shall be considered a net written option
if either at inception or over the life of the contract a net premium
is received in cash or as a favorable rate or term.
MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix X
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
Thomas J. McCool, Associate Director
Michael A. Burnett, Project Director
Gerald C. Schober, Project Manager
Orice M. Williams, Deputy Project Manager
Cody J. Goebel, Senior Evaluator
James R. Black, Senior Evaluator
Leslie F. Siddeley, Evaluator
Kiki Theodoropoulos, Evaluator (Communications Analyst)
Cecile O. Trop, Assistant Director, Advisor
John H. Treanor, Banking Management Expert
ACCOUNTING AND INFORMATION
MANAGEMENT DIVISION, WASHINGTON,
D.C.
Donald H. Chapin, Chief Accountant
Robert W. Gramling, Director
Linda M. Calbom, Director
Marcia B. Buchanan, Assistant Director
Clayton T. Clark, Project Manager
BOSTON REGIONAL OFFICE
Nancy S. Barry, Evaluator
Nicolas F. Deminico, Evaluator
Lester P. Slater, Jr., Site Senior
Thomas S. Taydus, Evaluator
Alfred R. Vieira, Regional Assignment Manager
CHICAGO REGIONAL OFFICE
Lenny R. Moore, Evaluator
John A. Wanska, Evaluator
Susan R. Bradshaw, Evaluator
Melvin Thomas, Evaluator
NEW YORK REGIONAL OFFICE
Richard G. Schlitt, Senior Evaluator
Raymond L. Gast, Evaluator
SAN FRANCISCO REGIONAL OFFICE
Doreen S. Eng, Evaluator-in-Charge
Jack W. Erlan, Regional Management Representative
Yola Lewis, Evaluator
OFFICE OF GENERAL COUNSEL,
WASHINGTON, D.C.
Lorna MacLeod, Attorney
OFFICE OF SPECIAL INVESTIGATIONS,
WASHINGTON, D.C.
Donald G. Fulwider, Assistant Director
*** End of document. ***