Chapter

Annex II Developments in the Regulation of International Banking

Author(s):
International Monetary Fund
Published Date:
January 1994
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The impetus for recent regulatory initiatives in international banking has come from the growth of derivatives markets and the increasing involvement of wholesale banks in these markets.1 The debate over the regulation of derivatives markets has led to a redoubling of the long-standing efforts by bank regulators to improve the capital cover for risk positions entered into by international banks, without unduly distorting incentives.2 This effort resulted in the publication of three proposals in April 1993 that recommended a capital requirement against market risk, a broader recognition of netting as a means of reducing credit risk, and disclosure of interest rate risk.

Recent trends in the markets for derivative instruments are described first, followed by a discussion of the proposed extensions of the Basle capital requirements.

Growth of the OTC Derivatives Markets

The notional principal amount of exchange-traded derivative instruments increased by 69 percent in 1993, reaching $7.8 trillion, which was more than 12 times the total in 1986 (Table A3).3 Interest rate futures and options together had a notional principal value of $7.3 trillion in 1993, while currency futures and options accounted for $111 billion and stock index futures and options for $406 billion. Turnover of these contracts on organized exchanges rose by 22 percent in 1993, reaching a combined total of 774 million contracts (Table A4).4 Trading was boosted in both 1992 and 1993 by the turmoil in the European exchange rate mechanism.5

While comparisons between the markets are difficult, activity on the OTC market appears to have grown more rapidly than has activity on the exchanges. At the end of 1992, the notional principal value of outstanding interest rate swaps and currency swaps was $4.7 trillion (Table A5). This was 22 percent higher than the end-1991 notional principal and more than five times the end-1987 figure. In the second half of 1992 alone, the notional principal of new interest rate swaps was $1.5 trillion, and new currency swaps reached $146 billion (Table A6).

In more specific terms, the growth of the markets is characterized by increasing globalization, increasing involvement by banks, and increasing complexity of products.6 At the end of 1987, 79 percent of all outstanding interest rate swaps by notional value were denominated in U.S. dollars (Table A7). However, by the end of 1992, U.S. dollar interest rate swaps represented only 46 percent of outstanding interest rate swaps. Similarly, the proportion of U.S. dollar currency swaps has declined from 44 percent of the outstanding notional value in 1987 to 36 percent in 1992. A parallel trend is observed in the distribution of notional principal and turnover of exchange-traded instruments between the United States, Europe, and Japan (Tables A3 and A4).

Swaps are used to reduce funding costs and to transfer payment characteristics and interest rate or currency risk exposures. Thus, for example, an issuer of a straight bond might swap the proceeds into an obligation to pay a floating rate, or a U.S. corporation might issue a deutsche mark bond and swap the proceeds into dollars, thereby eliminating exchange rate risk. The counterparty data on interest rate swaps show that by far the most important participants in these markets are financial institutions, which held 76 percent of the outstanding contracts by notional principal value of interest rate swaps in 1992 (Table A5). In the market for currency swaps, however, financial institutions accounted for only 54 percent of the outstanding positions at the end of 1992.

The involvement of banks in the OTC markets has motivated much of the regulatory examination of derivatives. The notional value of financial derivatives (including forwards) held by U.S. bank holding companies was $5.1 trillion in June 1992, which was 27 percent higher than the notional value in September 1990.7 In June 1992, bank holding companies with less than $10 billion in capital held about $34 billion in interest rate swaps and $153 million in currency swaps. These were, respectively, more than 47 percent and 186 percent higher than the corresponding figures in September 1990. Many regional banks in the United States have started to sell derivative products to clients in addition to using derivatives as a financing and risk management tool for themselves. Many mutual funds have used derivatives to manage risk or enhance returns.8

The use of interest rate and currency swaps by nonfinancial institutions has also increased substantially.9 The amount of interest rate swaps used by governments and international institutions has increased from $47.6 billion at the end of 1987 to more than $242 billion at the end of 1992 (Table A5). The use of interest rate swaps by corporations has also increased significantly, from about $129 billion in 1987 to about $666 billion at the end of 1992. In the same five-year period, currency swaps used by governments and international institutions rose from $33.9 billion to $110.6 billion, and currency swaps used by corporations increased from $51.6 billion to $282.2 billion.

Outstanding notional principal in the sophisticated OTC products such as caps, collars, and floors increased from $468 billion at the end of 1991 to $507 billion at the end of 1992. The notional principal value of outstanding swaptions rose from $109 billion at the end of 1991 to $127 billion at the end of 1992.

Many reasons have been cited as explanations for the rapid expansion of the OTC market. These include (i) a rise in the demand for hedging instruments owing to increases in the volatility of exchange rates and interest rates; (ii) an increase in the demand for sophisticated instruments to profit from relatively large interest rate differentials across borders and across different investor groups; (iii) a rise in the demand for sophisticated products to unbundle risk and to alter the risk characteristics of portfolios in a rapidly changing investment environment; (iv) a reduction in the cost of providing OTC derivatives securities owing to advances in technology (including computing and information processing facilities); (v) a growing demand by banks to seek new business as the profitability of their traditional lending business has declined; and (vi) worldwide deregulation and financial market liberalization.

Strengthening Capital Requirements

The Basle Committee proposed a capital adequacy standard in July 1988 that provided an explicit approach by which the minimum capital requirement to cover credit risk for both on- and off-balance sheet positions could be computed. In addition, it provided guidelines on what could be counted as capital. In 1989, the Council of the European Community issued an Own Funds Directive (OFD) and a Solvency Ratio Directive (SRD) for similar purposes.

While the 1988 accord was well received, it has been long recognized that its focus on credit risk alone was too narrow. Other risk factors, such as interest rate risk and exchange rate risk, might be very important, especially for positions that are held for relatively short periods of time. Furthermore, banks might have an incentive to seek a higher return on capital by substituting interest rate or exchange rate risk for credit risk when designing their portfolios if capital requirements apply only to credit risk. Market participants have also expressed concern that the definition of capital is too restrictive. That definition was chosen to cover banks’ traditional loan positions, which tend to be held for long horizons. However, as banks’ “trading books”—which are composed of relatively short-term positions—become more important, a more flexible definition might be appropriate.

It is also widely recognized that the 1988 accord was too stringent in its treatment of netting. Under that accord, only netting by novation was recognized for the purposes of calculating the capital requirement. The 1990 Lamfalussy Report suggested that any legally enforceable form of bilateral netting should be recognized, since netting can improve the efficiency and the stability of the banking system by reducing credit exposure, liquidity risk, and transaction costs.10

The 1993 Basle Proposals

In response to these concerns, the Basle Committee released in April 1993 a set of three consultative papers that contains proposals to revise the 1988 accord. The papers consider: (i) the recognition of netting for the capital requirements for credit risk; (ii) the reporting of, and capital requirements for, market risk and foreign exchange risk; and (iii) the measurement and reporting of interest rate risk. Furthermore, a new tier of capital, called tier 3 capital, was also defined.

The 1993 Basle proposals are similar in many ways to the Capital Adequacy Directive (CAD) issued by the EC Council to modify and supplement its 1989 directives, which had been criticized for the same reasons as the 1988 Basle accord.11 The CAD and the new proposals follow the same approach in measuring interest rate risk and have the same duration-based market risk weights. Furthermore, for debt securities, the two share the same structure for aggregating market and specific risk and have the same risk weights for specific risks. However, the two differ significantly in the treatment of foreign exchange risk and position risk in equities. In those respects, the Basle proposal is more stringent than the CAD. On the other hand, the CAD applies to both banks and securities houses while the Basle proposals apply only to banks.

Capital Adequacy Standards

The proposed framework. The main conceptual breakthroughs of the proposals on the computation of capital requirements are (i) the recognition of a need to treat items in the loan book and the trading book of banks differently when setting minimum capital requirements; (ii) the recognition of a need to account for market risk and specific risk differently; and (iii) the calculation of capital requirements for general market risk from a portfolio perspective.

The trading book is composed of (i) proprietary positions in financial instruments; (ii) exposures due to unsettled transactions; and (iii) positions taken in order to hedge other elements of the trading book. Because these positions are usually held for only a short time, risks arising from adverse movements in interest rates, exchanges rates, or other prices can be very important relative to credit risk. This suggests that positions in the bank’s trading book and loan book should be treated differently. Under the new proposals, the capital requirement for items in the loan book is calculated in the same way as specified in the 1988 accord, with only some changes to reflect the more general recognition of bilateral netting. However, the capital requirement for items in the trading book is calculated based on a new framework.

In this new framework, risk exposure is separated into specific risk and a general market risk. The key distinction between the two is that the specific risk exposures of different positions are generally unrelated, which is not true for market risk. The specific risk exposure of the entire trading book can be computed simply as the sum of the specific risk exposures of each position in the book. However, since the market risk of different positions is related, the proposals suggest a portfolio approach that permits some offsets between long and short positions in the calculation of the general market risk exposure. Thus, the total capital requirement is computed as the sum of a specific risk charge (applied to the gross position of the portfolio) and a general market risk charge (applied to the net position of the portfolio). This is the so-called building block approach in the proposals.

Furthermore, since the nature of the specific risk and market risk varies across types of instruments, the Basle proposals classify positions into debt securities positions, equity positions, and foreign exchange positions and use different approaches for calculating the specific risk and general market risk charges for these groups of instruments. Under the proposed framework, a bank’s minimum capital requirement is computed as the aggregate of capital charges for the specific and market risks for each of its debt and equities positions, plus charges against foreign exchange risk and credit risk arising from its loan book.

It is important to note that, in general, the various components of general market risk are neither uncorrected nor perfectly correlated. In simply adding the capital charges for general market risk of debt securities to the capital charge for foreign exchange risk and to the capital charge for general market risk of equity positions, the Basle Committee implicitly assumed that the market risk elements are perfectly correlated. This approach is a conservative one, as the standard deviation of portfolio value computed in this way is always at least as high as the actual standard deviation of the portfolio value under less than perfect correlations among the risk factors. The approach has the merit of being easy to implement since time-varying relationships among the many risk factors are ignored. Furthermore, the capital requirement for each individual risk factor can be set separately.

Specific risk of debt securities. As in the 1988 accord, debt securities are classified into a number of broad categories by issuer; then a different risk weight for each category is assigned to capture differences in the probability of default or credit rating change for different groups of issuers. There are five such categories under the 1993 proposals: (1) government (with no risk weight); (2) qualifying securities (basically investment grade) with residual maturity of six months or less (with a risk weight of 0.25 percent); (3) qualifying securities with residual maturity between 6 and 24 months (with a risk weight of 1 percent); (4) qualifying securities with residual maturity exceeding 24 months (with a risk weight of 1.6 percent); and (5) other securities (with a risk weight of 8 percent).12 The CAD has the same definition of these categories and assigns the same risk weights.13

The definition of “qualifying” as investment grade is an important improvement over the 1988 accord in which the classification of counterparties was dependent not on credit rating but on whether they were Organization for Economic Cooperation and Development (OECD) country institutions. For example, under the 1988 accord, loans to OECD official borrowers carry a zero risk weight; claims on banks incorporated in OECD countries carry a 20 percent weight; residential mortgages have a 50 percent weight; and foreign currency loans to non-OECD governments and loans to private companies carry a 100 percent weight.14 Since the weighted exposures are multiplied by 8 percent to yield the capital requirement, the effective percentages for comparison with the risk weights in the 1993 proposal are 0 percent, 1.6 percent, 4 percent, and 8 percent, respectively. Under the 1988 accord, an interest rate contract with less than six months to maturity to a private firm, in a non-OECD country, that is rated AAA or equivalent by approved rating agencies, would carry capital charge equal to 8 percent of the marked-to-market value under the so-called current exposure approach. Under the new proposal, the capital charge would be 0.25 percent of the marked-to-market value of the position.

General market risk of debt securities. The general market risk of debt securities is mostly interest rate risk. Unlike credit risk, which is counterparty-specific (and hence position-specific), interest rate changes can affect many positions in the book simultaneously. The approach taken in the 1988 accord, which computes the total capital charge as the sum of capital reserves for individual positions, is perceived to be inappropriate by many market participants who have argued that interest rate risk should be accounted for from a portfolio perspective in which offsets at least between long and short positions should be allowed.

The interest rate risk exposure of a portfolio of debt securities is determined by the sensitivity of the value of the portfolio to interest rate changes and by the volatility of interest rates. The sensitivity of a portfolio of debt securities and derivatives to changes in interest rates can be constructed from the duration measures of the debt instruments and the deltas of the derivative instruments, which can be calculated from pricing models or from simulation techniques.15 The volatility of interest rates can be implied from options prices or calculated from historical data. However, for relatively small institutions that lack sophisticated risk management systems, these computations can be prohibitively difficult when their trading books contain a large number of positions. Hence, the Basle Committee has developed a “standard” approach, which is a compromise to facilitate implementation.

This standard “maturity ladder” approach involves setting (i) a manageable number of maturity bands (instead of a continuum of maturities); (ii) a representative duration measure for each band (instead of a duration measure for each instrument); and (iii) a representative interest rate change for each band (instead of a different change for every interest rate maturity within each band).

Under this approach, each position is converted into a combination of simple debt instruments that are then classified into 15 maturity bands. For example, a ten-year interest rate swap under which a firm is receiving floating rate interest and paying fixed is treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing date (often six months) and a short position in a ten-year fixed rate bond. A long position in a three-month interest rate future maturing in one month is reported as a long position in a government security with a maturity of four months and a short position in a government security with a maturity of one month. An option on a debt instrument is treated as if it is a position equal in value to the amount of the underlying instrument, multiplied by the delta of the option determined by an approved option pricing model.

Each converted position is then assigned a risk weight, which is the product of the representative modified duration measure for the maturity band and an assumed interest rate change for the particular maturity band.16 The capital requirement is then calculated as the sum of the weighted positions (where long and short positions can offset each other).

However, positive and negative positions in the same maturity band might not be perfect hedges for each other because of the size of each maturity band and the existence of gap risk and spread risk. As an example of spread risk, a long position in a three-month U.S. Treasury bill is not a perfect hedge for a short position in a three-month Eurodollar bond since the three-month Treasury bill rate and the three-month LIBOR or Eurodollar rate are not perfectly correlated. The variation in this spread is a risk factor that should be taken into consideration. Another example is gap risk: a long position in a three-month Treasury bill is not a perfect hedge for a short position in a four-month Treasury bill (even though they are classified in the same maturity band) because the three-month yield and the four-month yield are not perfectly correlated.

To provide for such imperfections in the mutual hedging of instruments in the same maturity band, the Basle Committee proposed to impose a vertical disallowance. This disallowance is added to the net capital charge in the computation of the capital requirement for debt securities. A vertical disallowance for each maturity band is calculated as 10 percent of the smaller of the total capital charge for long positions within the band and the total capital charge for short positions within the band. The total vertical disallowance is then computed by summing the vertical disallowances across maturity bands. Without the vertical disallowance, the pairs of positions in the above examples will be treated as perfect offsets as if there is no risk at all.

Similarly, positive and negative positions in different maturity bands are not perfect hedges for each other since the yield curves need not move in a parallel fashion. In order to account for such imperfect offsets, the Basle Committee also proposed the imposition of horizontal disallowances. Since positions from distant maturity bands are the worst offsets, the capital charge should be increased appropriately. For this purpose, the Committee has proposed to group the maturity bands into three different maturity zones. Within-zone horizontal disallowances are smaller than across-zones disallowances. Also, adjacent-zones disallowances are smaller than nonadjacent-zones disallowances.

While the CAD does not explicitly mention these disallowances, the computation of capital requirements is essentially equivalent to the imposition of such disallowances, since matched and unmatched positions within and across maturity bands are assigned different weights that take into account the risk from hedging with nonidentical instruments.

The Basle Committee also proposed to allow banks with more sophisticated risk management systems to use an alternative method under which the duration of each position is computed separately. However, this is permitted only if the alternative method produces results that are consistently equivalent with the standard method.

Specific risk of equity securities. The specific risk of an equity security is the risk of an unexpected change in the price of the security that is unrelated to the general movement of the stock market. The Committee has proposed that the specific risk charge for an institution be computed as 8 percent of its gross equity position—the aggregate value of all equity positions without any offset between long and short positions. However, at the discretion of national regulators, a 4 percent weight can be applied if the equity portfolio is liquid and diversified. Under the CAD, the specific risk charge is 4 percent of the overall gross equity position instead of 8 percent. Furthermore, if the portfolio is liquid and diversified, a 2 percent weight can be allowed.

General market risk of equity securities. Since general market risk is common to all equity securities, the market risks of long and short positions can offset each other. Thus, the actual risk exposure depends on the overall net equity position rather than the gross position. Under the 1993 proposal, the capital charge for the general market risk of an equity portfolio is computed as 8 percent of the overall net position of the portfolio. The CAD follows the same approach and has the same 8 percent weight.

Foreign exchange risk. Foreign exchange risk is the risk of loss owing to fluctuations in exchange rates. The exchange rate risk exposure of a portfolio is determined by (i) the sensitivity of the value of the portfolio to changes in exchange rates; (ii) exchange rate volatilities; and (iii) correlations between exchange rates. Computing the sensitivity of the portfolio to exchange rate changes can be difficult because the values of foreign exchange derivatives are often complicated functions of the exchange rate. Strictly speaking, to determine the foreign exchange risk exposure, the behavior of all exchange rates on which the contracts depend has to be modeled, correlations need to be taken into consideration, and the future profits or losses of the entire portfolio should be simulated. However, such modeling and computation can be too complicated and expensive for smaller banks. Hence, the Basle Committee proposed a shorthand method for measuring foreign exchange risk.17

The Basle Committee also proposed that institutions with the necessary expertise, computer systems, and data could, if permitted by their national supervisors, use an alternative method based on simulations. However, an additional 3 percent charge is added to the capital charge obtained from the simulation. Consequently, the minimum capital charge can never be less than 3 percent of the overall net foreign exchange position.

The CAD is more lenient than the Basle proposal in that under a similar standard method, the capital charge is computed as 8 percent of the amount by which the overall net foreign exchange position exceeds 2 percent of the institution’s own funds. Furthermore, under the simulation method, the CAD requires only that the capital charge be larger than 2 percent of the overall net foreign exchange position.

Netting

In the 1988 accord, only netting by novation was recognized for the purpose of calculating capital requirements. Netting by novation entails a bilateral contract between two counterparties under which a new obligation to pay or receive a given currency is automatically amalgamated with all previous obligations in the same currency, thereby creating a single legally binding net position that replaces the larger number of gross obligations. The 1993 proposals extend the recognition of netting for capital requirement purposes to include any bilateral netting agreement that is legally binding in the jurisdictions of both parties and meets the minimum standards recommended by the 1990 Lamfalussy Report.

The more general recognition of bilateral netting for the computation of capital requirement is facilitated by recent legal developments on the enforceability of close-out netting. A close-out netting arrangement can eliminate cherry-picking behavior at the time of bankruptcy, and its enforceability is usually regarded as the legal basis for bilateral netting for capital adequacy purpose. In the United States, legal developments facilitate the recognition of bilateral netting.

Under the new Basle proposal, for banks using the so-called current exposure method in the 1988 Basle accord, the credit exposure on bilaterally netted forward transactions is calculated as the sum of the net marked-to-market replacement cost, if positive, plus an add-on based on the notional underlying principal. For banks now using the so-called original exposure method under the 1988 Basle accord, a reduction in the credit conversion factors applying to bilaterally netted transactions is permitted temporarily until the market risk related capital requirements are implemented. The original exposure method, which computes capital charges as percentages of notional values, will ultimately be abandoned for netted transactions, as it does not account for current and potential future exposures separately and hence is not entirely compatible with the idea of netting.

Industry Responses to the 1993 Basle Proposals

Regarding the treatment of market risk and interest rate risk, a frequent comment from market participants has been that the proposals may increase capital requirements for the affected institutions. An increase in capital requirement would be due to the size of the vertical disallowance and the computation of total capital charge as the simple sum of the capital charges for individual general market risk elements. There is also a concern that the proposals do not create incentives for banks to adopt more advanced risk measurement systems. Instead, most banks would have to maintain two risk reporting systems (one for the computation of capital requirement under the Basle proposals and a more complicated one for everyday risk management). This is financially inefficient and can reduce banks’ competitiveness relative to nonbanks. Furthermore, there is also a general feeling that the distinction between the trading book and the loan book should be clearly defined. Leaving the definition to the discretion of national authorities can potentially create unfair competition among banks in different nations.

The banking industry generally welcomed the recognition of bilateral netting since this can reduce capital requirements, which in turn will allow banks to take on more business than they are currently able to accept. The Bank for International Settlements (BIS) estimated that this proposal may reduce capital requirements for swap dealers by between 25 and 40 percent. The International Swaps and Derivatives Association (ISDA) estimated that the recognition of bilateral netting could reduce capital requirements by as much as 48 percent.

Some market participants have argued that a 10 percent vertical disallowance is too large, particularly for an institution that has a lot of interest rate swaps and short-term debt instruments. Since a floating rate instrument is at par immediately after a payment set date, the value of the floating rate side of a swap is treated as a debt instrument with maturity date equal to the next payment set date and with a principal amount equal to the notional value of the swap, which can be a huge number. As a result, a 10 percent charge can be a substantial burden.

Some participants have also expressed concern that simply adding the capital charges for individual risk elements can result in an overestimation of the amount of capital required. At the heart of the criticism is the implicit assumption of perfect correlation among the risk factors. Participants have argued that the correlation between two risk factors should be taken into account when aggregating the capital charges. If risk factors are imperfectly correlated, then less capital should be needed. In addition, the proposed aggregation approach might distort banks’ activities since risk factors having low correlations are overcharged relative to risk factors having high correlations. Some market participants have therefore recommended that actual correlations estimated from historical data should be used.

A remaining criticism deals with the calculation of add-ons and the way they are included in the computation of capital charges. The Committee’s decision to retain the rules in the 1988 accord on add-ons has been criticized as being inconsistent with the idea of netting. Under the 1988 accord, add-ons are computed as a percentage of the gross notional principal. That is, netting is allowed for potential future exposure. The Committee’s explanation is that there is no guarantee that there will be offsets of exposures in the future, so it might be prudent to keep the current scheme. Critics, on the other hand, tend to argue that this is too conservative. They have complained also that computing credit exposure as the sum of the addons and the higher of the net replacement value and zero might overstate the actual capital requirement needed. The argument is that under the proposed rule, a financial institution will be required to hold capital equal to the add-on regardless of its net replacement value. That is, the institution is even required to hold capital to safeguard a liability. The position of the Basle Committee is that the purpose of the add-ons is to cover potential future exposure; there is no reason to expect that there would be no future exposure just because the current exposure is zero.

Under the recent proposals, derivatives positions are converted into equivalent positions in the underlying instruments based on the deltas of the derivatives. However, delta can change as the price of the underlying security changes. There is therefore an additional risk element—gamma risk—related to the sensitivity of the delta with respect to the price of the underlying security. This gamma risk can be substantial. Furthermore, related to the gamma risk is the risk of changes in volatility—vega risk. Given the highly volatile nature of exchange rates and the rapid changes in volatility, many market participants have essentially taken derivatives positions to bet on volatility changes. These positions are typically created to have zero delta. As such, no capital charge is attached, yet these can be highly risky positions. The failure of the Basle proposals to cover gamma risk and vega risk can potentially lead to distortion in the banks’ activities in which these uncharged risks are substituted for those covered by the proposals in order to reduce the capital requirement.

Some practitioners have complained that the 3 percent foreign exchange risk add-on that would be added to the capital requirements obtained from simulation methods is arbitrary and can be a severe penalty for banks using a sophisticated and probably more accurate approach to risk management. This can discourage the adoption of advances in risk management technology, which goes against the spirit of the exercise.

Recommendations from Regulators

In the United States, the 1988 Basle accord was adopted by all bank regulators. In a joint report, the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of Currency (OCC) discussed the importance of the market risk component of the derivatives activities of commercial banks and argued for a portfolio-based evaluation of this risk.18

The importance of interest rate risk has also been noted by these agencies. In September 1993, they issued a proposal on measuring banks’ interest rate risk and establishing a related capital requirement.19 Under this proposal, a bank’s interest rate risk exposure can be measured by a supervisory model similar to the interest rate risk measurement model proposed by the Basle Committee in April 1993 or by the bank’s own risk management system if it is approved by the regulator. Two alternative methods were proposed for setting minimum capital requirement. Under a so-called minimum capital standard approach, an explicit capital charge based on the amount of interest rate exposure in excess of a supervisory threshold would be imposed. Under the so-called risk assessment approach, the capital requirement would be assessed on a case-by-case basis, dependent on the bank’s interest rate risk exposure, internal risk controls, and financial condition.

Bank regulators also recognized the importance of netting arrangements. In a circular issued in October 1993, the OCC recommended that each national bank should use master close-out netting agreements with its counterparties to the broadest extent possible as long as those agreements are legally enforceable. The OCC also proposed that for positions collateralized by cash or government securities, the risk weight used in the computation of risk-based capital requirement should be reduced to reflect the minimal credit risk of these positions.

Harmonization of Standards for Banks and Securities Firms

In some countries, securities houses are subject to capital requirements by securities and exchange regulators. For example, in the United States, securities houses are subjected to SEC capital requirements that utilize a different approach from that of the Basle Committee. The “Net Capital Rule” of the SEC requires a minimum level of liquid net worth after some deductions—the “haircuts”—to account for market and credit risks. The haircut for unrealized profit associated with OTC derivatives positions is 100 percent, which is viewed by many market participants as too stringent. The SEC is considering modifying the Net Capital Rule to better capture the credit and market risks of derivative products. In May 1993, it issued a proposal in which the calculation of the market risk exposure of interest rate swaps was considered. Two alternative approaches to dealing with interest rate swaps were suggested. Under the first approach, a swap book is treated as a portfolio of debt securities with the same interest rate sensitivity. These “converted” debt securities are then treated as simple bond positions in the net capital calculation. Under the second approach, swaps are assigned to maturity bands currently used by government securities, and then a capital charge of 0 percent to 6 percent of the notional value, depending on the maturity, is applied to each swap. The capital charges for long and short positions in swaps are allowed to offset each other depending on the relative maturities of the swaps. In March 1994, the SEC issued a proposal to modify the capital requirements for brokers or dealers by allowing them to use a theoretical pricing model developed by the Options Clearing Corporation when calculating capital charges for listed options and related positions.

The Commodity Futures Trading Commission (CFTC) follows a similar haircut approach to setting capital requirements for brokers and dealers engaged in commodity futures transactions. The approaches used by the SEC and the CFTC are in contrast to the “risk-weighted capital approach” in the 1988 Basle accord for banks and the recently proposed “building-block approach” by the Basle Committee. Generally, there are also differences in the definition of capital between bank and securities firm regulators.

In order to promote harmonization of regulations applied to securities companies in different countries, the International Organization of Securities Commissions has devoted substantial effort to setting up global capital standards. To date, the effort has not been brought to completion because of disagreements within its Technical Committee.

Accounting and Disclosure

As a result of the complicated nature of the regulatory structure for the OTC derivative markets, data on OTC derivative market activities are collected by a large number of regulators and concerned parties under different regulatory and accounting regimes in many countries. However, given the lack of uniformity of reporting documents and the discrepancies in reporting requirements, it is very difficult to aggregate all the information to give a clear picture of the market situation. This is further complicated by the fact that OTC derivative positions are generally off-balance sheet items and are not readily available from institutions’ financial statements.

Given that all major securities houses in the United States are engaged in OTC derivatives activities, either directly or through subsidiaries, information on the risk exposure of these companies from the derivatives activities of their subsidiaries is needed. To this end, both the SEC and the CFTC have required brokers and dealers with affiliates engaging in OTC derivatives trading to report on the portfolios of these units. In February 1994, the CFTC proposed a set of rules to further improve disclosure. These rules require a company unit that engages in swaps transactions to file quarterly and annual reports on its financial situation and to provide information on how it monitors and controls the risks related to swap trading. Some regulators have emphasized the importance of identifying the source of revenue for market participants, especially dealers. The concern is that the current lack of information has made it impossible for the regulators to tell whether the many profitable dealers are serving a financial intermediation function or not—or if most of their profits are from proprietary trading or speculation.

To improve the international coordination of disclosure requirements, the SEC, the CFTC, and the Securities and Investment Board in the United Kingdom announced in March 1994 that they will share their information on the OTC derivative markets.

The broad range of OTC derivatives products and the ease with which new tailor-made OTC products can be created has significantly complicated the application of existing instrument-specific accounting standards, many of which were issued well before many OTC derivative products were created. Furthermore, the accounting method used can be affected by whether or not the transaction is used for hedging purposes. Under the so-called hedge accounting approach, hedges are reported as related to the position being hedged and are not marked to market. The issue is complicated if the hedge is imperfect.

Efforts are under way to write new accounting rules for OTC derivative transactions. In the United States, the Financial Accounting Standards Board (FASB) has introduced Financial Accounting Standard (FAS) numbers 105 and 107, and Interpretation number 39. FAS 105 requires that the notional amount of OTC derivative positions be reported in the firm’s financial statement or in the accompanying notes together with their nature and terms. It also requires that information on the concentration of credit risk to groups of counterparties be reported. FAS 107 requires the disclosure of the fair value of related on- and off-balance sheet derivative instruments. FASB Interpretation 39 allows the offsetting of derivatives positions with the same counterparty under a master netting arrangement. The FASB is still working on improving the accounting and disclosure of OTC derivative transactions.

In its July 1993 report, the Group of Thirty recommended that the agencies that set national accounting standards should (i) provide comprehensive guidance on the accounting and reporting of transactions in derivatives and (ii) work toward international harmonization of standards.20 The Group also suggested that firms should disclose the following information: (i) management’s attitude toward financial risks; (ii) how instruments are used; (iii) how risk is monitored and controlled; (iv) accounting policies; (v) analysis of credit risk; and (vi) the extent of dealers’ activities in financial instruments.

The Group of Thirty further recommended that dealers should regularly perform simulations to determine the market risk of their portfolio. It is important for the market participants to have a risk management unit, which is independent of the trading units, to monitor transactions, develop risk limits, identify various risk components, and review the pricing models and valuation systems used by the traders.21

In its study of the OTC derivatives markets, the Group of Thirty proposed that regulators should recognize netting arrangements to the extent that they are legally enforceable. The Group also recommended that dealers and end-users should be encouraged to use a common master agreement with all counterparties to document existing and future derivatives transactions, including foreign exchange forwards and options.

There are also concerns about the involvement of nonbanks in the derivative markets; see section on Strengthening Capital Requirements, below.

The notional principal value refers to the face value of the instruments underlying the derivative contract. This is used to calculate payments under the contract and is not a measure of the exposure of the institutions holding these contracts. The latter is provided by the replacement cost of the contract, which is estimated at approximately 2 percent of the notional value for interest rate swaps and 5 percent for currency swaps.

The measure of turnover used in Table A4 is the number of contracts traded. Comparisons over time are complicated, since contracts representing different amounts of the underlying instruments are traded on different exchanges and new contracts are frequently introduced.

See Goldstein, Folkerts-Landau, and others (1993a) for a discussion of the impact of the exchange rate crisis in September 1992 on derivatives trading.

These complex products have names such as swaptions, forward swaps, knockouts, step-up recovery floaters, index-amortizing notes, and lookback options.

See Board of Governors of the Federal Reserve System and others (1993).

While many mutual funds are barred by their investment guidelines from participating in the swaps markets, some are bypassing the restriction by investing in structured notes.

With this increased use of derivatives have come more frequent reports of losses as in the cases of, among others, Metallgesellschaft, Codelco, Rockefeller Center Properties, Procter and Gamble, and Gibson Greetings (see Box 1).

Different risk weights are proposed for qualifying issues with different residual maturity because uncertainty about creditworthiness increases with the life of the security.

For precise definitions of the different categories, see Bank for International Settlements (1988), Part II.

Delta measures the sensitivity of the price of a derivative security with respect to a change in the price of the underlying security.

The representative duration measure for a particular maturity band is computed as the modified duration of a bond with a maturity equal to the mid-point of the time band, assuming an 8 percent interest rate and an 8 percent coupon. Furthermore, the assumed interest rate change is designed to cover about two standard deviations of one month’s yield volatility in most major markets.

See Section III for a description of how the shorthand method is applied to foreign exchange exposures.

See Federal Register (1993).

The importance of managerial oversight of risk management operations is exemplified by the recent losses incurred by Codelco and Metallgesellschaft discussed in Box 1.

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