Overview of derivatives disclosures by major U.S. banks.

Gerald A. Edwards, Jr, Assistant Director, and Gregory E. Eller, of the Board's Division of Banking Supervision and Regulation, prepared this article.

An important source of information about derivatives activities has been the published annual reports and other publicly available financial reports of banks and other companies. Meaningful disclosures about derivatives help users of financial statements to better understand derivatives activities and thus promote market discipline. Banking organizations and the accounting profession have taken a number of steps in recent years to improve the quality of disclosures about derivatives activities. Promoting meaningful disclosures and analyzing this information are important parts of the Federal Reserve's supervisory approach to derivatives activities of banks.(1)

This article discusses the disclosures about derivatives activities in the 1993 and 1994 annual reports of the top ten U.S. banks that deal in derivatives. It also summarizes the accounting standards and recommendations of industry groups and regulators that contributed to the 1994 disclosures. The main thrust of these efforts has been to make derivatives more transparent," in that relevant information is presented in a way that allows the public and regulatory authorities to make informed judgments about a company's derivatives activity. Finally, the article reviews the improvements in qualitative and quantitative disclosures since 1993.

BACKGROUND

In the past year, some highly publicized financial losses were attributed to derivative contracts that were held by several large corporations and municipalities. As a result, public attention has focused on derivatives. Although most financial market professionals see derivatives as efficient tools for managing risk, widespread confusion about them persists among the public. Much of the confusion may stem from the recent increase in the complexity of these instruments.

A standard definition, which will be used here, is that a derivative is a financial contract whose market value depends on the value of one or more underlying "goods." The underlying good can be a commodity, such as a metal or an agricultural product; a financial instrument, such as a stock, bond, or foreign currency; or an index, such as an interest rate or equity index. More simply, a derivative is a contract between two parties in which they agree to fix the price of something today for exchange, or settlement, on a future date. The amount of cash changing hands between the parties is calculated on the settlement date and is based on the difference between the prevailing market price for the good and the price specified in the contract.

The following example illustrates a frequently used type of derivative, a forward contract, in which the buyer agrees to purchase and the seller agrees to deliver a commodity at a specified price on a certain date.

Two companies, a fuel distributor and a manufacturer, decide to enter into a derivative contract. The distributor has an inventory of 1,000 gallons of gasoline, about three months' supply. The manufacturer purchases 1,000 gallons of gasoline about every three months for use in its factory. On the one hand, the distributor is worried that the price of gasoline will fall in the near term from its current, or spot, price of $1 per gallon; on the other hand, the manufacturer is concerned about price increases. They enter into a derivative contract in which the distributor agrees to sell 1,000 gallons of gasoline on a specific date three months hence at $1 per gallon, and the manufacturer agrees to buy it then at that price. Rather than deliver the gasoline on a date that may be close to but not exactly the same as the date on which the manufacturer needs to buy it, they will instead settle in cash. Three months later, the spot price is $0.85 per gallon. In settlement of the contract, the manufacturer pays the distributor $150, that is, $1.00 per gallon (contract price) - $0.85 per gallon (spot price) x 1,000 gallons. (If the gasoline price had increased to $1.15, the distributor would have paid the manufacturer $150.) The distributor then sells its inventory in the open market for $850, and the manufacturer buys its gasoline for $850 on the open market.

In this example, both parties have hedged against the risk of unfavorable price changes in a commodity by entering into the derivative contract that compensates them for such a change. The distributor forgoes the gain from a price increase to avoid a loss on the value of its fuel inventory, and the manufacturer forgoes the savings from a price drop to avoid increased production costs resulting from a rise in the price of gasoline. When the derivative contract and the physical commodity are viewed together, the benefit to the companies is clear: They have effectively locked in the price of 1,000 gallons of gasoline at $1 per gallon for three months. The distributor and the manufacturer are seeking, in the example, to manage their risk from changes in market prices through the derivative contract. Reducing their risk exposures is one of the main purposes for which both financial and nonfinancial companies use derivatives.

Derivatives may also be entered into for speculative or trading purposes. In the example, either the distributor or the manufacturer or both could have entered into the contract to profit from their respective predictions about price changes. Alternatively, a financial intermediary could take opposite positions in two forward contracts, promising to pay the distributor a fixed price for the gasoline on a certain date and to accept another fixed price from the manufacturer for the same quantity of fuel. Then, no matter whether the price rose or fell, the intermediary, settling in cash, would pay (or receive), on the contract with the distributor, an amount of money that would offset the amount of money that it received (or paid) on the contract with the manufacturer. The intermediary's compensation is the difference between the fixed prices specified in the two contracts.

Derivatives can be designed to fit a multitude of situations. For example, derivatives are available on "catastrophe indexes" for the West Coast (earthquakes), Midwest  floods), and East Coast (hurricanes) that insurance companies may find useful as alternatives to negotiating reinsurance contracts with other insurers. Derivative contracts on electricity are being devised, and these may become the basis of an important market for utilities and their customers as electric utilities are deregulated.

Despite this apparent profusion, basically there are only two classes of contracts: forwards (illustrated in the example) and options. Each can be viewed as a "building block," in that it may be combined with the other in various ways to create instruments of greater complexity that may be used in sophisticated hedging strategies or in speculative transactions. (See box "Classes of Derivatives" for an overview of various types of derivatives.) Because these contracts can be quickly negotiated, a firm's susceptibility to loss from changes in prices (its risk profile") can be vastly altered in a matter of days or even hours through the use of derivatives.

Derivatives themselves generally involve risks to which banks and other companies have long been exposed, for example, credit, market, liquidity, and legal risks (see box "Risks Associated with Derivatives"). However, because derivatives are often more complex, for example, than traditional bank products, their risks can be more difficult to measure and manage.

Use of Derivatives by Banks

During the past few years, the use of derivatives in the banking industry has grown rapidly (see box "Some Uses of Derivatives by Financial Intermediaries"). Derivatives are now an important product of many banks, yet measures of the size of this activity are difficult to devise, in part because the contracts represent promises of cash flows in the future. As a result, many market observers rely on notional or principal amounts of contracts in assessing the size of the market. The notional amount is the face amount of a contract to which the rates or indexes that have been specified in the contract are applied to determine cash flows. For example, in an interest rate swap in which two parties agree to exchange fixed for floating interest payments on $10 million of debt, the notional amount of the contract is $10 million. In general, the notional amount is never exchanged and does not reflect the risk of the position. Furthermore, aggregate notional amounts are often overstated because of double counting of contracts between dealers and because contracts are often used to offset the effect of other derivatives. Nevertheless, changes in notional amounts over time give an indication of the growth of derivatives activities.

From 1990 to the end of the first quarter of 1995, the total assets of those U.S. banks involved in derivatives grew almost 35 percent, from $2.3 trillion to $3.1 trillion. During the same period, however, the notional amounts of derivatives contracts almost tripled, rising from $6.8 trillion to almost $18 trillion.

Although the number of banks involved in derivatives has risen since 1990, it is still relatively small - about 600 as of March 31, 1995. Also, the largest banks account for most of the activity: The top fifteen banks hold more than 95 percent of the derivatives contracts (as measured by notional amounts) of the U.S. banking industry.

Accounting for Derivatives

The issues involved in the accounting treatment of derivative contracts are also complex. Accounting theory has not kept up with the innovations represented by the development of derivatives. At present, financial statements do not effectively represent the risk profile of a company that uses derivatives nor its management's intentions for controlling risk relating to derivatives.

Derivative instruments, like traditional loan commitments, are executory contracts. That is, the two parties to the contract have made mutual promises, but they have not yet performed their promised duties. Companies typically report a contract in their financial statements only after some performance has taken place. For example, in a firm commitment to lend, the amount of the financial contract does not appear on the balance sheet until the borrower actually draws on the loan. Another example is a firm purchase order received by a manufacturer. These orders make up the company's backlog but are not generally recognized in the financial statements until some performance takes place, such as shipment of the manufacturer's product. An important focus of accounting is matching performance under a contract with its recognition in the financial statements. Because executory contracts will affect future financial results as their terms are fulfilled, under generally accepted accounting principles companies must nevertheless describe in their current financial statements material, binding commitments that will be performed in the future.

In keeping with this treatment of executory contracts, the accounting treatment of derivative instruments may reflect only the next required contractual performance, such as accruing the expected payment or receipt of cash, as of the balance sheet date. Under this procedure, an example of accrual accounting, even though a party to a derivative - an interest rate swap, for example - may be obligated to make a series of cash payments over several years because of changes in interest rates, these potential future obligations are not reflected on the current balance sheet. Hence, the derivative contract is "off balance sheet," and its risks and rewards are not clear to the financial statement reader. Furthermore, when used as hedges, gains or losses on derivative contracts may be deferred to match interest income from loans, or interest expense on deposits or other items being hedged. Future benefits or obligations associated with off-balance-sheet contracts, then, are not well captured in the financial statements and therefore lack transparency.

Although executory contracts may not be reported on a balance sheet, they nonetheless have economic value. A manufacturer with a two-year sales backlog is probably better off than one with no backlog. Similarly, an interest rate swap entitling a company to receive a fixed rate of 8 percent will be more valuable than a contract that pays 7 percent. The traditional accounting requirement that some performance occur before a contract appears on the balance sheet, however, is replaced in some situations (such as for a dealer's trading portfolio) by an estimation of the contract's economic value. This accounting practice, called "marking to market," is the process of determining the market value of financial contracts (by market quote, if available; otherwise through estimation techniques), recording that value on the balance sheet, and reflecting the change in value in reported earnings.

The accounting treatment of derivatives is now a hodgepodge of mark-to-market accounting and accrual accounting and depends on the type of contract and the purpose for which the party entered into the contract. As the use of derivatives has expanded, the deficiencies of their accounting treatment have become more evident, and the need for more consistency is widely recognized.

Professional organizations that set accounting standards have been exploring a number of alternatives to current practice but have had much difficulty in reaching a consensus. Although accountants cannot now agree whether marking to market or accruing cash flows is the appropriate method for accounting for derivative contracts in every instance, all would agree that until a more consistent accounting method is devised, an interim step to improving the transparency of off-balance-sheet instruments is more thorough disclosures about the contractual terms of derivatives and discussions by management of their hedging programs and the results of those programs.

Changes in Disclosure Requirements

and Recommendations

A new accounting standard issued by the Financial Accounting Standards Board (FASB) significantly expanded the required disclosures about derivatives and was effective for the 1994 annual reports of both financial and nonfinancial companies. Financial institutions also responded to initiatives by several industry and regulatory groups that called for additional disclosure of derivatives activities.

FASB Requirements before 1994

Before 1994, the FASB required that all firms preparing financial statements in conformance with generally accepted accounting principles disclose the following information about financial instruments with off-balance-sheet risk of accounting loss:(2)

Classes of Derivatives

Derivatives we contracts that their market values by reference to a physical commodity or to another contract, such as a debt or equity instrument, or by reference to an interest rate or equity index (collectively referred to as "goods"). Some derivative instruments can be settled by the delivery of the referenced good or by the payment of cash, while others are settled strictly in cash. There are two basic classes of derivatives - forwards and options.

Forward Contracts

A forward is a bilateral agreement in which one party, the buyer, is obligated to purchase the contracted-for good, and the second party, the seller, is obligated to sell the good to the buyer. A party who is buying or selling a good at some time in the future may wish to hedge against the risk of interim changes in the price of the good by entering into a forward contract today. At the inception of the forward contract, the price, quantity, and grade of the good, the delivery date, and the place of delivery are fixed. The price to be paid in the future under a new forward contract will be closely related to the good's current market price (its spot price), with adjustments for costs to maintain or carry an inventory of the good, such as for storage, insurance, and interest.

Futures. A future contract is a type of forward in which a clearinghouse normally serves as a counterparty to both the buyer and seller. In this arrangement, the time and cost of finding a willing counterparty are reduced; credit risk is also reduced because the parties are looking to the clearinghouse for performance. Clearinghouses typically reduce their credit risk by requiring collateral and marking positions to market frequently. In order to be traded on organized exchanges, futures contracts must have standard commodity-unit and delivery terms to ensure their liquidity. Futures are available for agricultural products and other commodities, bonds and other interest-bearing instruments, equity interests, and foreign exchange.

Forward Rate Agreement (FRA). As the name indicates, an FRA is a forward contract, settled in cash, in which required payments are based on the difference between a spot market rate and the contractual forward rate. If the spot rate at expiry is higher than the forward rate, the seller pays the difference; if the spot rate is lower, the buyer pays the difference.

Swaps. An interest rate swap may be viewed as a series of forward rate agreements packaged into a single instrument. In a simple interest rate swap contract, one party agrees to make fixed cash payments, and the counterparty agrees to make variable payments based on a floating-rate index, such as the London Interbank Offered Rate (LIBOR). The parties then exchange payments according to a certain schedule for the life of the swap, which may be several years. Besides interest rates, the structure of exchanging a fixed payment for a floating payment has been applied to such goods as foreign exchange, precious metals, and bulk commodities.

Option Contracts

An option contract is a unilateral agreement in which one party, the option writer, is obligated to perform under the contract if the option holder exercises his or her option. (The option holder pays a fee or "premium" to the writer for this option.) The option holder, however, is not under any obligation and will require performance only when the exercise price is favorable relative to current market prices. If, on the one hand, prices move unfavorably to the option holder, the holder loses only the premium. If, on the other hand, prices move favorably for the option holder, the holder has theoretically unlimited gain at the expense of the option writer. In an option contract the exercise price (strike price), delivery date (maturity date or expiry), and quantity and quality of the commodity are fixed.

The main types of options are calls and puts. A call option grants the holders of the contract the right, but not the obligation, to purcahse a good from the writer of the option in consideration for the payment of cash (the option premium). A put option grants the the holder the right, but not the obligation, to sell the underlying good to the option writer.

Interest Rate Caps and Floors. Caps and floors may be viewed as a series of call options packaged into a single financial instrument in which the underlying good is an interest rate index. For example, a borrower arranges to borrow at a variable rate reset quarterly at LIBOR. He also purchases a 6.5 percent rate cap. If LIBOR rises to 9 percent, the borrower pays his creditor 9 percent and receives from the cap writer 2.5 percent (9 percent - 6.5 percent option exercise price). The borrower has effectively limited his interest expense to a maximum of 6.5 percent plus the premium paid for the interest rate cap.

Under a floor contract, the borrower writes an option in which he agrees to pay the difference between the strike price and the interest rate index specified in the contract. The premium received offsets a portion of the overall interest expense of the obligation; however, the debtor retains exposure to higher interest rates and forgoes the benefit of lower interest rates on his floating-rate obligation.

Risks Associated with Derivatives

Generally, the risks associated with derivative instruments are the same as those arising from other bank financial instruments. The major categories of risk are the following.

Credit Risk is the possibility of loss from the failure of a counterparty to fully perform on its contractual obligations. Types of information that may be disclosed about credit risk include the following:

* Gross positive market value - the gross replacement cost of a contract, without the effects of any netting arrangements.

* Current credit exposure - the replacement cost of a contract, including the effect of netting arrangements

* Potential credit exposure - possible replacement costs if favorable price movements (making the contract more onerous to the counterparty) occur in the future

* Credit risk concentrations - indicators of a lack of diversification in either geographic areas or industry groups

* Collateral and other credit enhancements that may reduce credit risk

* Counterparty credit quality, nonperforming contracts, and actual credit losses

Market Risk is the possibility that the value of on-or off-balance-sheet positions will adversely change before the positions can be liquidated or offset with other positions. For banks, the value of these positions may change because of changes in domestic interest rates (interest rate risk) or foreign exchange rates (foreign exchange rate risk).

For some of the larger institutions, information about their internal value-at-risk measures and methodology can improve the understanding of their exposure to market risk. Value at risk involves the assessment of potential losses in portfolio value because of adverse movements in market risk factors for a specified statistical confidence level over a defined holding period.

Liquidity Risk has two board types: market liquidity risk and funding risk. Market liquidity risk arises from the possibility that a position cannot be eliminated quickly either by liquidating it or by establishing offsetting positions. Funding risk arise from the possibility that a firm will be unable to meet the cash requirements of its contracts.

Operational Risk is the possibility that losses may occur because of inadequate systems and controls, human error, or mismanagement.

Legal Risk is the possibility of loss that arises when a contract cannot be enforced - for example, because of poor documentation, insufficient capacity or authority of the counterparty, or enforceability of the contract in a bankruptcy or insolvency proceeding.

Some Uses of Derivatives by Financial Intermediaries

Use of Interest Rate Swaps

A finance company of a manufacturer purchases equipment sales contracts, bearing fixed interest rates, from the dealer network. The overall portfolio of sales contracts has a weighted-average life of three years and a yield of 12 percent. To finance its operations, the finance company sells short-term commercial paper in the secondary market. If a sudden increase in short-term rates occurs, the finance company's net interest margin will be decreased.

To reduce this risk, the finance company could enter into a three-year interest rate swap in which it receives the commercial paper rate and pays a fixes amount, with a notional amount equal to the amount of commercial paper outstanding. Because the cash received on the swap equals the company's interest expense on the commercial paper, the finance company has effectively locked in its net interest margin as the difference between the fixed rate received on the sales contract portfolio and the fixed payments on the interest rate swap. The finance company could have achieved the same goal by issuing three-year bonds bearing a fixed interest rate; however, using a swap may be preferable if it offers greater flexibility, speed, or a higher net interest margin.

A bank performs a gap analysis to analyze its interest rate sensitivity, and management finds that for the interval of less than three months, liabilities exceed assets by $100 million, whereas in the one-year interval, assets exceed liabilities by $120 million. Management is concerned that a sudden increase in interest rates would adversely affect income as its liabilities reprice at the higher rates more quickly than its assets do, and its goal is to have no more than a net $25 million in any period.

One solution for reducing this exposure would be to enter into a one-year interest rate swap, with a notional amount of $100 million, in which the bank pays fixed interest and receives a quarterly floating rate of interest. The $100 million notional amount, when analyzed as a component of the gap schedule, reduces the liability sensitivity for the interval of less than three months and decreases the one-year asset sensitivity, resulting in a balanced three-month interval and a $20 million asset sensitivity in the one-year interval, a result that meets management's goal.

Use of a Put Option

A mortgage company experiences a large increase in demand for home mortgages as a result of a downward trend in rates. It normally sells the loans it originates in the secondary market. The company is concerned that mortgage rates may unexpectedly increase, in which case many more consumers than usual will seek to fund commitments that were made earlier, at lower rates. These mortgages, bearing below-market rates, will sell at a discount in the secondary market. If rates continue to fall, most consumers will allow the commitments to expire.

One approach to hedging against the risk of loss from funding below-market-rate commitments would be to purchase put options on a bond whose market value tracks that of home mortgages as interest rates change. The option gives the company the right to sell the bond at the strike price, and if interest rates do indeed rise, the company profits if the bond's market value falls relative to the option's strike price. this profit on the option helps offset the loss from selling the below-market-rate mortgages resulting from the loan commitments. If rates are unchanged or if they fall, the market value of the bond underlying the option may exceed the option's strike price, which would render the option worthless at expiration. The company then loses the premium. Mortgages, however, will be originated and sold at face value. At the cost of the premium paid for the option, the bank has insured against incurring a loss on the commitments resulting from an increase in rates.

* The face, contract, or notional principal amount

* The nature and terms of the instrument and a discussion of its credit and market risk, cash requirements, and related accounting policies

* The accounting loss the company would incur if any party to the financial instrument did not perform according to the contract's terms and any collateral proved to have no value

* The company's policy for requiring collateral or other security and a description of collateral presently held.

For all financial instruments (those with off-balance-sheet risk of accounting loss and those without), significant concentrations of credit risk from an individual counterparty or groups of counterparties must also be reported. Furthermore, companies must disclose the fair market value of their financial instruments, both assets and liabilities, whether or not they are recognized on the balance sheet.

SFAS 119

In response to calls for improved disclosure of derivatives activities, the FASB issued Statement of Financial Accounting Standards Number 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments (SFAS 119). Under this new standard, which was effective for 1994 year-end reports, a company that issues or holds derivatives is required to differentiate in its disclosures between derivatives used for trading purposes and those used for risk management or other end-user reasons.

Trading Activities

A dealer is required to report the fair value (both year-end and annual average) of its derivatives positions and disaggregate from trading revenues the share earned from derivatives. This disaggregation may be either reported for derivatives alone or broken down by some other method, such as lines of business or types of risk exposure (for example, interest rate or foreign exchange), as long as trading profits from derivative instruments are clearly presented. The FASB encouraged, but did not require, the disclosure of similar data about nonderivative trading assets and liabilities, whether they are financial instruments or nonfinancial items, to give a more comprehensive picture of the firm's trading business.

End-User Activities

For derivatives used for hedging or other risk-management purposes, a firm is now required to describe its objectives in using derivatives and discuss its strategies for achieving those objectives. The firm must also describe how it reports derivatives in its financial statements and give certain details about gains or losses being deferred. The fair values of end-user derivatives must also be shown separately from the fair value of items hedged by the derivatives; previously most companies combined the fair values of the two.

SFAS 119 also encourages a firm to disclose quantitative information, in a manner consistent with its method for managing risk, that would be useful to readers of its financial statement in evaluating its activities.

Private Groups

In 1993, the Group of Thirty presented a report containing a number of recommendations on derivatives disclosure.(3) The report said that financial statements of dealers and end-users should contain sufficient information about their use of derivatives to provide an understanding of the purposes for which transactions are undertaken, the extent of the transactions, the degree of risk involved, and the way the company has accounted for these transactions. The report also recommended the disclosure of information about management's attitude toward financial risks, the ways financial instruments are used, the ways risks are monitored and controlled, and analyses of derivatives positions at the balance sheet date as well as the credit risk inherent in those positions. The report also recommended that dealers provide additional information on the extent of their activities in financial instruments.

In 1994, a banking industry group, the Institute of International Finance (IIF), developed a framework for reporting credit exposures arising from derivatives.(4) The framework consisted of management discussions about policies and controls affecting credit risk and the reporting of quantitative data on counterparty credit quality and more information about contractual terms.

Federal Bank Regulatory Agencies

In 1994, the Federal Reserve and the other federal banking agencies proposed and issued in final form expanded regulatory reporting requirements that applied to all banking organizations. They required, among other things, a more detailed breakdown of notional amounts and, for larger banks, the market values of derivative instruments according to broad risk exposure and management objectives. For larger banks, they also required additional information on trading revenues and the effects of end-user derivatives on income. This information became available to the public beginning with regulatory reports for the first quarter of 1995. These regulatory requirements may also have influenced disclosure in the annual reports for 1994.

Euro-currency Standing Committee

of the Group of Ten Central Banks

Even though the derivatives market is considered global, disclosure practices among countries are quite diverse. As a result, several efforts have been made to harmonize and improve disclosure about derivatives activities internationally. A working group of the Euro-currency Standing Committee of the Group of Ten central banks, chaired by Peter R. Fisher, Executive Vice President of the Federal Reserve Bank of New York, developed recommendations regarding ways to improve the financial reporting of derivative activities; these recommendations may have influenced the 1994 annual reports of firms involved in derivatives activity.(5) The Fisher Group recommended principally that a firm disclose quantitative information about its market and credit risk exposures and its performance at managing these risks to frame its discussion of qualitative information. The report recommended that, to the extent feasible, quantitative information on a firm's consolidated portfolios (that is, derivatives and on-balance-sheet financial instruments relating to traditional banking activities) should also be reported. These data should reveal the portfolios' riskiness and management's success at managing that risk. A key recommendation was that firms base their annual report disclosures on the kinds of information the firm's own management uses for analyzing risk. Many firms might, for example, disclose value-at-risk measures for market risk if they use that method in their risk management processes. Such measures assess the likelihood of loss from adverse market price movements over a specified time period (see box "Risks Associated with Derivatives").

For credit risk, the Fisher Group noted that most firms were disclosing only current credit exposure. It suggested that transparency would be improved if information about counterparty credit quality, potential exposure, and the variability of credit risk exposure were disclosed.(6) Management's success at controlling credit risk would be indicated to financial statement users by the disclosure of actual losses and other details about derivatives with credit problems.

COMPARISON OF 1993 AND 1994

ANNUAL REPORTS OF THE TOP TEN

U.S. DEALER BANKS

The analysis of the derivatives disclosures focused on information presented by the top ten U.S. dealer banks (measured by the notional amounts of their derivatives holdings) in their 1994 annual financial reports (table 1).(7)

1. Ten U.S. banks with the largest notional amount of
derivative contracts outstanding on December 31, 1994
   Billions of dollars

                               Notional   Fair market
         Institution           amount       value(1)

Chemical Banking Corp.          3,182         18
Citicorp                        2,665         27
J.P. Morgan & Co.               2,471         31
Bankers Trust New York Corp.    1,982         26
BankAmerica Corp.               1,376         14

Chase Manhattan Corp.           1,367         10
First Chicago Corp.               622          7
NationsBank Corp.                 511          2
Republic New York Corp.           239          2
Bank of New York Co.               80          1

  (1.) The fair market value, sometimes referred to as the replacement cost or
current credit exposure, is for off-balance-sheet derivatives subject to the
risk-based capital standards.
  SOURCE. Publicly available regulatory financial statements filed with the
Federal Reserve.

In general, substantial improvements were made in the 1994 annual reports relative to 1993 reports.(8) In particular, banks expanded their management's discussion and analysis of their derivatives activities and provided more quantitative information about these activities than in the 1993 reports. When the 1994 annual reports are compared with 1992 year-end financial statements (which generally disclosed little more than, notional amounts, credit exposures, the total value of the trading account, and total trading profits), it is clear that the groups pushing for improved standards have had significant influence in improving the overall quality of disclosures about derivatives activities.

Banks make disclosures about derivative instruments on a consolidated basis in two main sections of a typical annual report: management's discussion and analysis and the annual financial statements. The first is an analysis of the bank's financial condition and performance (including financial data) and typically includes a narrative of the bank's risk exposures and techniques for managing risk. This section of the annual report is not audited by independent accountants. The second section, the annual financial statements, reports the financial position, income, changes in stockholders' equity, and cash flow and include many footnotes. The financial statements and their footnotes are audited.

For purposes of this article, disclosures in both sections of the annual report were reviewed. In analyzing these reports, certain decisions were made to assess whether or not an institution had made a particular disclosure. For example, one institution might explicitly state certain quantitative information. In another bank's annual report similar information could be inferred from other complementary data. To distinguish between the two types of presentation, the analysis did not consider indirect presentation to be disclosure.

Qualitative Information

As indicated earlier, SFAS 119 now requires firms to discuss the use of derivatives in risk management activities (table 2). Although firms are not explicitly required to make this qualitative disclosure about trading activities, virtually all of the banks discussed in some detail the various risks they face in their trading operations and their processes for controlling their exposures. Nine of the top ten banks (the one missing had the smallest trading portfolio) discussed measurement and control of credit and market risks. More than half described how they manage the liquidity demands of their operations. Three banks rounded out their management discussion and analysis by describing how they control operating and legal risks. All institutions (to varying degrees) included cash market financial instruments (for example, bonds) within the scope of their narrative of risk management, an approach that provides a more balanced, broad-based discussion of managing risk exposures than would a strict focus on derivatives. The number of banks discussing these specific risks and their methods of controlling risk exposure has increased significantly since the 1993 annual reports, in which only the four largest dealers did so. Few banks explicitly discussed operational risks, but all discussed legal risks in varying detail in describing the legal characteristics of their netting arrangements with counterparties.(9) In addition, half of the organizations indicated in their 1994 reports whether or not they used leveraged derivatives (contracts using multipliers or other means to scale up cash flows relative to the reported notional amounts) in their business. This issue was not discussed in earlier annual reports.

2. Number of top ten banks discussing management
objectives and derivative risks in their annual reports,
1993 and 1994

                                      Number of banks
                                         disclosing
   Type of qualitative disclosure
                                      1993        1994

           Discussion of
       Management Objectives
          and Strategies

For trading activities                  4          9
For end-user activities                 4         10

       Discussion of Risks and
        Management Method

Placed in context with balance
     sheet risks                        7         10

Credit risk
How risk arises                         6          9
Risk management method                (1)          9

Market risk
How risk arises                         6          9
Risk management method                (1)          9

Liquidity risk
How risk arises                         4          6
Risk management method                (1)          6

Operating and legal risks
Description                             1          3
Risk management method                (1)          2

     Discussion of Other Topics

Leveraged instruments                   0          5
Estimation of market values           (1)         10
Accounting policies for derivatives    10         10

  (1.) Generally, disclosures about risk management methods and approaches
for estimating market value were not as extensive in 1993 as they were in
1994.

Most organizations described their risk control processes by identifying the management group responsible for setting trading policies and describing the managerial procedures that were in place to ensure compliance with these policies. The typical report gave an overview of risk management that briefly sketched the bank's business objectives and its management philosophies (for example, describing the extent to which its operations are centralized or diffuse). Most banks described the information systems and management tools used for assessing results.

As required under generally accepted accounting principles, all organizations discussed in the footnotes to their financial statements their methods for reporting derivatives used for trading or end-user purposes. Under these standards, a firm must discuss its accounting policies and describe how it values derivative contracts, recognizes income and expense from derivatives, and nets derivatives for financial reporting purposes. Firms have long been required to describe their accounting policies in their annual reports; however, the disclosures in 1994 were much more specific regarding the accounting treatments for derivatives. More recently, firms have been required to disclose the fair value of financial instruments and their means of determining fair value. In line with these requirements, all banks provided much more detailed and useful descriptions of the methods and assumptions used in valuing financial instruments that do not have observable market prices.

Quantitative Information

The top ten institutions continued to expand the disclosure of the general terms of their derivative contracts (table 3). All banks last year reported the notional amounts of various types of derivative contracts, in almost all cases distinguishing dealer positions from those used for end-user purposes. This year, all banks not only presented the notional amounts of their derivatives but also provided a schedule of certain derivative positions listing their notional amounts by maturity; seven banks provided this type of schedule last year. More than half of the banks this year reported gross positive and negative market values of their derivative positions as of the report date in contrast to 1993 when no banks reported gross negative values.

3. Number of top ten banks disclosing the general terms
of derivative contracts in their annual reports, 1993 and
1994

                                               Number of
      Type of quantitative disclosure           banks
                                              disclosing

                                             1993      1994

         Notional Amounts

Dealer (trading account) positions             5         9
End-user positions                            10        10
Combined                                       8         4
Adjusted to reflect leveraged derivatives      0         0

Maturity schedule
Dealer (trading account) positions             1         6
End-user positions                             7        10
Combined                                       2         1
Contract rates
Receive or pay notional amounts                2        10

Market Value Data

Gross positive market value                    7         7
Gross negative market value                    0         6
Trading account
Trading assets separated from trading
    liabilities                                0        10
Cash instrument detail
  End-of-period                                0         9
  Average for period                           0         6
Derivative instrument detail
  End-of-period                                0         9
  Average for period                           0         7
  No detail of trading account -
      totals only                             10         1

End-user derivatives positions
Overall market value                           9         9
By related asset or liability being hedged     6         9
By type of derivative                          2         6

Trading Disclosures

For 1994 most dealers expanded the level of detail in the reporting of their trading positions and trading revenues (table 4). The trading account for the first time disaggregated the fair values of derivative contracts in a gain position (assets) from those with losses (liabilities) because of more restrictive rules on netting for accounting purposes that were effective in 1994.(10) These details were supplemented with more information on the types of instruments, both cash market and derivative, that made up the trading portfolio.

4. Number of top ten banks disclosing in their annual
reports data on risks and income relating to derivatives
they trade, 1993 and 1994

                                            Number of banks
                                              disclosing
     Type of quantitative disclosure
                                           1993     1994

    Risks of Off-Balance-Sheet
        Instruments

Market risk - trading activities
Daily value at risk, confidence level,
    holding period                           0        8
High and low value at risk                   0        5
Average value at risk                        0        7
Confidence band determined by
    daily value at risk                      0        6
Daily change in value of portfolio           0        4
Average daily change in value of
    portfolio                                 0        3
Change in portfolio value exceeded
    value at risk                            0        4

Credit risk
Current credit exposure (that is,
    with netting)                           10       10
 Maturity schedule                           7        9
 Volatility of credit exposure               0        0
Gross positive market value                  7        7
Potential credit exposure                    1        2
Counterparty credit quality                  4        5
Concentrations
 Exposure by geographic area                 4        4
 Exposure by industry group or
     government entity                       4        6
Other (for example, exposures greater
    than percentage of capital)              0        6
Collateral and other credit enhancements     0        2
Actual credit losses                         4        6
Nonperforming contracts                      1        6
Risk-based capital credit equivalent
     for derivatives                         4        7

Liquidity risk
Breakdown between OTC and
    exchange-traded derivatives              3        3
Other                                        0        1

Disaggregation of Trading Income

Risk exposure or line of business            2        5
Type of instrument
Cash positions versus derivative
     instruments                             5        6
Other                                        3        0
Net interest revenue from cash positions     6        5

Market Risk. The four largest derivatives dealers (according to the share net trading profits contributed to 1994 pretax income) reported both management's intended limits on risk exposure (daily value at risk at year-end, and high, low, and average value at risk during the year) and actual results in trading portfolio volatility. This value-at-risk disclosure also included the likelihood, or statistical confidence level, that such results would be observed, although assumptions about the holding period for estimating the results were typically not specified. The disclosure of numerical details of value at risk by the larger dealers is a significant innovation for 1994. In the previous year's annual reports the banks disclosed that their risk management methods relied on value at risk without disclosing value-at-risk data, whereas in their 1992 reports many banks were virtually silent about their risk management techniques. The indicators of actual trading portfolio performance used in 1994 by these four banks included histograms of daily price changes, reporting the annual high, low, and average price changes of the trading portfolio, and the frequency of daily price changes in excess of the day's value at risk.

Four other banks also interwove quantitative details in the qualitative discussion about risk management policies, indicating value-at-risk measurements (or other methods analogous to value at risk). These banks, however, did not publish information about the actual performance of their trading portfolios. Only one of these four banks gave some flavor to the dynamics of their risk-taking during the year by disclosing the high and lo limits of its value at risk during 1994.

In its paper, the Fisher Group illustrated its recommendations with several approaches to disclosing market risk and the firm's performance in managing the risk. Some of the top ten banks used these approaches in their 1994 annual reports (table 5). Four banks used a graphical approach to convey information about their trading portfolios. One bank provided a scatter diagram of daily value at risk and daily changes in portfolio value. Two institutions published a histogram of actual portfolio performance, indicating the distribution of daily profit or loss but not daily value at risk, so that gauging results against management's intentions was difficult. The fourth institution showed a bar chart of quarterly high, low, and average value at risk and quarterly trading revenue.

5. Number of top ten banks with 1994 disclosures about
market risk based on Fisher Group recommendations

                                                Number of
     Type of disclosure                          banks

                                                disclosing

Daily value at risk (at year-end)                   8
Average value at risk for year                      7
Annual high and low value at risk                   5
Portfolio price change exceeding value at risk       4
Average daily change in portfolio value             3
Frequency distribution of price change versus
    value at risk                                   1

Credit Risk. Besides increasing information on market risk, the banks disclosed more about their credit risk in the 1994 annual reports (table 4). As in the 1993 reports, all banks reported their current credit exposure. Five banks gave indications of the credit quality of their derivatives portfolio by disclosing the proportion of credit exposures to investment-grade and unrated counterparties. One institution broke down its derivatives credit exposure by its internal risk rating - the first time this disclosure has been made in the annual report of a top ten dealer bank. Six institutions published details about the concentration of current exposure according to industry or government entity. Several among these also reported current exposure by geographic concentration. Moreover, two institutions reported the value of collateral and other credit enhancements connected with their trading portfolios. The banks provided little quantitative information of this type in 1993, when some gave only limited data on industry concentrations.

In 1993, only four banks quantified their actual credit losses and nonperforming derivatives contracts or explicitly stated that the amounts were immaterial. In 1994, two additional banks reported information about derivatives with credit problems. Nine institutions furnished a maturity schedule of derivatives contracts to indicate credit (and market) risk.

Although these types of disclosure are an improvement over 1993 reports, other measures of credit risk have yet to be explored in these annual reports. For example, potential credit exposure has been reported by only two banks (which also reported such estimates in 1993), and none of the top ten reported any measure of the volatility of credit risk arising from derivatives. Most banks, however, quantified in their annual reports the benefits of reduced credit exposure resulting from netting agreements with counterparties.

The Fisher Group suggested several means of indicating the firm's credit risk and its performance in managing it. Many of the quantitative measures were adopted in 1994 by the top ten banks or had been disclosed in previous years (table 6).

6. Number of top ten banks with 1994 disclosures about
credit risk based on Fisher Group recommendations

     Type of disclosure                      Number of banks
                                               disclosing

Current exposure                                   10
Maturity schedule (notional)                        9
Industry or geographic concentration                6
Actual credit losses                                6
Counterparty credit quality                         5
Potential exposure                                  2
Volatility of exposure                              0
Measure of losses versus allocated capital          0

As a supplement to their disclosures of credit risk and capital adequacy, seven dealer banks reported the credit-equivalent amount of risk-based capital for off-balance-sheet contracts in describing their risk-weighted assets and risk-based capital ratios.

Liquidity Risk. As in 1993, quantitative information about liquidity risk was limited in 1994 annual reports (table 4). Three banks distinguished exchange-traded contracts from over-the-counter instruments, generally through disclosure of the notional amounts related to futures contracts and exchange-traded purchased options versus over-the-counter contracts. Exchange-traded contracts are generally considered more liquid than over-the-counter instruments because of their standardized terms, readily available price information, and low credit risk.

Dealer Income. To comply with SFAS 119, all of the top ten banks disaggregated their trading revenues in their 1994 annual reports compared with eight institutions in 1993 (table 4). Seven banks reported results according to the type of instrument that earned the income. Five banks (compared with two in 1993) reported their trading income according to their lines of business or risk exposure with little differentiation between derivatives and cash-market instruments. There was considerable variability among the income disclosures, with some providing only the information required under SFAS 119 and others giving a more complete picture of profits from trading both derivative and nonderivative financial instruments. Five institutions also disclosed net interest income from traded cash positions.

Disclosures about End-User Derivatives

The primary focus of disclosure about derivatives used for hedging or other risk management purposes is market risk. Market risk incorporates information about the institution's exposure to interest rate (and to a lesser extent foreign exchange) risk arising primarily from traditional bank activities, such as those involving investments, loans, and deposits. The most common disclosures about derivatives that had been designated for hedging or other risk management purposes were schedules of contractual terms: notional amounts, maturities, and (for swaps) rates paid and received.

Market Risk. Almost all banks limited their discussion of market risk (outside the trading portfolio) to interest rate risk. The most prevalent means of communicating how derivatives are used to manage a bank's interest rate risk was a gap position schedule, which was used by eight banks - the same number as in 1993 (table 7). Gap schedules are used in a method of managing interest rate risk that organizes financial assets and liabilities according to maturity or repricing frequency in a number of time intervals. The difference between assets and liabilities in each time interval ("gap" or net exposure) forms the basis for assessing interest rate risk. Under this approach, derivatives of various maturities can be used to adjust the net exposure of each time interval to alter the overall interest rate risk of the institution.

7. Number of top ten banks disclosing details of end-user
derivatives in their annual reports, 1993 and 1994

                                               Number of banks
                                                 disclosing

     Type of quantitative disclosure
                                              1993      1994

        End-User disclosure

Market risk
Effect of derivatives on duration               1         2
Effect of derivatives on gap position           8         8
Effect of specified rate shock                  3         5
Value at risk for end-user portfolios           0         3

Effect on revenue and expense
Of derivatives alone                            4         8
Overall sensitivity of net interest margins     3         4
Amount of deferred gains or losses              6         5
Amortization period - deferred gains
   or losses                                    2         5
Unrealized gain or loss derivatives             7        10

Gap analysis is the simplest approach to assessing interest rate risk. It is a "snapshot" that portrays the risk for only the date of the balance sheet. Thus, it does not capture the dynamics of changes in the bank's mix of products or the effect of changes in rates on instruments that can be called or redeemed. To remedy this deficiency, banks supplemented the gap schedule with either a discussion of the effect on earnings of a specified rate shock or a discussion of earnings-at-risk methods (a method analogous to value at risk) applied to nontrading portfolios. Four institutions described the consequences to earnings of an interest rate shock. One indicated the effect large changes in rates that were observed in 1994 would have had on that year's earnings had derivatives not been in place for hedging purposes. The other three reported the effect on projected 1995 income of an arbitrary shock of 100, 150, or 200 basis points in interest rates. The assumptions in the analysis about how quickly the arbitrary rate shocks developed were either not stated or only vaguely described.

One bank disclosed the duration (the weighted-average collection time of an instrument's cash flows) of its risk management derivatives but did not provide the duration of cash positions; this omission makes it difficult to assess the effect of the derivatives on the overall duration of the institution's financial instruments. Most banks, in varying detail, described whether the derivatives were linked to specific components of the balance sheet or were used to manage overall risk exposures.

In recognition of the expansion of value-at-risk methods to activities not related to trading, two banks furnished quantitative information on the value at risk related to end-user derivatives. Also, one institution provided a corporate-wide value-at-risk measure that took into account both trading and end-user derivatives as well as traditional financial instruments.

SFAS 119 made technical changes to the way that the fair value of financial instruments is to be disclosed in annual reports. As a result, disclosure of the fair value of financial instruments in the 1994 reports was generally clearer and more understandable than before. For the first time, firms were required to disclose the fair value of financial assets and liabilities carried at historical cost separately from the fair value of derivatives used to hedge those instruments. Made in this way, the disclosure showed more clearly whether an instrument was favorable (an asset) or unfavorable (a liability) at year-end.

Effect of Derivatives on Earnings. Details of the way derivatives affect income and expense accounted for on an accrual basis (that is, instances in which instruments are not marked to market with gains or losses recognized in income but instead track cash flows) were more widely reported in 1994. Eight banks, compared with four in 1993, reported the effect that derivatives accounted for on an accrual basis had on revenue. Half of these institutions also reported the overall effect on net interest margins of their end-user derivatives activities. Five banks disclosed deferred gains or losses on end-user derivatives and provided details of when the deferrals would be reflected in future earnings; only two banks published this information in 1993.

CONCLUSION

The level of detail and clarity of annual report disclosures about derivatives activities greatly improved for the top ten dealer banks as a group for 1994. The banks that published the more innovative annual reports in 1993 continued to lead the group in 1994 with quantitative details of value at risk and actual results of their trading activities. The disclosures in 1994 (as in, 1993) were more informative for those banks whose trading revenues posed a larger share of their overall income. Institutions that focused primarily on traditional banking activities made fewer disclosures about trading than other dealers, perhaps because trading was an adjunct to their primary business.

The experimentation encouraged by the FASB, regulators, and industry groups is evident from the diversity of methods used by the top ten banks in presenting information about their derivatives activities. No annual report can be singled out as having the best method, and several banks had unique approaches to disclosing some aspects of their derivatives activities. As new approaches are developed by the major banks, further progress in improving derivatives disclosure will likely be made.

The Federal Reserve has long supported balanced improvements in annual report disclosures, particularly those about derivatives activities. The U.S. federal banking agencies will continue to be interested in improved disclosures about these activities and will likely coordinate more extensively with national supervisors from other countries in this important area. (1.) Other components to supervision include on-site examinations and related off-site monitoring of regulatory reports and capital standards. The Federal Reserve has also developed extensive examination guidance that works to reinforce the development of strong risk management policies within banking organizations. Furthermore, the Federal Reserve has been encouraging improvement in accounting standards for hedging and other derivatives activities. (2.) "Accounting loss" on a financial contract is a potential loss in excess of the amount of the contract reported on the balance sheet. For example, an interest rate swap that has a value of $100 on the balance sheet date after it is marked to market could result in more than $100 of loss if there is an unfavorable movement in interest rates. This contract, though reported at market value, has off-balance-sheet risk of accounting loss. In contrast, a loan of $100 has no off-balance-sheet risk of accounting loss (ignoring environmental or lender liability claims) because the possible loss is capped at $100 even if there is a full charge-off of the loan. (3.) Group of Thirty, Derivatives: Practices and Principles, report by the Global Derivatives Study Group (Washington: July 1993). The Group of Thirty is a private, nonprofit research organization involved with international economic and financial issues. (4.) The Institute of International Finance, Inc., A Preliminary Framework for Public Disclosure of Derivatives Activities and Related Credit Exposures (Washington: August 1994). (5.) See Bank for International Settlements, Public Disclosure of Market and Credit Risks by Financial Intermediaries, discussion paper prepared by a working group of the Euro-currency Standing Committee of the Central Banks of the Group of Ten countries (Basle: September 1994). (6.) Current credit exposure is the loss that would be experienced if a counterparty defaulted today. The contract's fair market value today, or replacement cost, is widely viewed as its current credit exposure. Only a contract that is favorable to the bank (that is, an asset) has current credit exposure. A contract that is unfavorable to the bank (a liability) presents credit risk to the bank's counterparty. Potential credit exposure attempts to measure the maximum loss on a derivative contract that may occur over the life of the contract if the counterparty defaults in the future. This potential loss can be estimated by projecting the fair market value of the contract based on the occurrence of favorable (unfavorable to the counterparty) rate or price changes. The statistical likelihood of favorable price movements can be assessed from historical price data. (7.) In this article, "bank" means banking organizations that comprise bank holding companies and their bank affiliates and other subsidiaries that are consolidated for presentation in an annual report. (8.) The banks making up the top ten changed from 1993 to 1994. Continental Bancorp., which was ranked in the top ten in 1993, was acquired by BankAmerica Corp. in 1994. It was replaced by Bank of New York, which had been eleventh in 1993. (9.) Under a master netting agreement, the counterparties agree to settle a number of derivatives subject to the agreement on a net basis in the event of default. Thus, the nondefaulting party can offset favorable contracts (assets) against unfavorable contracts (liabilities) owed to the defaulting party. Although master netting agreements are generally enforceable in the United States, in some jurisdictions it is uncertain whether the nondefaulting party's favorable contracts could be abrogated and unfavorable contracts enforced in an insolvency proceeding of the defaulting party. (10.) Beginning in 1994, for accounting purposes companies were permitted to net assets and liabilities relating to those derivative contracts with a counterparty that were subject to a legally enforceable master netting agreement and were not permitted to net across counterparties. In previous years, industry practice was to "grandslam" net - that is, report the net fair market value of all derivative contracts across all counterparties. As a result of this change in method, several large dealer institutions saw their assets and liabilities increase by several billions in 1994.