United States General Accounting Office

GAO Report to Congressional Committees

November 1996 FINANCIAL

DERIVATIVES

Actions Taken or

Proposed Since

May 1994

G O A

years

1921 - 1996

GAO/GGD/AIMD-97-8

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-260656 

November 1, 1996

The Honorable Richard G. Lugar

Chairman

The Honorable Patrick J. Leahy

Ranking Minority Member

Committee on Agriculture, Nutrition

 and Forestry

United States Senate

The Honorable Alfonse M. D’Amato

Chairman

The Honorable Paul S. Sarbanes

Ranking Minority Member

Committee on Banking, Housing,

 and Urban Affairs

United States Senate

The Honorable Pat Roberts

Chairman

The Honorable E (Kika) de la Garza

Ranking Minority Member

Committee on Agriculture

House of Representatives

The Honorable Jim Leach

Chairman

The Honorable Henry B. Gonzalez

Ranking Minority Member

Committee on Banking and Financial Services

House of Representatives

The Honorable Thomas J. Bliley, Jr.

Chairman

The Honorable John D. Dingell

Ranking Minority Member

Committee on Commerce

House of Representatives

The Honorable Jack Fields

Chairman

The Honorable Edward J. Markey

Ranking Minority Member

Page 1 GAO/GGD/AIMD-97-8 Financial Derivatives
B-260656 

Subcommittee on Telecommunications

 and Finance

Committee on Commerce

House of Representatives

This report is a follow-up to a report we issued in May 1994 that responded

to your requests concerning derivative products. Our 1994 report

identified a number of risks, both to individual firms and to the financial

system as a whole, associated with those products. We initiated this

follow-up review to determine what progress has been made by financial

regulators and industry participants to address the areas of concern we

identified in 1994 and to determine what still needs to be done. In

particular, we examined what actions were taken or proposed to

(1) strengthen corporate governance and internal controls for derivatives

dealers and major end-users, (2) improve regulation of major U.S.

derivatives dealers, (3) provide federal oversight of major derivatives

dealers that are unregulated affiliates of securities firms and insurance

companies, (4) promulgate comprehensive and consistent accounting and

disclosure requirements for derivatives, and (5) harmonize regulatory and

accounting standards internationally.

We are sending copies of this report to other appropriate congressional

committees; executive branch agencies, including the Secretary of the

Treasury, the Chairman of the Securities and Exchange Commission, the

Chairperson of the Commodity Futures Trading Commission, the

Chairman of the Federal Reserve Board, the Comptroller of the Currency,

the Chairman of the Federal Deposit Insurance Corporation, and the

Acting Director of the Office of Thrift Supervision; and other interested

parties. We will also make copies available to others on request.

Major contributors to this report are listed in appendix X. I may be

reached on (202) 512-8678 if you or your staff have any questions.

James L. Bothwell

Director, Financial Institutions

 and Markets Issues

Page 2 GAO/GGD/AIMD-97-8 Financial Derivatives
Executive Summary

Purpose In May 1994, GAO issued its report on financial derivatives that identified a

number of risks, both to individual firms and to the financial system as a

whole, associated with those products.1

 The report made a series of

recommendations to federal financial regulators and to Congress to

improve the monitoring and management of these risks and to close

certain regulatory gaps that GAO identified. The report also recommended

that the Financial Accounting Standards Board (FASB) promulgate

comprehensive and consistent accounting and disclosure standards for

derivatives.

The volume of derivatives activity has continued to grow rapidly since

1994, which indicates that derivatives are increasingly viewed by market

participants as valuable and important risk management tools. The Bank

for International Settlements (BIS)2

 estimated that the total outstanding,

global notional/contract amount of derivative products as of March 31,

1995, was about $55.7 trillion.3

 In addition, after GAO’s report was issued,

some major banks, commercial corporations, and local governments

experienced major losses attributed to their use of derivatives. Such losses

underscored the risks that GAO identified in its report.

GAO initiated this follow-up review to determine what progress has been

made by financial regulators and industry participants to address the areas

of concern identified by GAO in its May 1994 report and to determine what

still needs to be done. In particular, GAO examined what actions were

taken or proposed to (1) strengthen corporate governance and internal

controls for derivatives dealers and major end-users, (2) improve

regulation of major U.S. derivatives dealers, (3) provide federal oversight

of major derivatives dealers that are unregulated affiliates of securities

firms and insurance companies, (4) promulgate comprehensive and

consistent accounting and disclosure requirements for derivatives, and

(5) harmonize regulatory and accounting standards internationally.

1

Derivatives are financial products whose value is determined from an underlying reference rate,

index, or asset. The underlying include stocks, bonds, commodities, interest rates, foreign currency

exchange rates, and indexes that reflect the collective value of various financial products. See

Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133, May 18,

1994).

2

BIS was established in 1930 in Basle, Switzerland, by European central banks. The objectives of BIS

are to promote the cooperation of central banks, to provide additional facilities for international

operations, and to act as trustee for international financial settlements.

3

In 1995, central banks in 26 countries conducted a global survey of derivatives markets. BIS

coordinated the survey and aggregated the data to produce global market statistics. The

notional/contract amounts are one way derivatives activity is measured. However, while

notional/contract amounts are indicators of volume, they are not necessarily meaningful measures of

the actual risk involved. The actual amounts at risk for many derivatives vary both by the type of

product and the type of risk being measured.

Page 3 GAO/GGD/AIMD-97-8 Financial Derivatives
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Background Derivatives serve an important function in the global financial marketplace

and, appropriately managed, can provide effective ways to reduce

financial risks, lower financing costs, or generate profits. Controlling the

risks derivatives pose to market participants and the financial system is

primarily the responsibility of boards of directors and senior managers of

dealers and end-users, as well as financial regulators.

Carrying out this responsibility effectively is important because derivatives

can contribute to catastrophic losses if they are not properly managed and

controlled. In 1994 and 1995, banks, commercial corporations, and local

governments reported billions of dollars in losses involving derivatives and

related financial products. These losses also resulted in enforcement

actions brought by regulators against Bankers Trust New York

Corporation (and two of its subsidiaries), a major U.S. derivatives dealer;

the filing for bankruptcy by California’s Orange County, one of the largest

and wealthiest U.S. counties; and the failure of Baring Brothers & Co., Ltd.,

a U.K. merchant bank with a 200-year history.

GAO focused its 1994 report on four basic types of derivatives—forwards,

futures, options, and swaps. This report addresses these four types of

derivatives and also discusses losses attributed to structured notes and a

type of mortgaged-backed security called collateralized mortgage

obligations (CMO). These financial products have characteristics and risks

similar to those of derivatives. As shown in table 1, some derivatives are

standardized contracts traded on organized exchanges. Others, called

over-the-counter (OTC) derivatives, are customized contracts that are not

traded on exchanges. They include negotiated terms, such as amount,

payment timing, and interest or currency rates.

Page 4 GAO/GGD/AIMD-97-8 Financial Derivatives
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Table 1: Definitions of Financial

Products Type of financial product Definition

Derivatives

Forwards (OTC)

Futures (must be exchangetraded in the United States

unless specifically exempted)

Forwards and futures obligate the holder to buy or sell a

specific amount or value of an underlying asset, reference

rate, or index at a specified price on a specified future

date.

Options (OTC or exchangetraded)Options grant the purchaser the right but not the

obligation to buy or sell a specific amount of the

underlying at a particular price within a specified period.

Swaps (generally OTC) Swaps are agreements between counterparties to make

periodic payments to each other for a specified period.

Other financial products

Structured notes (OTC) Structured notes are a type of debt security whose

cash-flow characteristics depend upon one or more

indexes. They may have added features such as

embedded options.

Collateralized mortgage

obligations (OTC)

CMOs entitle their purchasers to receive a share of the

cash flows from a pool of home mortgages.

Source: GAO.

The markets for these products vary in size. The $55.7 trillion in total

notional/contract amounts outstanding reported by BIS represents the

results of the first comprehensive central bank survey to measure the size

of the global derivatives market. Of this total amount, the four basic types

of OTC derivatives totaled $47.5 trillion and exchange-traded derivatives

totaled $8.2 trillion, both adjusted for double counting. BIS also reported

gross market values for OTC derivatives outstanding, which provide a

better measure of the economic significance of these derivatives contracts

than do the notional/contract amounts.4

 These values were about $2.2

trillion dollars, or 4.6 percent of the $47.5 trillion in notional/contract

amounts outstanding of OTC derivatives. To our knowledge, directly

comparable data for structured notes and CMOs do not exist. The best

available data show the amounts of these products issued by U.S.

government-sponsored enterprises each year. These data indicate that the

4

Gross market values were defined as the costs that would have been incurred if the outstanding

contracts had been replaced at market prices prevailing as of March 31, 1995. They equal gross positive

plus gross negative market values.

Page 5 GAO/GGD/AIMD-97-8 Financial Derivatives
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total amounts of these products issued in calendar year 1995 were about

$10 billion for structured notes and about $23 billion for CMOs.

OTC derivatives dealing in the United States continued to be concentrated

in seven banks, five securities firms, and three insurance companies or

their affiliates, some of which were federally regulated and some of which

were not. Derivatives dealers and markets have also remained extensively

linked internationally, as illustrated by the Barings failure, which involved

regulators and market participants around the world.

GAO focused this review on the derivatives oversight activities of federal

financial regulators in the United States and selected foreign financial

regulators. In addition, GAO reviewed regulatory and auditor reports

related to selected losses associated with derivatives. GAO also reviewed

the accounting practices of a judgmentally selected sample of banks and

thrifts, determined whether they had established relevant internal control

systems to manage the risks of derivatives, and analyzed what the

potential effects of proposed accounting standards would be on these and

other institutions. Finally, GAO assessed derivatives disclosure practices

and initiatives to improve those practices. GAO recognizes that many of the

derivatives-related issues addressed in this report, such as risk

management and corporate governance, have broader applications to

firms’ overall activities.

Results in Brief Market participants, regulators, and others have taken or proposed a

number of actions to improve the management, oversight, and disclosure

of derivatives risks consistent with GAO’s prior recommendations. For

example, many U.S. derivatives dealers and end-users indicated in industry

surveys that they have strengthened their corporate governance systems

and improved risk management and internal controls.5

 Market participants

and others have also developed and refined recommended practices

intended to improve internal controls over derivatives activities.

Federal bank regulators are (1) requiring capital that more accurately

reflects derivatives risks, (2) collecting more extensive information on

bank derivatives activities, and (3) examining banks using guidelines that

5

Governance systems involve the internal functioning of organizations through which economic

activity is conducted. These systems have to do with transactions and relationships within the

organization itself, including who controls what, who makes decisions, and who has what

responsibilities for what claims against the revenues and assets of a company or government. While

this report refers to these systems as corporate governance, the systems discussed also apply generally

to governmental entities.

Page 6 GAO/GGD/AIMD-97-8 Financial Derivatives
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are better focused on derivatives risks. The Securities and Exchange

Commission (SEC), in cooperation with the Commodity Futures Trading

Commission (CFTC), is also collecting more extensive information and

working with securities firms that have major OTC derivatives affiliates in a

voluntary program to provide some federal oversight to these large,

unregulated nonbank dealers.

FASB has issued enhanced disclosure rules, as GAO recommended, and has

proposed an accounting standard for derivatives that should help stem

misleading accounting practices and, for the first time, would require that

all derivatives be recorded in financial statements. SEC has also proposed

more qualitative and quantitative disclosures about derivatives use by

public companies.

Internationally, there has been progress toward greater regulatory

harmonization and coordination, as evidenced by major international

regulatory initiatives and information-sharing agreements. These include

the joint guidance on sound risk management practices issued by the

Basle Committee on Banking Supervision6

 and the International

Organization of Securities Commissions (IOSCO), and an international

agreement among regulators of futures markets intended to improve their

coordination and communication in the wake of the Barings collapse.

Although market participants, regulators, and others have acted to

improve the management, oversight, and disclosure of derivatives risks,

many of the concerns that GAO identified in its 1994 report still remain. For

example, in the cases GAO reviewed, each of the derivatives dealers and

end-users that suffered major losses had serious weaknesses in their risk

management, internal control, and corporate governance systems.

Compliance with guidelines and recommended risk management practices

is essentially voluntary for derivatives dealers and end-users other than

regulated entities, and some surveys have shown that firms using

derivatives are not involving their boards of directors in risk management.

SEC has acknowledged that there may be benefits associated with

management or auditor reports on internal control systems of SEC

registrants that are major dealers and end-users of complex derivative

products as GAO recommended. In fact, SEC receives these types of reports

through a voluntary program with securities firms that have affiliates that

6

The Basle Committee on Banking Supervision is a committee of banking supervisory authorities that

was established by the Central Bank Governors of the Group of Ten countries in 1975. It meets under

the auspices of BIS in Basle, Switzerland. The Group of Ten consists of 11 major industrialized

member countries—Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,

Switzerland, the United States, and the United Kingdom.

Page 7 GAO/GGD/AIMD-97-8 Financial Derivatives
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are major OTC derivatives dealers. However, SEC has stated that it is

focusing on accounting for and providing greater disclosure of market risk

for derivative products, which it views as a more appropriate priority at

this time. In addition, the OTC derivatives dealing activities of securities

firm and insurance company affiliates, which are still growing, continue to

be largely unregulated. Finally, FASB has proposed, but still has not issued,

comprehensive accounting standards for derivatives that would provide

financial statement users with appropriate, consistent financial

information on which to base their investment, management, or oversight

decisions. FASB’s proposal faces much opposition. The public comment

period on the proposal ended October 11, 1996.

The actions regulators, market participants, and others have taken or

proposed to improve the management, disclosure, and regulatory

oversight of derivatives risk are consistent with GAO’s 1994 report

recommendations. However, many of the concerns expressed in GAO’s

1994 report are still valid; it is too soon to determine the effectiveness of

many of the actions taken or proposed to date; and some of GAO’s

recommendations have yet to be fully implemented.

Principal Findings

Weaknesses in

Corporate

Governance and

Internal Controls

Contributed to Major

Losses

Given the risks associated with derivative products, weaknesses in

corporate governance systems and inattention to the importance of

effective internal controls can leave major derivatives end-users and

dealers particularly vulnerable to significant losses. During 1994 and 1995,

a number of entities sustained major losses associated with derivatives

and related financial products that were attributed largely to flawed

corporate governance systems that did not establish effective

risk-management and internal controls. In some cases the losses were so

severe that the entities filed for bankruptcy or failed. For example, in

December 1994, Orange County, California, filed for bankruptcy after

losing an estimated $1.7 billion on the county Treasurer’s large and highly

leveraged investments. After the bankruptcy filing, reports by auditors and

others indicated that the county’s Board of Supervisors failed to act on its

responsibilities. The losses reportedly occurred in an atmosphere of

inadequate risk management and poor supervision of the county

Treasurer’s investment strategies. Other reports raised concerns about the

county’s reliance on investment income to fund a significant portion of the

Page 8 GAO/GGD/AIMD-97-8 Financial Derivatives
Executive Summary

budget and warned that it was not fiscally responsible to continue

budgeting in this manner.

Similarly, in February 1995, Barings failed as a result of over $1 billion in

futures and options trading losses incurred by one of its employees.

According to the British Board of Banking Supervision Inquiry, Barings’

management failed at various levels to institute a proper system of internal

controls; to enforce accountability for all profits, risks, and operations;

and to adequately follow up on a number of warning signals over a

prolonged period. Of the many internal control weaknesses cited, one of

the most basic inadequacies was the employee’s responsibility for both

initiating and recording trades on the bank’s books. This control weakness

allowed him to hide losses and continue trading until those losses

exceeded the bank’s capital. This control weakness had been reported by

the bank’s internal auditors, but Barings’ management took no action and

did not follow up on the internal audit reports’ findings.

Industry surveys, which GAO did not verify, show that some market

participants have reported making improvements in their corporate

governance systems and internal controls over derivatives. According to a

follow-up survey of derivatives dealers and end-users conducted by the

Group of Thirty in 1994, more dealers and end-users are including their

directors and senior managers in risk-management decisions.7

 Other

market participants, however, have indicated in different surveys that

firms using derivatives are not involving their boards of directors in

derivatives risk management. Adherence to any set of recommended or

benchmark derivatives risk-management practices is essentially voluntary,

except for regulated entities such as banks, and this is reflected in the

mixed results of the surveys.

Formal assessments of internal controls similar to those required of large

U.S. banks and thrifts under the Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA) can provide a model for improving

corporate governance and internal controls.8

 Five securities firms that

have major OTC derivatives dealer affiliates voluntarily provide SEC these

types of assessments. However, SEC’s general approach has been to focus

on providing enhanced accounting for and disclosure of market risk

7

The Group of Thirty is an international financial policy organization whose members include

representatives of central banks, international banks and securities firms, and academia.

8

FDICIA requires (1) management of large banks and thrifts to perform annual, comprehensive

assessments of financial institutions’ systems of internal controls over financial reporting; (2) the

institutions’ independent external auditor to review management’s assessment; and (3) management to

report the results of these assessments to federal regulators.

Page 9 GAO/GGD/AIMD-97-8 Financial Derivatives
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inherent in derivative products. SEC has proposed requiring additional

public disclosures regarding dealer and end-user risk exposures,

objectives, general strategies, and instruments specifically used to manage

risks. These proposed disclosures, however, may not provide sufficient

assurance that appropriate risk management policies are in fact being

followed. Without denying the importance of internal controls over

activities involving financial instruments and assurances that these

controls are working, SEC has stated that its focus on additional market

risk information may be a more appropriate priority at this time. GAO

continues to believe that periodic assessments of internal controls,

accompanied by public reporting on the results of those assessments,

would make boards of directors and senior managers more accountable to

shareholders, regulators, and the general public about the effectiveness of

the system of controls and, thereby, help to prevent large losses.

Federal Bank

Regulators Have

Acted to Improve

Derivatives Oversight

Federal bank regulators have taken several steps to improve their

oversight of U.S. banks’ derivatives activities that are consistent with GAO’s

prior recommendations. As required by FDICIA, bank regulators

strengthened their risk-based capital standards by incorporating

concentration of credit risk, risk of nontraditional activities, and interest

rate risk. In September 1996, final rules were issued that would also

incorporate market risk into bank capital standards. Banks deemed to

have inadequate controls for these risks may be required to hold capital

above the minimum requirements. In addition, federal bank regulators

have expanded bank reporting requirements designed to better enable

them to monitor and oversee banks’ derivatives activities. For example,

banks are now required to report separately the notional/contract amounts

for their OTC and exchange-traded derivatives contracts, and certain banks

must report information on revenues from their trading activities. Federal

bank regulators, however, disagreed with GAO’s recommendation that they

collect information on the concentration of counterparty credit exposures

for those banks that are major OTC derivatives dealers. They said that this

information is available through their ongoing monitoring and surveillance

activities and changes too frequently to be useful if collected periodically.

GAO continues to believe that such information would enable regulators to

identify credit concentrations across the industry and manage potential

threats to the financial system that could arise if counterparties were to

fail or experience financial difficulties.

In addition to improving bank capital standards and reporting

requirements, federal bank regulators have also implemented new

Page 10 GAO/GGD/AIMD-97-8 Financial Derivatives
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procedures to better focus their examination activities on specific risks

and on the way banks manage these risks. For example, the Office of the

Comptroller of the Currency has begun implementing a risk-based

approach to supervising certain large national banks. This new

supervisory approach revolves around nine categories of risk and is

designed to determine how well these banks measure, monitor, and

manage those risks. In addition, GAO reviewed a total of 12 bank

examination reports for the period 1992 to 1994 for the 7 largest U.S. bank

derivatives dealers and found improvements in the way federal examiners

reviewed these banks’ derivatives risks.

SEC and CFTC Have

Worked to Address

Regulatory Gaps

Since 1994, CFTC has implemented risk-assessment rules that are generally

equivalent to the risk-assessment rules SEC implemented in 1992. These

rules give CFTC and SEC access to information about the activities of OTC

derivatives dealers that are unregulated affiliates of registered futures

commission merchants and registered broker-dealers, respectively.

Further, SEC initiated the Derivatives Policy Group (DPG), comprising the

six U.S. broker-dealers with the highest volume OTC derivatives affiliates

and worked with this group, in cooperation with CFTC, to develop a

voluntary framework for oversight of broker-dealers’ unregulated OTC

derivatives activities.9

The DPG framework explicitly addressed some of GAO’s concerns about the

lack of federal oversight of these large, nonbank OTC derivatives dealers.

Specifically, the DPG members volunteered to abide by internal control

guidance they, SEC, and CFTC agreed would enhance their risk management

practices. Five of the six members also agreed to have their external

auditors provide reports to SEC and CFTC on their compliance with the

internal control guidance and to provide additional information to SEC and

CFTC about the OTC derivatives activities of their unregulated affiliates.

Accordingly, since the first quarter of 1995, SEC and CFTC have received

quarterly information from each of the five DPG members on their OTC

derivatives affiliates’ trading revenues, individual counterparty exposures,

credit concentrations, and estimated amounts of capital at risk. Although

the DPG framework was not intended to serve as a means of imposing

capital standards, the information provided to SEC and CFTC gives

regulators a basis for assessing the adequacy of capital.

9

The six DPG members are CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan

Stanley, and Salomon Brothers. While CS First Boston is a DPG member, it has an OTC derivatives

affiliate that reports to, and is regulated by, the Bank of England. Therefore, it does not report

information to SEC or CFTC.

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Although the DPG framework is a positive step toward having some federal

oversight of the large, OTC derivatives dealers that are affiliates of

securities firms, compliance with it is voluntary and has been limited to

the six DPG member firms. Furthermore, neither SEC nor CFTC has the

explicit authority to enforce operational changes, conduct examinations,

or impose capital requirements on the unregistered OTC derivatives

affiliates of broker-dealers and futures commission merchants.

A regulatory gap remains for the three insurance companies that are OTC

derivatives dealers. While the National Association of Insurance

Commissioners has recommended improvements in derivatives

disclosures and examinations for insurance companies, these

recommendations do not apply to the activities of the OTC derivatives

dealer affiliates of insurance companies.

Accounting Issues

Continue To Be of

Concern

Accounting standards for derivatives continue to be insufficient, thus

inhibiting the quality of information reported in derivatives end-users’

financial statements. Required financial statement disclosures about

derivatives, while improved, are not adequate to make up for the lack of

standards governing how derivatives transactions are to be recorded in

end-users’ financial statements. GAO’s review of 12 banks and thrifts that

were end-users of derivatives indicated that over half of these institutions

were using deferral hedge accounting for risk-adjusting activities based on

anticipated market movements. The deferral hedge accounting practices

used by these institutions allowed them to delay recognizing gains or

losses on these derivatives transactions. GAO believes that deferral hedge

accounting should be limited to activities intended to decrease an entity’s

exposure to risk of loss and should not be applied to derivatives activity

that attempts to profit from or speculate on market movements.

GAO also found that a similar problem existed with accounting for

investment securities, particularly structured notes and CMOs. The use of

historical cost accounting for these securities has allowed some

investment managers to hide losses in the market value of the securities

and, in some cases, to mask the resulting weakened financial condition of

an entity.

GAO believes that the solution to the accounting problems of both

derivatives and investment securities lies in the adoption of

comprehensive market value accounting. Comprehensive market value

accounting would require that all changes in market values of derivatives,

Page 12 GAO/GGD/AIMD-97-8 Financial Derivatives
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investment securities, and other financial instruments be recorded in

income when they occur, thus advising financial statement users of such

changes. GAO recognizes, however, that implementing a comprehensive

market value accounting model presents difficult issues, such as

determining appropriate values for instruments that are not regularly

traded. These issues have generated considerable opposition to this

method of accounting and would have to be considered and addressed

before comprehensive market value accounting could be adopted.

In March 1996, the Governmental Accounting Standards Board (GASB)

issued a proposed standard that would require all investment securities to

be carried at fair value.10 This proposed standard, if adopted, would

resolve many of GAO’s concerns about state and local governmental

entities’ accounting for investment securities. However, the proposed

standard does not address accounting for off-balance sheet derivatives,

which are gaining greater use by state and local governmental entities. In

addition, it does not require disclosure of market risk in the entities’

financial statements.

In June 1996, FASB issued a proposed standard that would require all

derivatives, including structured notes and CMOs, to be recorded at fair

value on the balance sheet. The related changes in fair value would be

recognized in earnings or a component of equity, depending on the

designated reason for holding derivatives. In cases where derivatives were

used to hedge existing assets or liabilities, the offsetting gains or losses in

fair value of the assets or liabilities would be accelerated and recognized

in earnings in the same period. This proposed standard helps address GAO’s

concerns about the use of deferral hedge accounting for derivatives

activities that do not reduce an entity’s exposure to risk of loss and about

the use of historical cost accounting for investment securities with

derivatives-like characteristics. However, because the proposed standard

does not provide for market (or fair) value accounting for all financial

instruments, it would not resolve issues related to continued use of

historical cost accounting for many investment securities and other

financial instruments. In addition, because it would require a matching of

derivatives transactions with underlying assets or liabilities, the proposed

standard has raised concerns among those who use derivatives to hedge

on a portfolio-wide, or macro, basis that such hedging activity will not be

easily accommodated.

10GASB establishes accounting standards for state and local governments.

Page 13 GAO/GGD/AIMD-97-8 Financial Derivatives
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While FASB’s proposed standard includes enhanced disclosure

requirements, it, like GASB’s proposed standard, does not include required

disclosures that quantify market risk from derivatives and other

investment activities. SEC issued proposed disclosure requirements in

December 1995 that would include market risk disclosures. However,

these proposed requirements, if adopted, would be required only for

public companies.

While FASB’s and GASB’s proposed standards are a step in the right

direction, comprehensive market value accounting for all financial

instruments would provide a more viable method to address the issues

regarding accounting for financial instruments—including those raised by

macrohedgers. Because stemming inappropriate accounting practices is

needed now, FASB’s current proposed standard would provide an interim

solution until the issues surrounding adoption of a comprehensive market

value accounting approach can be addressed. In addition, SEC’s proposed

disclosure requirements would help bolster this interim solution by

requiring disclosure of market risk and other useful information. The SEC,

GASB, and FASB proposals are controversial, and therefore the final

outcome of these proposals is uncertain.

Progress Is Being

Made Internationally

Like their U.S. regulatory counterparts, financial regulators in the six

foreign countries GAO reviewed used a number of different approaches

intended to enhance their oversight of derivatives activities. As GAO

recommended in 1994, U.S. regulators have increased their efforts to work

cooperatively with foreign regulators to better harmonize international

regulatory standards. For example, in July 1994, the Basle Committee on

Banking Supervision and IOSCO for the first time concurrently issued

guidance to banking and securities regulators worldwide on sound risk

management of derivatives activities. U.S. and foreign bank regulators,

working through the Basle Committee on Banking Supervision, have also

expanded their risk-based capital standards for derivatives. SEC and CFTC

have participated in IOSCO working groups discussing capital standards

internationally and how to improve regulatory coordination. They have

also entered into agreements with foreign regulators to share information

and conduct joint examinations of international firms.

Further, the Barings failure motivated CFTC and the British Securities and

Investments Board to host a meeting of 16 regulatory authorities

responsible for supervising the world’s major futures and options

Page 14 GAO/GGD/AIMD-97-8 Financial Derivatives
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markets.11 The May 1995 meeting resulted in the Windsor Declaration,

which proposed that regulatory authorities take steps to improve their

coordination and communication. Information sharing agreements were

signed nearly a year later in March 1996, with exchanges and clearing

organizations signing one agreement and regulators signing a separate,

companion agreement. However, some countries could not participate

because of legal restrictions, which they are trying to overcome. Further,

confidentiality concerns may limit the effectiveness of the agreements for

exchanges in some countries. The success of regulators’ attempts to

overcome these concerns through their companion agreement depends on

the willingness of exchanges to go to their regulator to get the needed

information to the appropriate parties.

Recommendations A number of actions have been taken or proposed since 1994 that are

consistent with the recommendations that GAO made in its 1994 report.

However, GAO notes that its key recommendations to improve corporate

governance and internal controls for major derivatives dealers and

end-users, close regulatory gaps, establish comprehensive and consistent

accounting standards, and harmonize regulatory and accounting standards

internationally have yet to be fully implemented. While GAO is making no

new recommendations in this report, it believes that regulators,

accounting standards-setters, and others need to continue to take actions

necessary to completely respond to the intent of its prior

recommendations.

Agency Comments GAO requested comments on a draft of this report from the Chairman,

Securities and Exchange Commission; Chairperson, Commodity Futures

Trading Commission; Chairman, Board of Governors of the Federal

Reserve System; the Comptroller of the Currency; the Chairman, Financial

Accounting Standards Board; and the Chairman, Governmental

Accounting Standards Board. GAO met with representatives of each of the

federal regulators who gave us technical comments on the draft report.

Where appropriate, GAO incorporated these comments in the report. GAO

discussed the draft report with a FASB staff member who provided

technical comments. We also received technical comments from GASB

staff. FASB and GASB staff comments were incorporated where appropriate

in the report.

11Regulatory authorities from the following countries participated in the meeting: Australia, Brazil,

Canada, France, Germany, Hong Kong, Italy, Japan, the Netherlands, Singapore, South Africa, Spain,

Sweden, Switzerland, the United Kingdom, and the United States.

Page 15 GAO/GGD/AIMD-97-8 Financial Derivatives
Contents

Letter 1

Executive Summary 3

Chapter 1 

Introduction

22

Background 22

Structured Notes and Mortgage-Backed Securities 24

Volume of Derivatives Activity 26

Regulatory Framework 28

Accounting Standards Setting 31

Legislative Activity Since Our 1994 Report 31

Objectives, Scope, and Methodology 32

Agency Comments 36

Chapter 2 

Strong Corporate

Governance Is Critical

to Managing

Derivatives Risks

39

Corporate Governance Weaknesses Contributed to Losses 40

Internal Control Guidance Is Consistent With FDICIA Objectives

but Is Primarily Voluntary

44

Institutions’ Systems of Controls Were Generally Designed to

Include Key Controls

46

Industry Surveys Indicate Some Progress on Internal Controls 47

SEC Is Continuing to Look at Issues Related to Our May 1994

Recommendation

49

Conclusions 51

Chapter 3 

Bank Regulatory

Oversight Continues

to Improve

53

Risk-Based Capital Standards Were Expanded 53

Bank Regulators Have Expanded Regulatory Reporting

Requirements

58

Bank Regulators Have Improved Their Oversight 60

The Federal Reserve Took a Derivatives-Related Enforcement

Action

67

Conclusions 67

Page 16 GAO/GGD/AIMD-97-8 Financial Derivatives
Contents

Chapter 4 

SEC and CFTC OTC

Derivatives Oversight

Has Improved, but

Insurance Regulators’

Oversight Remains

Unchanged

70

CFTC Implemented Risk-Assessment Rules 70

The DPG Framework Provides for Voluntary Oversight 71

SEC and CFTC Continued Efforts to Revise Capital Standards 76

SEC and CFTC Took Enforcement Actions Against Dealer and

End-User Activities

77

State Insurance Regulatory Oversight Remains Unchanged 80

Conclusions 81

Chapter 5 

Accounting and

Disclosure Issues

Continue to Be of

Concern

85

Hedging Practices of Banks and Thrifts Varied Considerably and

Were Sometimes Speculative

85

Accounting Practices for Investment Securities With

Derivatives-Like Characteristics Resulted in Delayed Recognition

of Losses

88

FASB’s Proposed Standard Is a Positive Step Toward Addressing

Problems in Accounting for Derivatives and Similar Instruments

90

Some Improvements Made in Derivatives Disclosures, but

Enhancements Are Needed

97

GASB Proposed Standard Addresses Accounting for Investments 102

Conclusions 105

Chapter 6 

Efforts to Improve

International

Coordination

Continue

106

International Coordination Efforts Have Continued 106

Derivatives Regulation Continued to Vary Globally 112

Barings’ Failure Illustrated the Importance of International

Coordination and Sparked Coordination Efforts

116

Conclusions 119

Appendix I 

Flawed Corporate

Governance Systems

Contributed to

Significant Losses

120

Bankers Trust and Its Client, Gibson Greetings 120

Orange County, CA 122

Capital Corporate Federal Credit Union 125

Barings PLC 126

Page 17 GAO/GGD/AIMD-97-8 Financial Derivatives
Contents

Appendix II 

Results of GAO

Review of Key

Internal Controls at 12

Banks and Thrifts

128

Appendix III 

Prototype Guidelines

for Roles and

Responsibilities of

Boards of Directors

131

Appendix IV 

Prototype Report on

Internal Controls Over

Derivatives and

Related

Risk-Management

Activities

133

Appendix V 

Quantitative

Standards for Market

Risk Amendment

135

Page 18 GAO/GGD/AIMD-97-8 Financial Derivatives
Contents

Appendix VI 

Current Accounting

and Disclosure

Standards for

Derivatives and

Related Financial

Instruments

137

Accounting Requirements 137

Disclosure Requirements 139

Other Guidance 140

Appendix VII 

Derivatives Activities

of 12 Banks and

Thrifts

143

Extent and Use of Derivatives 143

Hedging Strategies 148

Hedge Criteria 152

Appendix VIII 

Voluntary Disclosure

of the 15 Major U.S.

Derivatives Dealers in

1994 Annual Reports

156

Appendix IX 

Description of FASB’s

Proposed Standard

159

Appendix X 

Major Contributors to

This Report

164

Tables Table 1: Definitions of Financial Products 5

Table 1.1. Notional/Contract Amounts of Derivatives Reported by

the 15 Major U.S. OTC Derivatives Dealers Year-End 1990

Through Year-End 1995

27

 Table 6.1: International Changes to Reporting Requirements 113

Page 19 GAO/GGD/AIMD-97-8 Financial Derivatives
Contents

 Table II.1: Summary of Results at 12 End-User Financial

Institutions

130

Table VIII.1: Voluntary Annual Report Disclosure 157

Figures Figure 1.1: Percent Changes in Derivatives Volume Reported by

15 Major U.S. OTC Derivatives Dealers, Year-End 1990 Through

Year-End 1995

28

Figure 5.1: SEC-Requested Disclosures 100

Figure VII.1: Notional/Contract Amount of Derivatives Held by

Purpose of Activity, as of December 31, 1993

144

Figure VII.2: Notional/Contract Amounts of Interest and Foreign

Exchange Rate Derivatives, as of December 31, 1993

145

Figure VII.3: Notional/Contract Amount of Derivatives by Type of

Contract, as of December 31, 1993

146

Figure VII.4: Notional/Contract Amount of Hedging Derivatives

by Type of Contract, as of December 31, 1993

147

Page 20 GAO/GGD/AIMD-97-8 Financial Derivatives
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Abbreviations

AFS available-for-sale

AICPA American Institute of Certified Public Accountants

BIS Bank for International Settlements

CAD Capital Adequacy Directive

CFTC Commodity Futures Trading Commission

CMO collateralized mortgage obligation

COFI Cost of Funds Index

COSO Committee of Sponsoring Organizations of the Treadway

Commission

DPG Derivatives Policy Group

EITF Emerging Issues Task Force

EU European Union

FASB Financial Accounting Standards Board

FCM futures commission merchant

FDIC Federal Deposit Insurance Corporation

FDICIA Federal Deposit Insurance Corporation Improvement Act of

1991

FFIEC Federal Financial Institutions Examination Council

FIA Futures Industry Association

GASB Governmental Accounting Standards Board

GSE government-sponsored enterprise

IASC International Accounting Standards Committee

IOSCO International Organization of Securities Commissions

ISDA International Swaps and Derivatives Association

LIBOR London Interbank Offered Rate

MGFI MG Futures, Inc.

MGR&M MG Refining and Marketing

NAIC National Association of Insurance Commissioners

OCC Office of the Comptroller of the Currency

OTC over-the-counter

OTS Office of Thrift Supervision

SEC Securities and Exchange Commission

SFA Securities and Futures Authority Ltd.

SFAS Statements of Financial Accounting Standards

Page 21 GAO/GGD/AIMD-97-8 Financial Derivatives
Chapter 1 

Introduction

Over the past 2 years much attention has been focused on derivative

products, most of which has centered on the well-publicized

multibillion-dollar losses suffered during this period by major commercial

corporations, banks, and local governments. Despite the losses,

derivatives use has continued to grow rapidly, reaching about $55.7 trillion

outstanding worldwide by 1995. Although they can be complex, derivatives

provide effective ways to manage financial risks, generate profits, and

lower financing costs, and the vast majority of the firms using derivatives

did so without reporting major unanticipated losses.

The losses attributed to derivatives in 1994 and 1995 focused regulators’

and market participants’ attention on the importance of sound derivatives

risk-management and internal control systems. Some of the losses showed

that understanding the risks in how profits are generated can be as

important as determining why losses occurred. As pointed out in our

May 1994 report, the risks that derivatives pose are not new or unique, but

certain derivatives can be more complex and volatile than other financial

instruments. The associated risks can be difficult to identify, measure,

monitor, and manage. For example, they may contain potential leverage,

or leverage multipliers, that can greatly increase an investor’s gains or

losses.

Background Derivatives are globally used financial products that essentially unbundle

and transfer risks from entities less able or willing to manage them to

those more willing or able to do so. The general types of risk associated

with derivatives—credit, market, legal, and operations—exist for many

financial activities. The values of derivatives are based on, or derived from,

the value of an underlying asset, reference rate, or index—called the

underlying. Common types of underlying assets are stocks, bonds, and

physical commodities, such as wheat, oil, and lumber. An example of an

underlying reference rate is the interest rate on the 3-month U.S. Treasury

bill. An example of an underlying index is the Standard & Poor’s 500 Index,

which measures the performance of 500 common stocks.

Derivatives include customized and standardized contracts. Some

derivatives are customized contracts between parties (also called

counterparties) that include one or more negotiated terms in addition to

price. Negotiated terms can include the quality and quantity of the

underlying, time and place of delivery, and method of payment. Other

derivatives are standardized contracts whose terms are fixed—except for

price, which the market determines. Derivatives can be privately

Page 22 GAO/GGD/AIMD-97-8 Financial Derivatives
Chapter 1 

Introduction

negotiated by the parties; these are called over-the-counter (OTC)

derivatives. Derivatives also can be traded through central locations,

called organized exchanges, where buyers and sellers or their

representatives meet to determine derivatives prices; these are called

exchange-traded derivatives.

Derivative products include forwards, futures, options, and swaps.

Forwards, futures, and options are typically used to hedge or to speculate.

Swaps are typically used to hedge or to obtain more desirable financing.

All derivative products can be combined to create more complex

derivatives, called hybrid derivatives. Forwards and futures are contracts

that obligate the holder to buy or sell a specific underlying at a specified

price, quantity, and date in the future. Forwards are commercial, private

contracts for the delivery of a commodity where delivery is deferred for

convenience. Futures are usually standardized contracts traded on

organized exchanges. Option contracts, which can be either customized

and privately negotiated or standardized, give the purchaser the right to

buy (call option) or sell (put option) a specified quantity of a commodity

or financial asset at a particular price (the exercise price) on or before a

certain future date.1

 Swaps are generally OTC agreements between

counterparties to make periodic payments to each other for a stated time.

Some swaps are now exchange traded.

Derivatives market participants include end-users and dealers. End-users

include banks, securities firms, insurance companies, governments,

mutual and pension funds, and commercial entities worldwide. Certain

institutions that use derivatives also act as dealers by quoting prices to,

buying derivatives from, and selling derivatives to end-users and other

dealers. They also develop customized derivative products for their

clients.

Market participants can use derivatives to protect against adverse changes

in the values of assets or liabilities, called hedging. Hedgers try to protect

themselves from market risk, which is the exposure to financial loss

caused by adverse changes in the values of assets or liabilities. They

protect themselves by entering into derivatives transactions whose values

are expected to change in the opposite direction as the values of their

assets or liabilities. For example, a hedger can protect asset values

through derivatives transactions that increase in value as the asset values

1

This is the definition of an American-style option. A European-style option can be exercised only on

its expiration date.

Page 23 GAO/GGD/AIMD-97-8 Financial Derivatives
Chapter 1 

Introduction

decline. The increases in value of the derivatives contracts (profits) will

offset, or hedge, the decrease in values of the assets (losses).

In contrast, market participants can also use derivatives to take on risk in

an attempt to profit from changes in the values of derivatives or their

underlyings, called speculating. Rather than purchasing the underlying,

speculators can use derivatives to attempt to profit by anticipating

movements in market rates and prices. As speculators enter into

transactions with hedgers and other speculators, they provide liquidity to

the derivatives markets, thereby helping to ensure that high volumes of

trading can occur without significantly affecting prices.

Derivatives can be more cost-effective for market participants than

transactions in the underlying cash markets because of the reduced

transaction costs and the leverage that derivatives provide. For example,

instead of buying or selling $100,000 worth of U.S. Treasury bonds, a

market participant can realize the benefits of buying or selling the same

amount of bonds by using a derivatives contract and posting a deposit,

called a margin, of only about $1,500, or 1.5 percent of the face amount of

the bonds. Likewise, a market participant can achieve a result similar to

buying or selling all of the stocks in the Standard & Poor’s 500 Index by

buying or selling a derivatives contract on this index for as little as 5 to

10 percent of the cost of the underlying stocks.

Structured Notes and

Mortgage-Backed

Securities

Some of the losses attributed to derivatives have involved either

structured notes or a specific type of mortgage-backed security called a

collateralized mortgage obligation (CMO). These financial products have

characteristics and risks similar to derivatives. We include them in our

discussion of losses but focus on the four traditional types of

derivatives—forwards, futures, options, and swaps—when we discuss

derivatives and derivatives oversight throughout the report, unless

otherwise indicated.

Structured notes are debt securities. Their cash flows, which resemble

those of derivatives, depend on one or more indexes, and they may have

added features such as embedded options. Structured notes are treated

similarly to derivatives by banking regulators. Indexes that typically are

used to determine the cash flows associated with structured notes include

Page 24 GAO/GGD/AIMD-97-8 Financial Derivatives
Chapter 1 

Introduction

the Federal Funds Rate, the London Interbank Offered Rate (LIBOR),2 and

the Cost of Funds Index.3

 Some common types of structured notes are

• range bonds that pay investors on the basis of whether a reference rate is

between levels of a specific index established at issue,

• index amortizing notes that pay investors on the basis of a predetermined

amortization schedule linked to the level of a specific index,

• inverse floaters that have coupon rates that increase as interest rates

decline and decrease as rates rise, and

• dual index notes that have coupon rates determined by the difference

between two market indexes.

In addition, some analysts consider step-up bonds to be structured notes.

The investor in these bonds is paid at an above-market yield for Treasury

securities for a short noncall period, and then, if not called, the coupon

rate steps up to a higher rate.4

Investors in structured notes that are issued by U.S.

government-sponsored enterprises (GSE) perceive little, if any, credit risk

because of investors’ perception of implied U.S. government backing.5

 The

investor, however, is exposed to market risks.

Mortgage-backed securities are financial products whose payments are

derived from a pool of home mortgages. CMOs are one of the most common

types of multiclass mortgage-backed securities.6

 By repackaging the

mortgage payments, issuers of multiclass mortgage-backed securities can

create securities that are customized regarding yield, risk, and maturities.

For example, payments to investors can be separated into principal-only

and interest-only securities that can be sold separately. The values of these

securities are sensitive to mortgage prepayment rates driven largely by

changing interest rates. That is, if interest rates decline, mortgagors are

2

LIBOR is the rate that banks charge each other for loans of Eurodollars in the London money market.

3

The Cost of Funds Index refers to an index for the 11th District of the Federal Home Loan Bank of

San Francisco. It reflects the actual interest expenses incurred during a given month by all savings

institutions headquartered in Arizona, California, and Nevada.

4

The issuer of these bonds specifies when the bond can be repaid, or called.

5

GSEs are privately owned financial corporations that were chartered by Congress to achieve the

public purpose of facilitating the flow of credit to certain sectors of the economy, such as housing,

agriculture, and higher education. Major GSEs include the Federal National Mortgage Association, the

Federal Home Loan Mortgage Corporation, the Federal Home Loan Bank System, the Farm Credit

System, and the Student Loan Marketing Association. The GSE issuing the structured note typically

enters into a swap to eliminate its exposure to the customized terms of the note.

6

Real Estate Mortgage Investment Conduits and CMOs are interchangeable terms.

Page 25 GAO/GGD/AIMD-97-8 Financial Derivatives
Chapter 1 

Introduction

more likely to prepay their mortgages. These prepayments accelerate the

payment of principal-only securities and reduce payments of interest-only

securities. Some classes of CMOs and interest-only and principal-only

securities are more risky than other classes, because their payments can

be especially sensitive to prepayment rates.

Multiclass mortgage-backed securities issuance is dominated by two GSEs:

the Federal National Mortgage Association, also called Fannie Mae, and

the Federal Home Loan Mortgage Corporation, also called Freddie Mac.

These securities are also issued by non-GSE conduits that securitize

mortgages not qualified for purchase by Fannie Mae and Freddie Mac.7

Volume of Derivatives

Activity

In 1996, the Bank for International Settlements (BIS) reported the results of

a comprehensive derivatives survey by the central banks of 26 countries.8

That survey estimated that total notional/contract amounts of derivatives

contracts outstanding worldwide were about $55.7 trillion as of the end of

March 1995.9

 About $47.5 trillion of this amount were OTC contracts and

$8.2 trillion were exchange-traded contracts.10 Although notional/contract

amounts are indicators of volume, gross market values, or replacement

costs, provide a more accurate measure of the economic significance of

the derivatives contracts outstanding.11 BIS reported the gross market

values of the OTC derivatives as being $2.2 trillion, or about 4.6 percent of

the notional/contract amounts. To our knowledge, directly comparable

data for structured notes and CMOs do not exist. The best available data

show the amounts of these products issued by U.S. GSEs each year. These

data indicate that the total amounts of these products issued in calendar

7

For a discussion of Fannie Mae and Freddie Mac, see Housing Enterprises: Potential Impacts of

Saving Government Sponsorship GAO/GGD-196-120, May 13, 1996).

8

BIS was established in 1930 in Basle, Switzerland, by European central banks. The objectives of BIS

are to promote the cooperation of central banks, to provide additional facilities for international

operations, and to act as trustee for international financial settlements. BIS also provides secretariats

for various committees. BIS coordinated the survey and aggregated the data to produce global market

statistics.

9

The notional, or principal, amount of derivatives contracts is one way that derivatives activity is

measured. However, it is not a necessarily meaningful measure of the actual risk involved. The actual

amount at risk for many derivatives varies by both the type of product and the type of risk being

measured.

10The amount for OTC contracts was adjusted for local and cross-border double counting. The amount

for exchange-traded-contracts was halved to adjust approximately for double counting.

11BIS defines gross market value as the cost that would have been incurred if the outstanding contracts

had been replaced at market prices prevailing as of March 31, 1995. It equals gross positive plus gross

negative market values.

Page 26 GAO/GGD/AIMD-97-8 Financial Derivatives
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year 1995 were about $10 billion for structured notes and about $23 billion

for CMOs.

Table 1.1 shows derivatives volumes from the annual reports of the 15

major U.S. OTC derivatives dealers we identified.12 These volumes

increased every year. Among the dealers we identified, bank dealers

dominate total derivatives volume, accounting for about 69 percent each

year since 1990; securities firms accounted for about 27 percent and

insurance companies the remaining 4 percent. The derivatives volumes

reported by insurance company affiliates grew more than the volumes

reported by either banks or securities firms in 4 of the 5 years we

analyzed, from year-end 1990 through year-end 1995. Banks reported the

largest growth in 1994. Figure 1.1 shows the percentage of change in

derivatives volumes for the 15 major U.S. OTC derivatives dealers from

1990 to 1995.

Table 1.1. Notional/Contract Amounts

of Derivatives Reported by the 15

Major U.S. OTC Derivatives Dealers

Year-End 1990 Through Year-End 1995

Dollars in billions

Dealers 1990 1991 1992 1993 1994 1995

Banks (7) $5,350 $5,811 $ 7,574 $10,353 $13,724 $15,809

Securities firms (5) 1,730 2,188 2,967 4,474 5,880 6,966

Insurance companies (3) 193 257 403 634 798 985

Total (15) $7,273 $8,256 $10,944 $15,461 $20,402 $23,760

Note 1: These amounts have not been adjusted for double counting.

Note 2: The 15 major U.S. OTC derivatives dealers are The Chase Manhattan Corporation;

Citicorp; J.P. Morgan & Co., Inc.; Bankers Trust New York Corporation; BankAmerica Corporation;

NationsBank Corporation; First Chicago Corporation; The Goldman Sachs Group, L.P.; Salomon,

Inc.; Merrill Lynch & Co., Inc.; Morgan Stanley Group, Inc.; Lehman Brothers; American

International Group, Inc.; The Prudential Insurance Company of America; and General Re

Corporation.

Source: Annual reports of the 15 dealers.

12They are the same dealers we discussed in our 1994 report, except that Chemical Banking

Corporation and The Chase Manhattan Corporation merged in 1995, and NationsBank Corporation

joined the ranks of the top seven bank dealers.

Page 27 GAO/GGD/AIMD-97-8 Financial Derivatives
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Figure 1.1: Percent Changes in

Derivatives Volume Reported by 15

Major U.S. OTC Derivatives Dealers,

Year-End 1990 Through Year-End 1995

Percent change

0

10

20

30

40

50

1990-1991

1991-1992

1992-1993

1993-1994

1994-1995

Changes in notional/contract amounts

Source: Annual reports of the 15 dealers.

Regulatory

Framework

Derivatives dealers and end-user financial institutions may be regulated by

federal bank regulators, the Securities and Exchange Commission (SEC),

and the Commodity Futures Trading Commission (CFTC), depending on

how the institutions are organized. State insurance departments are

responsible for monitoring the derivatives activities of insurance

companies that are both domiciled and licensed to operate in their

respective states.

Four federal regulators oversee banks and thrifts, some of which are also

subject to state regulatory oversight. The Office of the Comptroller of the

Currency (OCC) oversees banks with national charters. The Federal

Reserve System (Federal Reserve) oversees all bank holding companies

and those banks with state charters that are members of the Federal

Reserve. State-chartered banks that are not Federal Reserve members are

subject to the oversight of the Federal Deposit Insurance Corporation

(FDIC) and state banking authorities. The Office of Thrift Supervision (OTS)

oversees federally insured thrifts and thrift holding companies, whether

they are state or federally chartered. The Federal Reserve, the lender of

Page 28 GAO/GGD/AIMD-97-8 Financial Derivatives
Chapter 1 

Introduction

last resort for banks and other financial institutions, has the additional

responsibility of ensuring the overall stability of the U.S. financial system.

FDIC also has some backup responsibilities for all federally insured

depository institutions, even those primarily overseen by the Federal

Reserve, OCC, and OTS.

As part of this oversight responsibility, bank regulators assess bank and

thrift compliance with the Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA). FDICIA requires management of large

banks and thrifts to annually assess and publicly report on the

effectiveness of each institution’s internal control system over financial

reporting. It also requires an independent external auditor to attest to

management’s assertions in a separate report. In addition, FDICIA requires

large institutions to have an audit committee made up of outside directors

who are independent of institution management and to establish a

reporting link between the audit committee and external auditors. For the

largest institutions, FDICIA requires that audit committees include members

with banking or related financial management experience.

SEC regulates activities involving securities and the firms that trade these

products, including broker-dealers, which must register with SEC and

comply with requirements for regulatory reporting, minimum capital, and

examinations. Broker-dealers must also comply with the requirements of

the various exchanges and industry associations of which they are

members, such as the New York Stock Exchange and National Association

of Securities Dealers, which are granted self-regulatory authority under

the Securities Exchange Act of 1934. CFTC regulates activities involving

futures and the firms that trade these products, including futures

commission merchants (FCM)—firms that buy and sell contracts as agents

for customers. These firms also must comply with rules imposed by the

various futures exchanges and industry associations, such as the Chicago

Mercantile Exchange and the Chicago Board of Trade, as well as the

National Futures Association, all of which act as self-regulatory

organizations under the Commodity Exchange Act. For the most part,

neither SEC nor CFTC directly regulates OTC derivative products or the

dealers of these products unless their trading is conducted in a regulated

entity.

The regulatory approaches of these financial regulators differ. A primary

mission of bank regulators is to promote the safety and soundness of the

financial system and protect the federal deposit insurance funds—the

Page 29 GAO/GGD/AIMD-97-8 Financial Derivatives
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Bank Insurance Fund and the Savings Association Insurance Fund.13 They

address this goal through various actions, including establishing capital

requirements, establishing information reporting requirements, conducting

periodic examinations, and issuing enforcement actions. SEC’s and CFTC’s

primary purposes are to protect investors or customers in the public

securities and futures markets and to maintain fair and orderly markets.

Unlike bank regulators, who can regulate all bank activities, SEC and CFTC

are authorized to regulate only activities involving securities and futures

and only those firms that trade these products. To the extent OTC

derivatives are not securities or futures, neither agency directly regulates

those products nor the dealers of those products, unless such trading is

conducted in a regulated entity.

Federal financial regulators share information and ideas through groups

and task forces, such as the President’s Working Group on Financial

Markets.14 Individual agencies also work together on various issues. For

example, the banking regulators coordinate certain activities through the

Federal Financial Institutions Examination Council (FFIEC), which

develops uniform principles, standards, and report forms and coordinates

the development of uniform reporting systems and regulations.

Internationally, U.S. and foreign regulators work together through various

committees, such as the Basle Committee on Banking Supervision, which

develops capital standards and issues various types of guidance for

banks.15 Likewise, SEC and CFTC participate in the International

Organization of Securities Commissions (IOSCO) and their respective staffs

regularly serve on its Technical Committee, which issues reports and

provides guidance on securities regulation.16

13The Bank Insurance Fund and the Savings Association Insurance Fund are funded primarily through

assessments from federally insured banks and thrifts, respectively. Each is administered by FDIC. The

proceeds of these funds are used to compensate depositors, if necessary, should a federally insured

institution fail.

14This working group was originally established by Executive Order of the President on March 18,

1988, in response to the October 1987 market decline. It is chaired by the Secretary of the Treasury and

includes the chairs of the Federal Reserve Board, SEC, and CFTC. In addition, the meetings often

include representatives of other financial regulators, including OCC, OTS, FDIC, and the Federal

Reserve Bank of New York.

15The Basle Committee on Banking Supervision is a committee of banking supervisory authorities that

was established by the Central Bank Governors of the Group of Ten countries in 1975. It meets under

the auspices of BIS in Basle, Switzerland. The Group of Ten consists of 11 major industrialized

member countries—Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,

Switzerland, the United States, and the United Kingdom.

16As of August 1996, IOSCO had 121 member agencies from 73 countries.

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Accounting Standards

Setting

Investors, creditors, regulators, and other users of financial reports

generally depend upon accounting rules to help ensure the consistency

and reliability of information in these reports. The effective functioning of

our economy depends upon financial information that is widely used being

reliable and clearly understood. Such widespread use, understanding, and

confidence in financial statements requires that they be prepared in

conformance with established accounting rules. The Financial Accounting

Standards Board (FASB) establishes standards of financial accounting and

reporting for private sector entities. These standards are referred to as

generally accepted accounting principles and are promulgated through the

issuance of statements of financial accounting standards (SFAS) by FASB.

SFAS are officially regarded as authoritative by SEC and the American

Institute of Certified Public Accountants (AICPA). AICPA, through its

Accounting Standards Executive Committee, issues accounting guidance

on issues not otherwise covered in authoritative literature. SEC has

statutory authority to set accounting principles, but as a matter of policy, it

generally relies on FASB and AICPA to provide leadership in establishing and

improving accounting principles. However, SEC frequently issues

accounting and disclosure regulations to supplement guidance provided

by FASB and AICPA.

The Governmental Accounting Standards Board (GASB) establishes

standards of financial accounting and reporting for state and local

governmental entities. GASB pronouncements are recognized as

authoritative by AICPA.

Legislative Activity

Since Our 1994 Report

Six derivatives-related bills were introduced in Congress in 1994.17 These

bills included proposals to

• regulate derivatives activity and promote uniformity of such regulation;

• require increased disclosure about derivatives activity;

• require that GAO study the speculative uses of derivatives and the

feasibility of imposing taxes and margin requirements on speculative

derivatives activity;

• establish principles and standards related to accounting, customer

suitability, and risk management;

• require derivatives dealers to register with SEC; and

• prohibit depository institutions from using derivatives for speculation.

17Three of the bills predated our May 1994 report: S. 2123, May 17, 1994; H.R. 3748, Jan. 26, 1994; and

H.R. 4170, April 12, 1994. The bills introduced after our report were: S. 2291, July 18, 1994; H.R. 4503,

May 26, 1994; and H.R. 4745, July 13, 1994.

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None of these bills were passed.

As of June 30, 1996, four new derivatives-related bills were introduced.18

These bills included proposals to

• establish a federal derivatives commission to set principles and standards

for the supervision of derivatives activities;

• authorize the Federal Reserve to create a self-regulatory organization

whose members would include derivatives dealers not under the direct

regulation of SEC or CFTC;

• require regulatory agencies to jointly establish principles and standards

relating to capital, accounting, disclosure, customer suitability, and risk

management;

• require financial institutions to have a management plan that ensures

appropriate management oversight;

• establish prudent standards for managing risk and provide a framework

for internal controls;

• require that all derivatives dealers register and be subject to SEC

regulation; and

• prohibit depository institutions and credit unions from engaging in certain

derivatives activities.

As of July 1996, all four of the bills had been referred to committee with no

further action taken.

Objectives, Scope,

and Methodology

Our May 1994 report on derivatives identified the need for

(1) strengthened corporate governance and internal controls for

derivatives dealers and major end-users, (2) improved regulation of major

U.S. derivatives dealers, (3) comprehensive federal oversight of major U.S.

derivatives dealers that are unregulated affiliates of securities firms and

insurance companies, (4) comprehensive and consistent accounting and

disclosure requirements for derivatives, and (5) international

harmonization of regulatory and accounting standards. The objectives of

this follow-up report were to determine what actions have been taken or

proposed to address each of these needs and what still needs to be done,

as well as to analyze the causes of large losses attributed to derivatives

use.

18These bills included H.R. 20, H.R. 31, H.R. 1063, and S. 557.

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To update actions taken or proposed since our May 1994 report, we

reviewed relevant literature and interviewed various regulatory and

industry officials. We contacted selected U.S. and foreign financial

regulators. We reviewed regulatory and industry data and annual reports.

We identified the 15 major U.S. OTC derivatives dealers by using

information on derivatives activities from bank regulators, SEC, the

Securities Industry Association,19 and the dealers’ annual reports (see

table 1.1). These 15 dealers—7 banks, 5 securities firms, and 3 insurance

companies—had the highest levels of derivatives activity in their

respective industries. The seven banks and five securities firms we

focused on had considerably higher levels of derivatives activity than

others in their industry; and the three insurance companies were the only

U.S. insurance companies we could identify as derivatives dealers.

To update information on activities related to corporate governance and

internal controls, we reviewed existing guidance and frameworks issued

by regulators, industry participants, and related parties. We also reviewed

the causes of reported losses involving derivatives, structured notes, and

CMOs for a judgmentally selected sample of corporations, banks, and local

governments. To understand the role corporate governance may have

played in losses involving Bankers Trust and Gibson Greetings; Orange

County, California; Capital Corporate Credit Union (Cap Corp); and

Barings PLC (Barings), we reviewed regulatory examination and

enforcement documents, court documents, and relevant audit, regulatory,

and investigative reports that addressed derivatives use and the reasons

behind the losses. We also discussed these reports and conclusions with

knowledgeable regulatory and industry individuals.

We reviewed key controls relevant to oversight and management of

derivatives at 12 judgmentally selected end-user banks and thrifts.20 To

determine whether key controls had been designed into institutions’

systems, we compared their controls to a list of key internal controls that

all institutions should have in place. We compiled the list of key controls

from various sources, which included bank regulators’ examination

guidance; guidance from AICPA and the Committee of Sponsoring

19The Securities Industry Association is a trade group that represents broker-dealers that account for

about 90 percent of the securities business in North America.

20We selected end-user banks and thrifts that had a minimum of $1 billion in total assets and

notional/contract amounts of derivatives exceeding 25 percent of the amount of total assets. In

addition, we ensured that at least two of the selected institutions were examined by each of the four

bank and thrift regulatory agencies. We specifically excluded the institutions that were reviewed in our

May 1994 report.

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Organizations of the Treadway Commission (COSO);21 and

recommendations from the Group of Thirty (G-30).22 To determine the

internal controls in place at each of the 12 institutions, we reviewed bank

regulatory examination workpapers and discussed controls with

examiners, institution management, and, when possible, internal auditors.

We did not test the controls to determine if they were functioning as

described. We also discussed FDICIA requirements, such as formal internal

control assessments and external auditor attestations, with institution

management to determine their usefulness.

To update information on bank regulators, we reviewed their examination

guidance, examiner training, special studies, and other relevant

documents. Our analysis focused on the Federal Reserve and OCC because

they were the primary regulators of the seven major bank derivatives

dealers. To evaluate the quality and content of bank regulatory

examination activities relative to derivatives, we reviewed a total of 12

bank examination reports from 1992 to 1994 for the 7 largest U.S. bank OTC

derivatives dealers and conducted follow-up interviews with examination

staff. OCC examiners performed 7 of the 12 examinations we reviewed.

Federal Reserve examiners performed the remaining five. As part of our

review, we used bank examination guidance and G-30 recommendations

as criteria to identify the vital elements of an effective risk-management

system. We reviewed examination workpapers and interviewed examiners

to determine whether examiners had evaluated bank compliance for each

element. The focus of our review of the examinations of the seven bank

derivatives dealers was to evaluate the adequacy of the portion of the bank

regulators’ examination process that involved derivatives activities.

To update activities on the oversight of securities firms and insurance

companies with derivatives affiliates, we interviewed SEC and CFTC about

their derivatives oversight activities since 1994. In addition, we contacted

state regulatory officials in Delaware, New Jersey, and New York about

their derivatives oversight activities since our May 1994 report.23 We also

obtained information on industry activities involving derivatives. In

addition, we reviewed derivatives-related enforcement actions taken by

21COSO issued a framework entitled “Internal Control-Integrated Framework” in September 1992 that

has been widely accepted and provides a common basis for assessing the adequacy of internal control

systems.

22The G-30 is an international financial policy organization whose members include representatives of

central banks, international banks, securities firms, and academia.

23In our May 1994 report, we identified three insurance companies that had a major OTC derivatives

dealer affiliate or subsidiary. Those three insurance companies were domiciled in Delaware, New

Jersey, and New York.

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the regulators. We also contacted National Association of Insurance

Commissioners (NAIC) officials about its activities.

To determine what impact, if any, current derivatives accounting

standards had on financial reporting, we reviewed accounting practices at

the 12 selected banks and thrifts. Specifically, we reviewed (1) how they

were using and accounting for derivatives labeled as hedges and (2) what

effect proposed accounting standards might have on their derivatives

activities. We determined the extent and use of derivatives for hedging

purposes at each of the 12 banks and thrifts on the basis of data from their

Consolidated Reports of Condition and Income (call reports) or their

equivalent as of December 31, 1993, and from each institution’s 1993 or

1994 regulatory examination. We reviewed the examination workpapers,

supplemented by discussions with the examiners and institution

management, to understand each institution’s extent and use of

derivatives, the underlying strategies behind derivatives use, and the

accounting methods for these activities. We compared our understanding

with the institutions’ 1993 and 1994 annual report disclosures. We then

used existing accounting standards as a basis to assess the institution’s

accounting treatment of derivatives for hedging purposes. We met with

management at all 12 of the institutions to obtain their opinions and

suggestions on current and proposed accounting and disclosure

requirements and practices. However, we generally did not discuss our

conclusions concerning the institutions’ use of hedge accounting with

management or their external accountants.

To determine the current accounting standards for derivatives, we

reviewed existing and proposed generally accepted accounting principles

and other accounting guidance relevant to derivatives. We also had

discussions with staff from FASB and GASB and reviewed various discussion

papers, correspondence, and memoranda on accounting for derivatives

prepared by FASB staff.

In addition, we analyzed existing and proposed disclosure standards,

including SFAS No. 119 and SEC’s proposal for derivatives disclosures. We

discussed SEC’s disclosure proposal and other issues associated with

accounting for derivatives with SEC’s Chief Accountant. Finally, to

determine the amount of information disclosed about OTC derivatives, we

evaluated the annual report disclosures of a judgmentally selected sample

of 37 banks and thrifts.24 Separately, we analyzed the annual report

24The 37 banks and thrifts include 11 of the 12 banks and thrifts whose derivatives accounting

practices we reviewed and 26 other financial institutions.

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disclosures of the 15 largest OTC derivatives dealers as of December 31,

1994.

To determine the status of progress being made internationally, we

reviewed information issued since 1994 by several international

organizations—the European Union (EU),25 BIS, the Basle Committee on

Banking Supervision, the Euro-currency Standing Committee of the Group

of Ten countries, and the Technical Committee of IOSCO. In addition, to

determine what actions, if any, had been taken since our 1994 report, we

contacted a total of 11 bank and securities regulators in 6

countries—Australia, Germany, Japan, Singapore, Switzerland, and the

United Kingdom.26

We recognize that many of the issues addressed in this report have

broader application to the overall activities of firms. For example, our

discussions of corporate governance, which includes risk management

and internal controls, apply to the entire operations of a corporation.

We did our work between April 1994 and August 1996 in accordance with

generally accepted government auditing standards.

Agency Comments We requested comments on a draft of this report from the Chairman,

Securities and Exchange Commission; Chairperson, Commodity Futures

Trading Commission; Chairman, Board of Governors of the Federal

Reserve System; the Comptroller of the Currency; the Chairman, Financial

Accounting Standards Board; and the Chairman, Governmental

Accounting Standards Board. We met with representatives of each of the

federal regulators who gave us technical comments on the draft report.

Where appropriate, we incorporated these comments in the report. We

met with representatives of both of the boards that set accounting

standards. FASB and GASB representatives gave us technical comments on

the draft report that we incorporated into the report where appropriate.

(For reader convenience, we have included findings and

recommendations from our 1994 report at the beginning of each of

the following chapters.)

25The EU includes Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the

Netherlands, Portugal, Spain, and the United Kingdom. Its purpose is to unite these countries under

one system of rules and regulations in all aspects of trade, including financial markets.

26Commission Bancaire in France did not respond to our requests for updated information.

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Chapter 2 May 1994 Report Summary

Findings Strong corporate governance, which includes competent supervision by

firms’ boards of directors and senior management, can ensure that risk

management and internal control systems are in place and functioning as

anticipated. The audit committees of the boards of directors can provide

oversight of internal and external auditor activity to ensure appropriate

focus and to ensure that management is not overriding internal controls.

Although accountability for controlling the risks associated with

derivatives rests with the boards of directors and senior management,

auditors can play a primary role in testing compliance with

risk-management policies and controls. Management accountability for

internal controls can be enhanced through annual formal assessments and

public reporting on the effectiveness of risk-management policies and

controls. Review by the external auditor can enhance the reliability of

such reports. The likely effect of such assessments and reporting would be

to increase the attention given to derivatives risk management by senior

management and boards of directors.

Until the publication in 1993 of a report sponsored by the G-30, entities

lacked comprehensive guidelines for evaluating their risk-management

practices. That report recommended specific derivatives risk-management

practices as benchmarks for entities’ use. Bank regulators also found some

serious weaknesses in major dealers’ risk-management systems. However,

the 15 major U.S. dealers that we visited described derivatives

risk-management systems that generally conformed with the G-30

recommendations.

No regulation exists to bring all major derivatives dealers into compliance

with the recommendations of the G-30. To help rectify this weakness, we

believed the internal control and audit committee provisions of FDICIA

could be used as a model for strengthening corporate governance systems.

Applying the type of corporate governance provisions included in FDICIA to

all major dealers as well as insured banks would provide needed

safeguards for the public’s interest. In addition, these corporate

governance provisions also are applicable to major end-users of

derivatives.

Recommendations We recommended that SEC ensure that its registrants that are major

end-users of complex derivative products establish and implement

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corporate requirements for independent, knowledgeable audit committees

and public reporting on internal controls. Internal control reporting should

include assessments of controls over derivatives risk-management

systems. We recommended that such reporting should be attested to by

external auditors. We also recommended that the appropriate regulatory

authorities establish comparable requirements for all major derivatives

dealers.

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Since our 1994 report, some dealers and end-users of derivatives and

similar financial instruments reported major financial losses. These

entities all had serious weaknesses in their corporate governance systems.1

Regulators and financial industry groups have responded to these losses,

as well as to recommendations we and others have made, by issuing

guidelines and recommendations for improving risk management and

internal controls—essential elements of strong corporate governance.

Various industry surveys, while mixed, generally indicate that many

derivatives market participants—both dealers and end-users—have

voluntarily improved their risk management and internal control systems.

Although these voluntary actions for improving corporate governance and

controls are valuable, they may not be adopted by all of those who are

vulnerable to the risks associated with derivatives, structured notes, and

CMOs. In addition, we continue to be concerned that favorable market

conditions may mask the need for further improvements and that the

passage of time may lessen the vigilance of entities’ directors and senior

management.

We discussed the internal control assessments and reporting required

under FDICIA with officials from 12 end-user banks and thrifts. They told us

that they generally found the assessments and reports useful in enhancing

internal controls for these institutions. We continue to believe that internal

control assessments and reporting are essential for ensuring that the

directors and senior management of major OTC derivatives dealers and

end-users exercise their fiduciary responsibilities regarding derivatives

and similar financial instruments. SEC has acknowledged that there may be

benefits associated with management or auditor reports on internal

control systems of SEC registrants that are major dealers and end-users of

complex derivative products, as GAO recommended. However, SEC has

stated that it is focusing on accounting for and providing greater

disclosure of market risk for derivative products, which it views as a more

appropriate priority at this time.

1

Governance systems involve the internal functioning of organizations through which economic

activity is conducted. These systems concern transactions and relationships within an organization

itself, including who controls what, who makes decisions, and who has what responsibilities for what

claims against the revenues and assets of a company or government. While this report refers to these

systems as corporate governance, the systems discussed also apply generally to governmental entities.

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Corporate

Governance

Weaknesses

Contributed to Losses

Since our May 1994 report, some financial institutions, commercial

corporations, and local governments have sustained significant losses

attributed to activities involving derivatives, structured notes, and CMOs. A

common factor in each of the losses was a weak corporate governance

system that did not establish, maintain, or monitor effective risk

management and internal controls.

Characteristics of an effective corporate governance system include

• a responsible board of directors that approves policies governing the

nature and extent of derivatives use in the context of an overall

risk-management policy and that provides effective oversight;

• management that properly implements board-approved policies and risk

limits and that establishes controls to ensure that the risks of derivatives

activities are managed in accordance with the board’s authorization;

• qualified personnel and comprehensive systems that match the scope, size,

and complexity of derivatives activities and risks;

• established functions for monitoring activities that are independent of

trading personnel and allow for effective supervision of risks;

• audits that help ensure that approved policies, procedures, and limits

associated with significant risks are effectively implemented, followed,

and not circumvented by management; and

• independent and knowledgeable audit committees that provide effective

oversight of compliance with internal controls related to derivatives

activities.

Although no corporate governance system, however elaborate, can

prevent all losses, the following examples of some of the most publicized

losses from derivatives activities illustrate that the severe losses that

occurred might have been avoided or reduced in severity if the basic

principles of sound internal controls and governance systems had been

followed. These examples are discussed in more detail in appendix I.

The first example involved losses by a major OTC derivatives dealer,

Bankers Trust.2

 According to the Federal Reserve Bank of New York,

Bankers Trust failed to adjust its internal controls in response to a riskier

new line of business, marketing and sales of leveraged derivatives.

Subsequent investigations by the Federal Reserve, SEC, and CFTC found

problems related to this new line of business and failure of the entity’s

management to reasonably supervise individuals involved. Bankers Trust

2

In this report, unless otherwise indicated, Bankers Trust refers to the parent firm, Bankers Trust New

York Corporation, a bank holding company, and two of its wholly owned subsidiaries—Bankers Trust

Company, a bank, and BT Securities Corporation, a securities broker-dealer.

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suffered significant losses because of OTC derivatives when some of its

clients decided not to honor their derivatives obligations and sued

Bankers Trust.

According to the SEC settlement, Gibson Greetings, one of Bankers Trust’s

clients that defaulted on its obligations to Bankers Trust and subsequently

sued it, also lacked appropriate controls over derivatives activities. Several

key Gibson officials did not fully understand either derivatives or the risks

involved in the speculative structure of their investments with Bankers

Trust and were unable to readily determine the value of Gibson’s

derivatives holdings. According to an SEC release, Gibson relied totally on

Bankers Trust to establish values for use in preparing its financial

statements and in periodic reports filed with SEC. As a result, according to

SEC’s release, representatives of Bankers Trust were able to mislead

Gibson about the value of the company’s derivatives positions by

providing values that significantly understated the magnitude of the losses.

An example of significant derivatives losses concerning a local

government occurred in Orange County, California. According to a

California State Auditor’s report, Orange County filed for bankruptcy

when the county Treasurer’s flawed investment strategy, which stressed

yield over liquidity or security, resulted in about $1.7 billion in losses. The

losses reportedly occurred in an atmosphere of inadequate risk

management and poor supervision by the county board. A report by a

committee of the California legislature cited a lack of involvement by the

County Board of Supervisors as one cause of the bankruptcy filing. Other

reports by the County Auditor and an outside consultant identified

numerous internal control weaknesses that may have contributed to the

collapse of Orange County’s investment pool. The outside consultant also

noted that the county’s investment policy did not define a diversification

strategy, establish limits on levels of certain high-risk investments, or

prohibit leveraging of the investment portfolio. In addition, the report

stated that the Treasurer’s office did not periodically report the results,

status, or makeup of the investment portfolio, and periodic reviews of

securities’ market values were not documented and maintained. Because

the County Board of Supervisors and management did not perform their

basic governance responsibilities, they did not deal effectively with the

significant risks of the investment activities being carried out by the

Treasurer. This lack of oversight, combined with the basic control

weaknesses, resulted in unchecked high-risk investment strategies that

proved detrimental to the participants in the Orange County investment

pool.

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Another example of significant losses involved Cap Corp, which was

formerly one of the nation’s largest corporate credit unions with reported

assets of $1.6 billion. Cap Corp failed in January 1995 and was placed into

conservatorship by the National Credit Union Administration.3

 By

February 1995, when we testified before the Senate Committee on

Banking, Housing, and Urban Affairs, the total loss on Cap Corp’s portfolio

was about $61 million.4

 We said that Cap Corp’s failure was, in part, the

result of inadequate oversight by the board of directors of a risky

investment strategy, no internal audit function, and other weaknesses in

internal controls. In particular, Cap Corp lacked a model to test the overall

sensitivity of its investment portfolio to potential changes in interest rates.

Cap Corp also failed to react readily to the growing mismatch between its

assets and liabilities. Cap Corp’s board of directors not only failed to

ensure that an adequate risk-management system was established and

functioning, it also did not appear to adequately oversee Cap Corp’s

investment activities. Virtually all responsibility for Cap Corp’s investment

activities was delegated to an investment committee comprising Cap

Corp’s senior management, and the board showed little interest in the

decisions this committee made.

Finally, in February 1995, Barings, a British investment bank, collapsed

after losing over $1 billion trading financial futures and options on

exchanges in Singapore and Japan. The Bank of England report issued

after the bank’s failure indicated that one employee’s trading activities

apparently were responsible for all the losses.5

 The regulators said that

these losses went undetected as a consequence of failed management

oversight and a lack of basic internal controls. For example, Barings’

management did not adequately follow up on a number of warning signs,

including findings reported by the internal auditors, over a prolonged

period. According to the regulators’ report, this employee originally was

authorized to perform certain limited trading activities for customers.

However, he began to generate profits through unauthorized trading for

Barings’ own account. Despite significant reported profits, Barings’

management believed that his activity represented no significant risk to

Barings until the large losses suddenly became evident. Until this time, he

3

Corporate credit unions are nonprofit cooperatives that are owned by their respective member credit

unions. They serve their member credit unions by providing liquidity loans, investment products, and

other services.

4

Credit Unions: The Failure of Capital Corporate Federal Credit Union (GAO/T-GGD-95-107, Feb. 28,

1995).

5

“Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of

Barings,” Bank of England, (July 13, 1995).

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was able to conceal his losses largely because he was responsible for both

initiating and recording trades—a lack of basic separation of duties.6

Barings collapsed because of its management’s failure to institute a proper

system of internal controls; enforce accountability for profits, risks, and

operations; and follow up on warning systems.

The losses experienced by these entities occurred in part because their

boards of directors and top management did not effectively monitor

derivatives activities or require corrective action to establish controls

when significant weaknesses were noted. The Chairman of the Board of

Governors of the Federal Reserve, in testimony before the Senate

Committee on Banking, Housing, and Urban Affairs on November 27, 1995,

stated that conditions such as the concealment of losses by employees and

management threaten the integrity of our financial system. In commenting

on a loss at a U.S. branch of Daiwa bank,7

 as well as the loss at Barings, he

said:

“The over $1 billion loss suffered by Daiwa and the catastrophic losses suffered by Barings

in Singapore because of a rogue trader illustrate the enormity of the damage that can be

incurred by global trading banks when internal control systems are less than adequate. . . .

The lesson forcefully taught by these cases is that management must pay as much attention

to such seemingly mundane tasks as back office settlement and internal audit functions as

to the more exotic high technology front-end trading systems.”

Given the lax corporate governance associated with the losses reported

since 1994, we continue to support the wider application of FDICIA-type

internal control assessments and reporting to cover more than large

insured depository institutions. Losses at these entities clearly illustrate

the results that can occur when effective risk-management and internal

control systems are not developed, properly implemented, and vigilantly

enforced. Management assessments of internal control and

risk-management systems could have identified areas where controls were

weak or nonexistent and, overall, could have reinforced good

management. In addition, required public reporting on these assessments

could have motivated the board and management of the affected

organizations to improve corporate governance systems.

6

Trading activities are referred to as “front office” activities, in contrast to administrative activities like

bookkeeping that are referred to as “back office” activities.

7

Daiwa bank, a large Japanese bank, incurred $1.1 billion in losses at its New York branch from U.S.

government bond trading activities over an 11-year period.

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Internal Control

Guidance Is

Consistent With

FDICIA Objectives

but Is Primarily

Voluntary

The recurring linkage between weak corporate governance systems and

derivatives losses has focused attention on improving internal controls.

Market participants and others have issued various types of guidance and

frameworks that represent best practices for improving internal controls

over derivatives activities.8

 As discussed in more detail in chapters 4 and 6,

we believe that these best practices provide good ideas for improving

internal controls on a voluntary basis. However, we continue to believe

that all major OTC derivatives dealers and end-users could benefit from the

types of internal control assessments and reporting required under FDICIA.

In general, officials of some end-user banks and thrifts, which are subject

to FDICIA requirements, told us that the formal assessment of internal

controls required by FDICIA was beneficial. We found that many of the

corporate governance concepts embodied in FDICIA and our previous

recommendations were reflected in recommended practices outlined in

the various types of guidance. However, the recommended practices differ

in two important ways: (1) they are not mandated, and (2) they do not

require public reporting by management on its assessment of the

effectiveness of internal controls. Further, only the guidance of the

Derivatives Policy Group (DPG)9

 calls for a periodic assessment of the

effectiveness of these controls by auditors, but it does not require public

reporting of the results.10 We are concerned that should market conditions

improve, there will be less pressure to mandate these important practices,

leaving firms vulnerable to substantial losses when conditions change.

End-User Banks and

Thrifts Found FDICIA

Requirements Generally

Useful

To determine the usefulness of FDICIA’s required assessments, we

discussed the formal assessments of internal controls over financial

reporting with officials of the 12 end-user banks and thrifts that we

reviewed. Officials at most of the institutions told us that the formal

assessments were beneficial.

Most of the officials told us they used COSO’s framework for assessing the

adequacy of the internal controls in preparing their FDICIA assessments. We

8

These include the G-30 recommendations, the Derivatives Policy Group framework, the Futures

Industry Association’s Global Task Force on Financial Integrity recommendations, and guidance from

AICPA, COSO, Government Finance Officers Association, Basle Committee on Banking Supervision,

and IOSCO.

9

DPG was organized in 1994 to address the public policy issues raised by the OTC derivatives activities

of unregistered affiliates of SEC-registered broker-dealers and CFTC-registered FCMs and is consistent

with the recommendations in our 1994 report. DPG-member firms include CS First Boston, Goldman

Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Salomon Brothers.

10This aspect of the framework is consistent with IOSCO guidance that suggests that regulators require

management assessments and regulatory examinations or auditor’s reports on controls (with reports

submitted to regulators).

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were provided access to and reviewed the documentation of controls over

derivatives activities that three of the institutions prepared in conjunction

with their internal control assessments and found that these institutions

had done a substantial amount of analysis in the form of questionnaires,

flowcharts, and risk-evaluation working papers. The use of those kinds of

materials is suggested by the COSO framework documents. Management’s

observations on the FDICIA assessments at the selected banks and thrifts

are also discussed in appendix II.

DPG Issued Guidelines to

Improve Risk Management

In its March 1995 report, Framework for Voluntary Oversight, DPG

developed a self-regulatory framework for voluntary oversight of its

members’ unregulated OTC derivatives dealer affiliates.11 Although CS First

Boston is not a reporting intermediary, the remaining five firms represent

over 90 percent of the total U.S. broker-dealer OTC derivatives trading

activity.12 DPG’s self-regulatory framework consists of four interrelated

components: (1) management controls, (2) enhanced reporting,

(3) evaluation of risk in relation to capital, and (4) counterparty

relationships. (The last three components are discussed in ch. 4.)

The first component outlines risk-management guidance, including

suggestions for the implementation of internal controls for measuring and

monitoring the various risks a firm may be exposed to as a result of its

dealings in derivative products. This component also establishes that an

effective system of internal controls should include (1) the adoption of

risk management guidelines at an appropriate level of management; and

(2) the implementation of risk monitoring systems to identify, measure,

monitor, and report exposure to relevant risks and of risk management

processes to control those risks.

Under the framework, SEC and CFTC are to receive external auditors’

reports on firms’ internal and risk management controls. The external

audit reports, which are to be submitted annually, are to address the firm’s

compliance with its risk-management objectives, guidelines, and internal

11As stated in the framework, DPG contemplated that it would apply to any affiliate of an

SEC-registered broker-dealer (1) that is not subject to supervisory oversight with respect to capital;

(2) that is primarily engaged in the business of holding itself out to unaffiliated counterparties as a

professional intermediary willing to structure and enter into either side of an OTC derivatives

transaction as a principal; and (3) whose OTC derivatives activities are likely to have a material

impact, directly or indirectly, on its SEC-registered broker-dealer affiliate.

12CS First Boston has an OTC derivatives affiliate that is regulated as a bank by the Bank of England.

Although it does not report to SEC under the framework, SEC officials told us that under their risk

assessment rules, they receive copies of quarterly financial reports the affiliate files with the Bank of

England.

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procedures, which are called for by the DPG framework. SEC and CFTC have

agreed to maintain all information obtained from DPG members, including

the reporting on internal controls, on a confidential basis. Independent

verification of management’s assessment on controls by external auditors

could help provide valuable evidence that such controls exist for these

firms. However, unlike FDICIA assessments, which are publicly available,

maintaining information on a confidential basis does not provide public

accountability.

Institutions’ Systems

of Controls Were

Generally Designed to

Include Key Controls

In general, we found the 12 banks and thrifts we selected had systems of

controls that were designed to include most of the key controls relevant to

the types of derivatives activity in which they were engaged.13 We

reviewed various guidance-related documents, including AICPA audit guides

and regulatory guidance, to identify key controls related to derivatives.

Most of these controls were included in more than one guidance and were

contained in the COSO derivatives guidance.14 Appendix II includes a table

of the key controls for derivatives activities that we developed on the basis

of our review of information from the various guidance documents.

Although the 12 banks and thrifts had most of the key controls, we also

noted that regulatory examiners and internal auditors found that certain of

these controls could be improved. Controls needing improvements

included

• management-approved written policies setting risk limits;

• credit limits established for counterparty exposures;15

• regular committee meetings to oversee the hedging program, to report to

the board of directors, and to maintain documentation of decisions and

actions; and

• procedures to monitor risk limits and exposures on a daily or regular

basis.

13For the remaining key controls, we found incomplete data to verify that they were designed into the

system.

14In addition to the 1992 framework established by COSO for assessing the adequacy of internal

controls, in June 1996, COSO issued guidance to illustrate how the COSO framework might be applied

to derivatives activities. This specific application of the COSO framework recognizes the widespread

use and growing importance of derivatives in managing risks and recognizes that many directors and

senior executives may request assurance that their organizations could minimize exposure to undue

loss from inappropriate derivatives use.

15Counterparty exposure is the risk of loss that would occur if an entity’s counterparty failed to meet

its financial obligations.

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The fact that these controls needed improvement argues for the

importance of regular and effective audit and regulatory oversight. Such

oversight plays a critical role in monitoring derivatives risk and in

maintaining a strong system of corporate governance.

Industry Surveys

Indicate Some

Progress on Internal

Controls

Several industry surveys that have been completed since our 1994 report

assessed internal control practices at derivatives dealers and end-users. A

1994 G-30 survey indicated that derivatives dealers and end-users had

made progress in implementing the corporate governance

recommendations in its July 1993 derivatives report. However, the survey

also showed that not all the G-30 recommendations had been

implemented. Other surveys that reported on board of director

involvement with derivatives activities showed mixed results. We did not

attempt to verify or evaluate the quality of any of the survey data. Although

these surveys provide some indication of others’ recognition of the

importance of corporate governance, formal assessments of and public

reporting on internal controls would provide a better gauge of progress in

this area.

G-30 Survey Indicates

Progress

In December 1994, the G-30 published the results of a survey that showed

a high percentage of derivatives dealers and end-users responding had

adopted or were planning to adopt many of the G-30’s recommended

practices regarding corporate governance.16 Of the 125 dealer and 149

end-user respondents to the survey, the majority acknowledged that they

had, or were planning to implement within 12 months, policies relating to

corporate governance, including the following:

• The board of directors reviews and approves an entity’s overall

risk-management and capital policies.

• The board of directors reviews and approves any changes to overall

risk-management and capital policies made by senior management in

response to changes in business conditions.

• Management establishes and implements clearly defined risk-management

policies, procedures, and controls.

• Senior financial management reviews and approves procedures and

controls for implementing the entity’s risk-management policies governing

derivatives trading, operations, accounting, and disclosure.

16“Derivatives: Practices and Principles, Follow-Up Surveys of Industry Practice,” Group of Thirty,

(Dec. 1994).

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• Senior financial management reviews derivatives policies as business and

market circumstances materially change.

• Senior financial management periodically reviews risk-management

reports that specifically identify derivatives activities used in the hedging

of underlying business exposures (end-user respondents only).

• Policies and procedures governing and controlling risk management and

derivatives specifically address the purpose of derivatives transactions and

the types of risks that can be taken (end-user respondents only).

Although the results of the G-30 survey are encouraging, many end-users

thought that recommendations concerning the assessment of market risk

did not apply to them. For example, about 36 percent responded “does not

apply” to a question concerning their use of market simulations to test the

performance of their portfolios under abnormal market conditions.

However, without investigating each respondent’s individual

circumstances, we could not determine whether such responses were

reasonable. In addition, although the survey indicated a positive trend, it

did not request, and its results did not provide, information about how

entities ensure that these important policies and procedures are effectively

implemented and monitored.

Other Surveys Showed

Problems Persist

Other surveys also reported on the involvement of boards of directors in

establishing and monitoring derivatives activities. A survey of the use of

derivative instruments in multinational companies, conducted by Ernst &

Young LLP, showed that boards of directors, executives, and senior

management reported establishing policies to monitor and control

derivatives activities at 96 percent of the companies responding.17 In a

different survey also conducted by Ernst & Young LLP, nearly two-thirds

of investment funds that used derivatives reported that they did not have a

supervisory board or a risk-management committee responsible for setting

limits on derivatives use.18 The survey responses showed that only a few

boards of directors had a representative familiar with complex financial

instruments or risk management.

Another survey, conducted by the Wharton School at the University of

Pennsylvania in conjunction with the Canadian Imperial Bank of

17“The Use of Derivatives Investments in Multinational Companies,” Ernst & Young, LLP, (Feb. 1995).

An informal survey of 105 of the world’s largest multinational corporations.

18“Derivatives Usage by Investment Funds,” Ernst & Young, LLP, (Oct. 1995). Ernst & Young conducted

143 surveys with a judgmentally selected sample of U.S. and foreign investment fund companies in

1995.

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Commerce, indicated that fewer than half of the entities surveyed

regularly reported to their boards on derivatives usage.19 This survey also

reported that about one-quarter of the entities surveyed did not have a

documented policy on derivatives.

SEC Is Continuing to

Look at Issues Related

to Our May 1994

Recommendation

In our May 1994 report, we recommended that SEC ensure that its

registrants that are major dealers and end-users of complex derivative

products establish and implement corporate requirements for

independent, knowledgeable audit committees and public reporting on

internal controls. Internal control reporting by boards of directors,

managers, and external auditors should include assessments of derivatives

risk-management systems. Despite SEC’s recognition that there may be

benefits associated with management or auditor reports on internal

controls of SEC registrants that are major dealers and end-users of complex

derivative products and discussions about an alternative way to meet the

intent of this recommendation, SEC has not yet agreed to implement it.

Although SEC does not deny the importance of internal controls over

activities involving financial instruments and assurances that those

controls are working, it has stated that it is focusing on expanding

disclosure requirements on market risk as a more appropriate priority for

SEC at this time. Although we believe expanded disclosure is valuable, it

does not provide the additional accountability for boards of directors and

senior managers that would be accomplished through public reporting of

internal control assessments.

SEC officials expressed concern about the potential costs of imposing

responsibilities for public reporting on internal controls over derivatives,

especially if this included a requirement for attestation on such reports by

independent public accountants. Their concerns stemmed from the fact

that a number of years ago SEC withdrew two proposals for public internal

control reporting by management because of substantive public

opposition based in part on the claim that the proposals would be too

costly. The first proposal would have required auditor attestation; the

second did not, recognizing to some extent the cost objection to the first

proposal.

In our discussions with these officials, we pointed out that our

recommendation was confined to major end-users of derivative products.

However, they were still concerned about the cost imposed on even the

19“Wharton/CIBC Wood Gundy Survey of Derivatives Usage Among U.S. Nonfinancial Firms,” The

Wharton School of the University of Pennsylvania, (Oct. 1995). Questionnaires were mailed to a

random probability sample of 2,158 nonfinancial corporations.

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limited number of companies that we recommended be required to report

publicly. To address this concern, we suggested another less costly way to

meet the intent of our recommendation.

Instead of SEC requiring management reports and auditor attestation as

recommended in our May 1994 report, we suggested that SEC could issue

guidelines for directors’ oversight of derivatives activities. Such guidelines

could be based on guidance for directors already issued by bank

regulators and others. Our list of suggested guidelines appears in appendix

III. We reasoned that these guidelines would require that directors

carefully review derivatives policies and risk limits and the controls over

them. If not satisfied, they could call upon independent auditors to assist

them.

At SEC’s request, we also prepared and presented a draft prototype report

on internal controls over derivatives activities to illustrate the kind of

public reporting we were recommending. This report describes an entity’s

derivative products, the establishment of its risk limits and related

controls, and the involvement of the board of directors and the board’s

audit committee. We stated that the report was only illustrative, that it

could well be shortened or simplified, and could be broadened to include a

wider range of important internal controls. This prototype draft report is

presented as appendix IV.

SEC officials recognized that there may be benefits associated with

management or auditors’ reports on public companies20 internal control

systems but expressed some concerns with our alternative

recommendations. They said that SEC issuance of director guidelines

would represent unprecedented involvement in corporate governance and

expressed concern about the potential for director liabilities that might

flow even from nonauthoritative guidelines. SEC is focusing on accounting

for and providing greater disclosure of market risk for derivative products,

which it views as a more appropriate priority at this time.

In December 1995, SEC released for comment proposed expanded

derivatives disclosure requirements for public companies. Under the

proposed requirements, additional public disclosures would be made

regarding derivatives dealers’ and end-users’ risk exposures, objectives,

general strategies, and financial instruments used to manage risk. We

discuss these requirements in more detail in chapter 5.

20We use public companies in this report to mean companies that register their securities with SEC and

that are subject to SEC’s disclosure requirements.

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Conclusions Recent losses at the entities discussed in this chapter, as well as others,

emphasize the need for strong accountability over derivatives activities.

The losses also illustrate the potential danger associated with entities that

do not embrace the need for sound corporate governance to establish,

maintain, and monitor effective internal control systems.

Although voluntary efforts to strengthen corporate governance and

internal controls over derivatives can be valuable, they leave stakeholders

vulnerable if not uniformly adopted. SEC’s proposed requirements begin to

address our concerns, but they may not provide sufficient assurance to the

public that appropriate risk-management policies are, in fact, being

followed. We continue to believe the actions recommended by our

May 1994 report for effective corporate governance and management

assessment and reporting on internal controls are still appropriate.

Periodic assessments of internal controls, accompanied by public

reporting on the results of those assessments, would make boards of

directors and senior managers more accountable to shareholders,

regulators, and the general public about the effectiveness of the systems of

controls and, thereby, help to prevent large losses. We believe that

regulators at all levels of government should consider the

recommendations to facilitate effective actions by management and

boards of directors in managing derivatives activities.

Chapter 3 MAY 1994 REPORT SUMMARY

Findings Bank regulators use three primary means to oversee bank activities:

requiring adherence to minimum capital standards;1

 reviewing required

reports; and conducting periodic examinations to verify compliance with

capital, reporting, and other regulatory requirements. Although regulators

had made progress, improvements were still needed in regulatory

reporting and examinations. We found that although regulators required

banks to report information quarterly, they did not require sufficient

information on credit risk and earnings. In addition, capital requirements

did not address all risks, focusing instead on credit risk. However, U.S.

bank regulators participated in developing a proposal to incorporate

market risk through the Basle Committee on Bank Supervision. Other

ongoing efforts addressed interest rate risk, credit concentration, risks

from nontraditional activities, and broader recognition of bilateral netting.

1

Capital serves as a buffer against unexpected losses that cannot be absorbed from current earnings.

As a bank’s capital approaches low levels, regulators are warned that a bank’s financial health is

threatened and that they may have to intervene.

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We also found that although bank examinations addressed derivatives,

they did not adequately address internal controls.

Recommendations We recommended that financial regulators take several actions to improve

their capability to oversee OTC derivatives activities and respond to any

financial crisis involving derivatives. The recommended actions were to

develop and adopt a consistent set of capital standards; develop and

maintain a centralized repository of information (including information on

counterparty concentrations and earnings); and provide leadership in

working with industry representatives and regulators internationally to

harmonize standards for disclosure, capital, examination, and accounting.

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OCC, the Federal Reserve, FDIC, and OTS have made progress in improving

their oversight of derivatives activities consistent with the

recommendations we made to financial regulators in our 1994 report.2

They have expanded their risk-based capital standards to more accurately

reflect risk exposures and to include market risk. They have also

expanded their regulatory reporting requirements to include additional

information on derivatives activities. Further, they have improved their

examination process by taking several actions to more adequately address

risks and risk management. In 1994, the Federal Reserve took an

enforcement action against a bank holding company for activities related

to its derivatives business.

Risk-Based Capital

Standards Were

Expanded

Expanding risk-based capital standards continues to be an active area of

reform for bank regulators.3

 Reforms include efforts to ensure that the

major types of risk are reflected in capital requirements. Although some of

the reforms apply specifically to derivatives activities, others apply more

broadly to nonderivatives activities as well. In December 1994, U.S. bank

regulators issued final risk-based capital rules that should result in banks

holding capital that more accurately reflects their actual risk exposure.

These rules (1) provide broader recognition of offsetting risk exposures by

allowing banks to net these exposures and (2) revise the way banks

calculate the amount of capital needed to cover potential future changes in

derivatives contract values. Also, in December 1994, bank regulators

amended their risk-based capital guidance to include concentrations of

credit risk and an institution’s ability to manage such concentrations as

important factors in assessing overall capital adequacy. In August 1995, the

regulators issued a final rule requiring that risk-based capital requirements

take account of interest rate risk throughout an institution. Further, in

September 1996, they issued a joint final rule to incorporate the market

risk of the trading activities of internationally active banks into the

risk-based capital calculation. Finally, the Federal Reserve has requested

comment on an innovative approach to capital that would require banks to

set their own capital requirements for their trading risks and would

provide incentives in the form of penalties to ensure that the capital is

adequate.

2

This report focuses on the activities of the Federal Reserve and OCC, because they are the primary

regulators responsible for the seven major bank dealers we reviewed. However, FDIC and OTS also

have been active participants in improving derivatives oversight.

3

Risk-based capital requirements call for capital to be held against on- and off-balance sheet risks in

varying amounts according to measures of relative risk assigned by the regulators.

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Capital Rules Were

Amended to Allow Broader

Recognition of Bilateral

Netting and to More

Accurately Reflect

Potential Future Credit

Exposure

In response to amendments to the Basle Accord that allowed broader

recognition of qualified bilateral netting agreements,4

 U.S. bank regulators

issued a final rule for such netting (effective December 1994).5

 This

risk-based capital rule allows a bank to net, for risk-based capital

purposes, negative and positive market values of interest and exchange

rate contracts with the same counterparty. The contracts must be subject

to qualifying bilateral netting agreements. To ensure that a legal basis

exists to support the enforceability of a netting contract, U.S. banks must

obtain a written legal opinion that the contract is enforceable in all

relevant jurisdictions. The broader recognition of qualifying legally

enforceable bilateral netting agreements is significant because such

arrangements help to reduce financial institutions’ counterparty exposure

and settlement risks. Previously, U.S. banks were only allowed to net

obligations that were denominated in the same currency and due on the

same date on derivatives contracts with other counterparties.6

U.S. bank regulators issued a final rule (effective October 1995) to

implement amendments to the Basle Accord governing the calculation of

potential future credit exposures. The first part of the rule authorized

banks to recognize qualifying legally enforceable bilateral netting

agreements in calculating potential future exposures for risk-based capital

purposes. The other part expanded the coverage and increased the

maximum level of the credit conversion factors used to calculate the

add-on amount.7

 The conversion factors in the original Basle Accord

ranged from 0 to 5 percent, covered interest rate and exchange rate

contracts, and had two maturity categories—1 year or less and over 1 year.

According to one regulator, this final rule responded to concerns that

these original factors did not cover enough types of products and were not

high enough to cover potential exposures on contracts with long-dated

maturities. The amended conversion factors range from 0 to 15 percent;

4

“The International Convergence of Capital Measurement and Capital Standards,” also known as the

Basle Accord, is a risk-based framework endorsed by bank regulators from the United States and 11

other countries in 1988. Although it is not legally enforceable as a treaty, members regard the

framework as binding.

5

Bilateral netting, for U.S. bank regulatory purposes, is an arrangement between a bank and a

counterparty that creates a single legal obligation covering all included individual contracts. This

means that a bank’s obligation, in the event of the default or insolvency of one of the parties, would be

the net sum of all positive and negative fair values of contracts included in the bilateral netting

agreement.

6

This is known as netting by novation.

7

Conversion factors are used to estimate how much future movements of market rates and prices can

increase current amounts owed by a counterparty on derivatives contracts. The factors are expressed

as a percentage. Thus, a contract with a notional value of $1 million that was subject to a 15 percent

conversion factor would be calculated as having a potential future credit exposure of $150,000.

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cover six types of derivatives contracts (interest rate, exchange rate,

equity, gold, other precious metals, and other commodities); and include

maturity categories of 1 year or less, 1 to 5 years, and over 5 years.

U.S. Bank Regulators

Issued Final Rules to

Address Additional Risks

Section 305 of FDICIA required, among other things, that bank regulators

revise their risk-based capital standards to include concentration of credit

risk, risks of nontraditional activities, and interest rate risk.8

 In response,

on December 13, 1994, bank regulators amended risk-based capital

standards for insured depository institutions to “ensure that those

standards take adequate account of concentration of credit risk and the

risks of nontraditional activities,” which include derivatives activities.

Regulators are to consider the risks from nontraditional activities and

management’s ability to monitor and control these risks when assessing

the adequacy of a bank’s capital. Similarly, institutions identified through

the examination process as having exposure to concentration of credit

risk or as not adequately managing their concentration of risk are required

to hold capital above the regulatory minimums. Because no generally

accepted approach exists for identifying and quantifying the magnitude of

risk associated with concentrations of credit, bank regulators determined

that including a formula-based calculation to quantify the related risk was

not feasible.

U.S. bank regulators addressed the interest rate risk portion of section 305

through a two-step process. Step one consisted of a final rule issued on

August 2, 1995, that amended the capital standards to specify that bank

regulators will include in their evaluations of a bank’s capital adequacy an

assessment of the exposure to declines in the economic value of the

bank’s capital due to changes in interest rates. The final rules specify that

examiners will also consider the adequacy of the bank’s internal interest

rate risk management. Step one also included a proposed joint policy

statement that was issued concurrently with the final rule. This joint policy

statement described how bank regulators would measure and assess a

bank’s exposure to interest rate risk.

Originally, bank regulators intended that step two would be the issuance

of a proposed rule based on the August 2, 1995, joint policy statement that

would have established an explicit minimum capital requirement for

interest rate risk. Subsequently, bank regulators elected not to pursue a

standardized measure and explicit capital charge for interest rate risk.

8

Interest rate risk is the risk of potential loss arising from changes in interest rates. It exists in

traditional banking activities, such as deposit-taking and loan provision, as well as in securities and

derivatives activities.

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According to the bank regulators’ June 26, 1996, joint policy statement on

interest rate risk, the decision not to pursue an explicit measure reflects

concerns about the burden, accuracy, and complexity of developing a

standardized model and the realization that interest rate risk measurement

techniques continue to evolve. Nonetheless, bank regulators said they will

continue to place significant emphasis on the level of a bank’s interest rate

risk exposure and the quality of its risk-management process when they

are evaluating its capital adequacy. The bank regulators have

recommended to FFIEC that additional call report information be collected

on interest rate risk to improve their ability to monitor banks’ exposures.

They anticipate that this information will be included in the 1997 call

reports.

U.S. Regulators Issued a

Final Rule to Address

Market Risk

In September 1996, U.S. bank regulators issued a final rule based on the

Basle Committee on Banking Supervision’s January 1996 amendment to

the Basle Accord. The rule developed consistent capital standards for

market risk in internationally active dealer banks.9

 The final rule requires

that institutions adjust their risk-based capital ratio to take into account

both the general and specific risk of their debt and equity positions in their

trading accounts and the general market risk associated with foreign

exchange and commodity positions, whether or not they are in the trading

account. The rule requires that banks use their own internal models to

provide a measure of the institutions’ “value at risk,” subject to regulatory

modeling criteria.10 According to bank regulators, the elimination of the

standardized-model approach suggested in the Basle Committee on

Banking Supervision’s May 1993 proposed rule to address market risk

reflected strong industry opposition to the use of standardized models.

Industry officials felt a standardized model approach would be unduly

cumbersome, potentially inaccurate, and a disincentive to innovations and

improvements in internal models. Bank regulators believe that banks with

significant trading activities need to have good internal value-at-risk

models and that a standardized model would be inappropriate and

inadequate for such firms.

9

The rules apply to any bank or bank holding company whose trading activity equals 10 percent or

more of its total assets or whose trading activity equals $1 billion or more. In addition, a regulator can

include an institution that does not meet the criteria if deemed necessary for safety and soundness

purposes or can exclude institutions that meet the applicability criteria. The new rules become

effective January 1, 1998, but banks can begin implementing them as of January 1, 1997.

10Value at risk represents an estimate of the amount by which an institution’s positions in a risk

category could decline due to general market movements during a given holding period, measured

with a specified confidence interval.

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In order to adapt banks’ internal models for regulatory purposes, the bank

regulators have developed minimum qualitative and quantitative

requirements that all banks subject to the market risk capital standard will

have to use in generating their estimates of value at risk. The qualitative

requirements reiterate the basic elements of sound risk management.

According to the final rule, quantitative requirements are designed to

ensure that an institution has adequate levels of capital and that capital

charges are sufficiently consistent across institutions with similar

exposures. (See app. V for a detailed discussion of criteria.) A bank’s

calculation of value at risk, even with the quantitative criteria applied, may

not measure the full amount of capital necessary to protect against

potential market risk losses. The value-at-risk models, for example, may

not capture unusual market events. As a result, regulators require that a

bank’s value-at-risk capital charge be the larger of the previous day’s value

at risk, or the average daily value at risk over the last 60 business days

multiplied by at least 3.

The final rule also requires banks to conduct periodic backtesting. Banks

are to compare daily value-at-risk estimates generated by internal models

against actual daily trading results to determine how effectively the

value-at-risk measure identified the boundaries of gains or losses,

consistent with the predetermined statistical confidence level. Regulators

are to use the backtesting results to adjust the multiplication factor

(multiplier) that banks use to determine their capital requirement.11

The Federal Reserve

Explores a Different

Approach to Capital

On July 25, 1995, the Federal Reserve issued a request for comment on a

“pre-commitment approach” to capital requirements for market risks in

banks’ trading activities. Under the pre-commitment approach, the bank

would tell the regulator, in advance, how much of its capital was allocated

for trading risks during some specified period of time, such as the next

quarter. The estimate would determine the bank’s regulatory capital

requirement. To ensure that a bank’s capital commitment was adequate to

cover both its trading position risks and its ability to manage those risks, a

regulator would provide incentives in the form of penalties for a bank’s

failure to contain its loss within the committed-capital amount. These

penalties could include fines, higher capital requirements, restrictions on

trading activities, or public announcement of the bank’s delinquency.

Further, both the commitment and a bank’s risk-management system

would be subject to review by regulatory authorities, who would have to

11For example, if a bank exceeds its value-at-risk estimate 10 or more times in the previous 250

business days, its multiplier could be increased from 3 to 4.

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be satisfied that the pre-committed amount was consistent with the bank’s

trading position and risk-management system.

This proposed approach presumes that methods for measuring and

managing market risk will continue to evolve. It could encourage

development of progressive risk management tools, because the proposed

approach would devolve responsibility for setting capital from regulators

to banks and provide incentives for banks to set capital prudently. If

enacted with carefully designed penalties, it could create incentives for

banks to set aside adequate capital for the purpose of meeting unexpected

losses. According to a Federal Reserve Bank president, the Federal

Reserve recognizes that the penalties cannot be so severe that they impair

profitability or push a bank into financial distress. The approach could

also encourage banks to implement adequate risk-management systems

and internal models. Although no further action had been taken on this

approach as of July 1996, industry reactions have been generally favorable.

According to a Federal Reserve Bank president, the New York Clearing

House Association is organizing a pilot study of pre-commitment that “will

provide valuable experience with this innovative approach.”12

Bank Regulators Have

Expanded Regulatory

Reporting

Requirements

As part of their oversight, bank regulators collect information through

quarterly call reports, which include information on derivatives activities.

We recommended in our May 1994 report that financial regulators collect

information on the extent of major counterparty concentrations and the

sources and amounts of their derivatives earnings. Effective March 31,

1995, call report requirements were expanded to include much of the

information on derivatives-related activities that we had recommended.

Beginning in 1996, the call report was further expanded to include

information on credit losses from derivatives.

The expanded call reports require separate reporting of notional/contract

amounts for exchange-traded and OTC contracts. For each of the four types

of underlying risk exposure—interest rate, foreign exchange, equity

derivatives, and commodity and other—notional/contract amounts of

off-balance sheet derivatives contracts are reported separately for trading

or nontrading activities.13 Banks also are required to report the amortized

12The New York Clearing House Association, a pioneer American clearinghouse, was organized in 1853.

In addition to its operational clearinghouse functions, its objectives are also promotional and

self-regulative.

13Nontrading activities are further separated between contracts whose values are marked to market for

call report purposes and those that are not.

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cost and fair value of their high-risk mortgage securities and structured

notes that are held in either the held-to-maturity or available-for-sale (AFS)

portfolios.

Banks with greater than $100 million in assets are subject to additional

reporting requirements. For example, for each of the four types of

underlying risk exposure, these banks are required to report the gross

positive and negative fair values separately for (1) contracts held for

trading purposes, (2) contracts held for purposes other than trading whose

values are marked to market for call reporting purposes, and (3) contracts

held for purposes other than trading whose values are not marked to

market. In addition, these banks are required to report the combined

revenue from trading cash and derivative instruments. They are also

required to report the impact that derivatives contracts held for

nontrading purposes have on the bank’s net income. Further, these banks

are required to separately disclose the net effect of derivatives on interest

income, interest expense, and noninterest income and expense.

Although bank regulators now collect more derivatives information

through call reports, the reports do not include information on individual

counterparty exposures. Bank regulators did not view this

information-reporting omission as a major concern because they said the

information is available to them through their ongoing monitoring and

surveillance activities. OCC told us that its examiners obtained and

reviewed counterparty information on an ongoing and as-needed basis

during the bank examination process, including information on the extent

of major OTC dealers’ counterparty concentrations. OCC officials also told

us that collecting information on counterparty exposures through the call

report would create confidentiality problems because of the sensitivity of

the information. Federal Reserve officials told us that collecting quarterly

individual credit exposure information would not be useful because it is

fluid—counterparty exposures change frequently—and collateral is

involved. In addition, they said that they are in constant contact with bank

officials and have access to management reports, which would include this

type of information.

We note, however, that routinely gathering information on individual

counterparty credit exposures would enable regulators to identify credit

concentrations across the industry. In addition, analyzing industrywide

credit concentrations could help regulators manage potential threats to

the financial system that could arise if counterparties were to fail or

experience financial difficulties. Further, if a large derivatives dealer or

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end-user were to fail or develop severe financial problems, regulators

could use counterparty credit exposure information to identify and

prioritize the institutions that would have to be contacted as part of

mitigating a crisis or resolving a failure.

Bank Regulators Have

Improved Their

Oversight

Bank regulators have improved their oversight examinations of bank

derivatives activities. They have improved their on-site examinations by

focusing on derivatives risk management and key internal controls. They

also have issued improved examiner guidance that includes specific

guidance on issues related to risk management, trading, and derivatives

activities. Further, they have developed special units and training to

enhance examiners’ technical expertise, conducted special studies, and

increased the extent to which technical and examination-related

information is shared among examiners.

Bank Examinations More

Clearly Focused on

Derivatives Risks

On-site examinations remain regulators’ primary means for assessing the

quality of management operations and internal controls. As part of the

examination process, regulators are to assess the adequacy of internal

control systems, specifically identify critical internal control procedures,

test these procedures, and evaluate the results of these tests. For three of

the seven major U.S. bank derivatives dealers identified in our 1994 report,

we compared the examinations done by the Federal Reserve and OCC in

1994 to those they conducted in 1993. We found that the 1994

examinations were more clearly focused on the banks’ derivatives

risk-management and internal control systems. The extent to which bank

regulators had documented the assessments they performed as part of

their examinations also had improved. In addition, we compared the 1994

examinations of two of the banks to examinations conducted in 1992 and

found the 1994 examinations were generally more comprehensive.

Using bank examination guidance and G-30 recommendations as criteria,

we identified elements we believe are vital to an effective

risk-management system.14 We then determined how bank examiners

reviewed compliance with those elements. Although examiners reviewed

the internal control systems at the seven banks, we found that the extent

of internal control testing conducted as part of these examinations was

generally limited. Federal Reserve and OCC bank examiners confirmed that

they do not extensively test internal controls during on-site examinations.

14The elements include risk management, senior management and board oversight, capital

requirements, internal audits, and control over sales practices.

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They told us that one of the reasons they limit their internal control testing

is that such testing is done by the banks’ internal and external auditors.

According to an OCC official, it is the regulators’ job to make sure that

internal and external auditors perform internal control testing. However, a

Federal Reserve official acknowledged that more extensive internal

control testing may be necessary and stated that Federal Reserve staff are

considering using statistical sampling in their examinations. Supplemental

guidance issued by the Federal Reserve in May 1996 stated that the degree

of testing conducted during an examination is to depend on the quality of

management practices and the materiality of the activities or functions

being reviewed.

In addition, bank regulatory officials told us that they review certain key

processes during every examination, including the calculation of position

valuations, credit approval, adherence to internal position limits,

management reporting, and audit coverage. Bank regulatory officials also

said they concentrate examiner resources on intensive reviews in those

areas where they believe significant weaknesses exist.

We found that bank examiners used FDICIA-required internal control

assessment reports to varying degrees in the examination process.15

Examiners can use the work of management and auditors to supplement

their examination procedures as long as they adequately review the work.

Examiners at one bank had reviewed the internal control assessment

reports and had followed up with bank personnel to determine whether

the deficiencies identified in the assessments had been corrected.

Examiners at five of the banks had reviewed the internal control

assessments but did not use them extensively in conducting their

examinations. Examiners at the seventh bank said that the internal control

assessment reports did not contain any more information than they

obtained from other sources and thus were not used. A Federal Reserve

official noted some bank personnel had credited the requirement for

accelerating the pace of internal control improvements at their banks.

We found that examiners at all seven banks reviewed internal audit

reports, followed up on internal audit report findings, and assessed the

qualifications of the banks’ internal audit staff. However, we found no

evidence that bank examiners had extensively reviewed the workpapers

and supporting materials for the internal audit reports. For example, at

15The 1994 examinations we reviewed were the first examinations completed under FDICIA, which

also requires management to annually assess and report on the effectiveness of internal controls over

financial reporting. FDICIA further requires an external auditor attestation of management’s assertions

about the adequacy of controls, which is publicly available.

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three of the banks, we found no evidence that examiners had reviewed

internal audit workpapers during the 1994 examinations. At the other four

banks, we found that examiners had looked at only selected internal audit

workpapers. Similarly, examiners noted when external auditors had done

relevant work, but we found no evidence that examiners reviewed

external auditors’ workpapers during these examinations. Such reviews

could be an important means for determining the adequacy and scope of

the work of internal and external auditors. In addition, auditors’

workpapers may provide useful information not included in their reports,

which cover only material weaknesses. Since our review of these

examinations, bank regulators have undertaken efforts to improve

cooperation between external auditors and examiners and have attempted

to identify areas in which examiners could better use the work of external

auditors, including external audit workpapers.

Bank Regulators Issued

New and Updated

Examination Guidance

Since our 1994 report, OCC and the Federal Reserve issued various types of

detailed guidance, which focused on supervising and examining bank

risk-management and internal control systems. Bank regulators told us

that most of the guidance issued since our 1994 report simply formalized

the approach and procedures that bank examiners had used for some

time. Regulators told us they had been moving away from a

product-oriented examination approach to a more risk-oriented approach,

which is reflected in the guidance issued since 1994. In addition to issuing

more detailed guidance and examination procedures for risk management,

the Federal Reserve and OCC issued guidance on sales practices,16

structured notes, FCM activities, and trading activities in emerging markets.

OCC unveiled its “supervision by risk” program, which it considers to be a

departure from traditional supervision because of its forward-looking

nature that focuses on the quality of risk-management systems. The

Federal Reserve issued supplemental guidance on risk-focused

examinations.

OCC Examination Guidance

Focuses on Bank Risk

Management

Between May 1994 and August 1996, OCC issued new and expanded

guidance to its examiners. In May 1994, OCC issued answers to commonly

asked questions about BC 277.17 In July 1994, OCC issued additional

guidance to national bank examiners and banks about the market and

16This guidance is being examined as part of ongoing GAO work.

17BC 277, “Risk Management of Financial Derivatives” (Oct. 1993), is guidance that outlines specific

components of risk management and generally includes the role of senior management and board

oversight; management of various risks; and discussions of relevant legal issues, capital adequacy, and

accounting.

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liquidity risks associated with structured notes. In October 1994, OCC

issued detailed guidance and comprehensive examination procedures to

national banks and examiners to accompany BC 277.

In November 1995, OCC issued specific guidance for examinations of

CFTC-registered FCMs that are operating subsidiaries of commercial banks.

According to an OCC official, the guidance was an outgrowth of concerns

created by the failure of Barings due to the activities of its FCM affiliate.

The underlying risks associated with FCM activities are not new to banking,

although their measurement and control can be more complex than other

traditional banking activities. The guidance informs examiners about what

controls should be in place, including the role of a bank’s board of

directors and senior management in developing internal control policies

and procedures and risk-management systems. The guidance also

identifies nine categories of risk on which examiners should focus.18

Examiners are also to focus on board of director oversight of the bank’s

FCM activities by outlining what directors and management must do to

ensure adequate oversight of FCM activities. The guidance should help to

reinforce the importance of sound risk management and adequate internal

controls to bankers, because failure to comply could be considered an

unsafe and unsound practice.

In recent years, OCC has been incorporating risk-management assessments

into its examination activities. In December 1995, OCC issued examiner

guidance on its revised approach to supervision that is designed to

expand, enhance, and standardize the way examiners evaluate national

banks with assets of at least $1 billion. This approach, supervision by risk,

focuses on evaluating the quantity of risk exposure in an institution and

determining the quality of the risk-management system in place to control

that risk. To achieve more comprehensive examinations, OCC used the

same nine categories of risk identified in the November 1995 guidance for

FCM activities. Bank examiners are to use risk profiles prepared for each

bank to focus attention on the most serious concerns in a bank. According

to the Comptroller of the Currency, supervision by risk will help OCC do a

better job of responding to current and future risks to banks and the U.S.

financial system. He also noted that this proactive approach is a major

departure from the traditional transactional approach or more recent

approaches, which examined how banks handled past levels of risk.

18The nine categories of risk include credit risk, interest rate risk, liquidity risk, price risk, foreign

exchange risk, transaction risk, compliance risk, strategic risk, and reputation risk.

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Also, in December 1995, OCC issued additional guidance to examiners on

emerging market countries’ products and trading activities. According to

an OCC official, “trading and investment in the emerging countries makes

this one of the fastest growing global financial markets.” The examiner

guidance includes information on written policies and procedures, country

exposure, country exposure limits, aged or stale-data inventory controls,

compensation, and separation of functions.

The Federal Reserve’s

Examination Guidance Also

Focuses on Risk Management

The Federal Reserve also issued new and expanded guidance to its

examiners. In March 1994, the Federal Reserve issued a new

comprehensive examination manual that addressed trading activities. It

included more extensive instructions on evaluating internal control

systems than previous guidance. In August 1994, the Federal Reserve

issued examination guidance on structured notes, highlighting their risks

and the need for examiners to ensure that institutions are using them

according to their investment policies and procedures. In addition, in

March 1995, the Federal Reserve issued “Evaluating the Risk Management

and Internal Controls of Securities and Derivative Contracts Used in

Nontrading Activities.” It included specific guidance for examiners on

evaluating the risk-management practices used by banks for securities and

derivatives contracts of nontrading activities and stressed the importance

of an active board and senior management.

In November 1995, the Federal Reserve issued new guidelines on rating

the adequacy of risk-management processes and internal controls.

Examiners were instructed to give sufficient weight to the importance of

internal controls and risk management when evaluating management

under the bank and bank holding company rating systems. In 1996,

according to Federal Reserve officials, examiners began giving a formal

supervisory rating to the adequacy of a bank’s risk-management processes,

including internal controls. Under the bank regulators’ Uniform Financial

Institutions Rating System, commonly referred to as the CAMEL rating

system—which assesses capital adequacy, asset quality, management,

earnings, and liquidity—regulators would give risk management and

internal controls significant weight when evaluating management on a

scale from 1 (strong) to 5 (unsatisfactory). The guidance stressed the

fundamentals of sound internal controls discussed previously in this

report. In July 1996, FFIEC requested comments on proposed changes to the

existing CAMEL rating system that included increasing the emphasis on

the quality of risk management in each component and possibly adding a

new, sixth component to specifically address market risk sensitivity.

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Unlike the Federal Reserve guidance on CAMEL ratings, the FFIEC

proposal, if adopted, would be used by all bank regulators.

In May 1996, the Federal Reserve issued additional examination guidelines

on “Risk-Focused Safety and Soundness Examinations and Inspections.”

The guidance outlines the risk-focused examination process. The Federal

Reserve noted that this is a dynamic process because the procedures focus

on

“assessing the types and extent of risks to which a banking organization is exposed,

evaluating the organization’s methods of managing and controlling its risk exposures, and

ascertaining whether management and directors fully understand and are actively

monitoring the organization’s exposure to these risks.”

Bank Regulators Have

Taken Actions to Increase

Expertise, Conducted

Special Studies, and

Improved Information

Sharing

In addition to issuing revised examination guidance, bank regulators have

developed special units or expertise to broaden their technical capability,

conducted special studies, and enhanced information sharing. OCC officials

told us that in June 1994, they established a Risk Analysis Division to,

among other things, assist examiners in evaluating the models used by

banks to measure and analyze risk. Analyzing the integrity of bank

value-at-risk models is increasingly important to regulators because these

models are now used to incorporate market risk from trading activities

into the risk-based capital calculation. Focusing on banks with over

$20 billion in assets, OCC officials from the Risk Analysis Division told us

that they accompany examiners during on-site bank examinations and

communicate with examiners on an ongoing basis and with bank

personnel as needed.

We found that Federal Reserve examiners also performed technical

analysis as part of their examinations. For example, Federal Reserve

examiners performed a detailed, technical analysis of one bank’s pricing

model for mortgage-backed securities. On the basis of their analysis,

examiners suggested several improvements to the model, including

discussing weaknesses in the model’s use of a particular mathematical

technique. These types of examination activities are critical in light of

changes to the Basle Accord to incorporate market risk using internal

bank models.

Bank regulators also conducted special studies to improve their oversight

of derivatives and trading activities. For example, in May 1994, OCC staff

completed a study that compared the methodologies that active bank

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derivatives dealers use to measure market risk exposure.19 This study

summarized the banks’ market risk-measurement practices and made

several recommendations for improving examiner supervision and

evaluation of bank risk-management systems. In December 1995, staff

from various bank regulators issued a report on an examination of the

trading activities of commercial banks.20 The report addressed the growing

importance of trading activities and trading revenues at major U.S. banks.

It also addresses concerns raised by financial regulators, Congress, and

others that trading activities could pose undue risk to both individual

banks and the banking system in general. Specifically, the report noted

that concerns had been raised about the volatility of trading revenues

compared to other banking activities and the possibility of trading

activities producing sizeable and sudden losses. Federal Reserve officials

told us they were interested in putting trading activities “in the same light

as other banking activities.” The study found that between June 1984 and

June 1995, trading activities resulted in less volatility to dealer banks’

earnings than lending activities and that trading revenues were

consistently positive for the major dealer banks.21

Bank regulators also have taken steps to improve information sharing

among examination staff engaged in derivatives and trading activities

work. OCC officials told us they hold regular meetings of staff involved with

capital markets and periodic conferences where information is shared.

Federal Reserve officials also indicated that they conduct information and

training sessions for their capital markets examiners at least every 6

months. In addition, in June 1994, the Federal Reserve formed the Capital

Markets Coordinators group, which consists of senior Federal Reserve

officials, to meet with staff three times a year to discuss current capital

markets policy and examination issues.

19“Market Risk Measurement and Evaluation” (May 1994), Alfred P. Crumlish and Roger Tufts.

20“Trading Activities at Commercial Banks,” (Dec, 1995), a paper prepared by the staffs of OCC, FDIC,

and the Federal Reserve.

21Of the quarterly reports filed during this time frame by the seven largest bank dealers as of June 1995

(Bank of America NT&SA; Bankers Trust Company; Citibank, NA; Chase Manhattan Bank, NA;

Chemical Bank; Morgan Guaranty Trust Company; and Nationsbank, NA Carolinas), six instances

occurred in which a bank had a loss from trading activities for the quarter, and one bank accounted for

four of these instances.

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The Federal Reserve

Took a

Derivatives-Related

Enforcement Action

Bank regulators have the authority to implement enforcement actions

against an institution that fails to comply with laws and regulations.22 On

December 4, 1994, the Federal Reserve Bank of New York entered into a

formal written agreement with Bankers Trust New York Corporation, a

bank holding company, and two of its subsidiaries concerning leveraged

derivatives.23 This was the first enforcement action taken by the Federal

Reserve against a banking organization for its derivatives activities.

The agreement required Bankers Trust to take action in eight areas related

to its leveraged derivatives business. Items addressed included enhancing

management and supervision, strengthening internal audits, and ensuring

that each customer has the capacity to understand the nature and

characteristics of any leveraged derivatives transaction entered into with

Bankers Trust. The agreement also specified that Bankers Trust hire

outside counsel that is acceptable to the Federal Reserve Bank of New

York to assist Bankers Trust in reviewing (1) its method for allocating the

revenues and expenses of its leveraged derivatives business among

Bankers Trust and its affiliates and (2) its compliance with firewalls

related to corporate separateness.24 In addition, the agreement required

special counsel to review any employee conduct related to the leveraged

derivatives business that does not comport with bank policy or applicable

law and determine whether disciplinary action is appropriate. As of August

1, 1996, the agreement remained in place.25

Conclusions Bank regulators have improved their oversight of derivatives activities

through expanded risk-based capital standards, more extensive

22Regulators use both formal and informal enforcement actions. Formal actions are legally

enforceable, and regulators can use them to compel banks to take actions to address supervisory

concerns. Formal actions range from issuing cease and desist orders and ordering the suspension,

removal, or prohibition of individuals from bank operations to assessing civil money penalties and

entering into formal agreements with banks. Formal actions are authorized by statute. Therefore, if

banks do not consent to a formal action or fail to comply, regulators may enforce the action through

administrative or legal proceedings. Informal actions include agreements reached through

memorandums of understanding, commitment letters, and board resolutions.

23Leveraged derivatives transactions are defined in the agreement as “derivative transactions (i) where

a market move of two standard deviations in the first month would lead to a reduction in value to the

counterparty of the lower of 15 percent of the notional amount or $10 million, and (ii) for notes or

transactions with a final exchange of principal, where counterparty principal (rather than coupon) is at

risk at maturity, and (iii) for coupon swaps, where the coupon can drop to zero (or below) or exceed

twice the market rate for that market and maturity, and (iv) for spread trades that include an explicit

leverage factor, where a spread is defined as the difference in the yield between two asset classes.”

24Firewalls describe the legal separation of banking and broker/dealer operations within a financial

institution.

25In July 1996, independent counsel completed its report on Bankers Trust.

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information-reporting requirements, and additional supervisory guidance

and procedures. These improvements were consistent with the

recommendations in our May 1994 report. The Federal Reserve staff’s

proposed pre-commitment approach could fundamentally change the way

the capital requirement for market risk is calculated. Shifting the onus of

capital determination to banks could help better ensure that capital

reflects current market conditions and the latest measurement

methodologies. However, regulators would have to continue to closely

scrutinize the bank’s risk-management and control systems and carefully

craft regulatory penalties that would deter undercapitalization but would

not be so excessive as to compromise profitability.

Information-reporting requirements continue to be one of the primary

ways regulators monitor bank activities, including derivatives. The

expanded call report requirements that include separate reporting of

notional/contract amounts for exchange-traded and OTC contracts and

related revenue data should enhance bank regulators’ oversight

capabilities. Although bank regulators now collect more

derivatives-related information than they have in the past, they still do not

routinely collect and analyze industrywide information on individual

counterparty credit exposures. Such information could help regulators

monitor potential problems and respond to financial emergencies.

The Federal Reserve and OCC’s examination guidance that focuses on risk

management and internal controls should help promote sound internal

controls. Bank regulators’ efforts to increase staff expertise, conduct

various studies, and expand information sharing should help improve

examiners’ abilities to oversee the derivatives activities of banks.

Chapter 4 MAY 1994 REPORT SUMMARY

Findings SEC’s regulatory jurisdiction pertains only to activities related to securities.

Therefore, SEC does not regulate affiliates of broker-dealers whose

activities involve products that are not securities and who are not

registered as broker-dealers. Like SEC, CFTC’s authority does not apply to a

firm’s entire organizational structure. State insurance regulators do not

directly oversee the financial condition of affiliates of insurance

companies that are OTC derivatives dealers. Derivatives dealer affiliates of

insurance companies are subject to minimal reporting requirements and

no capital or examination requirements.

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Five major U.S. broker-dealers that we identified were conducting their

OTC derivatives dealing in one or more affiliates outside the entity

regulated by SEC or CFTC. We identified three OTC derivatives dealers that

were affiliates of U.S. insurance companies. These eight OTC derivatives

dealers constituted a rapidly growing component of the derivatives

markets.

Recommendations We recommended that Congress require federal regulation of the safety

and soundness of all major U.S. OTC derivatives dealers. We said the

immediate need was for Congress to bring the unregulated OTC derivatives

activities of securities firm and insurance company affiliates under the

purview of one or more of the existing federal financial regulators and to

ensure that derivatives regulation is consistent and comprehensive across

regulatory agencies.

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Has Improved, but Insurance Regulators’

Oversight Remains Unchanged

Since our May 1994 report, SEC and CFTC have taken several steps to

improve their oversight of the major OTC derivatives dealers that were

affiliates of securities firms. First, CFTC adopted risk-assessment rules that

allow it to receive periodic information on certain FCM affiliates. Second,

DPG’s framework for voluntary oversight, which was developed in

conjunction with SEC and CFTC, represented an important first step in the

evolution of oversight of the major OTC derivatives dealers that are

affiliates of U.S. broker-dealers. Third, SEC continued its efforts to explore

and evaluate whether capital standards should be modified in light of

activities in the derivatives market. In 1995, CFTC began similar efforts to

reevaluate its capital standards to determine whether the current method

of measuring capital requirements has kept pace with the changing

financial environment. Fourth, SEC and CFTC took enforcement actions

involving derivatives activities. Although these were positive steps for

oversight of securities and futures firms, oversight of insurance

companies’ derivatives dealer affiliates remained unchanged.

CFTC Implemented

Risk-Assessment

Rules

On December 31, 1994, CFTC implemented risk-assessment rules that allow

it to collect information to assess the risks posed by the activities of FCM

affiliates that pose material risks to the FCM.

1 CFTC consulted with SEC,

which had adopted similar information risk-assessment rules in 1992, and

other financial regulators to develop its risk-assessment rules. The CFTC

risk-assessment rules require FCMs to provide certain information about

their holding company and affiliates.2

 Organizational charts and

information on risk-management policies are to be provided once with

periodic updates as needed, and financial statements are to be provided

annually. The rules provide CFTC with the authority to seek additional

information as necessary. CFTC and SEC officials credited information

acquired from their risk-assessment rules, along with other information

available to them, with enabling them to determine whether U.S. firms had

any large exposures to Barings. (See chs. 2 and 6 and app. I for additional

discussion about Barings.)

CFTC deferred implementing final risk-assessment rules for reporting

information on (1) noncustomer accounts, (2) financial position and other

information relating to an FCM’s material affiliates, and (3) the occurrence

1

The risk-assessment rules generally apply to FCMs that hold customer funds of $6,250,000 or greater,

maintain adjusted net capital in excess of $5,000,000, or are clearing members of a contract market.

2

CFTC’s risk-assessment rules provide exemptive provisions for entities that are subject to the

regulatory oversight of other domestic and foreign regulatory bodies.

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Oversight Remains Unchanged

of triggering events.3 However, in May 1996, CFTC incorporated certain of

these proposed triggering events into its rule on early warning

requirements. For example, the new rule requires FCMs to report to CFTC

when a 20 percent or greater reduction in their net capital occurs.4 CFTC

was still considering implementation of the balance of the deferred

risk-assessment proposal as of August 1996.

The DPG Framework

Provides for Voluntary

Oversight

DPG member firms, in coordination with SEC and CFTC, developed a

self-regulatory framework to address public policy issues raised by the OTC

derivatives activities of “unregulated affiliates of SEC-registered

broker-dealers and CFTC-registered FCMs.” DPG’s voluntary self-regulatory

framework consists of four interrelated components. The first component,

which is discussed in chapter 2, outlines management controls. The

second component is a series of quantitative reports that cover credit risk

exposures and related information associated with OTC derivatives

activities.5

 The third component consists of an approach for estimating

credit and market risk exposures associated with OTC derivatives activities

and an approach for evaluating those risks in relation to capital. The

fourth component offers guidelines governing relationships with

nonprofessional counterparties. As noted in the framework, this initiative

is considered part of a process, not a single event. As DPG member firms

and SEC and CFTC gain insights, they anticipate further refinements to the

framework. Although the DPG framework is an important step in the

evolution of oversight of the major OTC derivatives dealers that are

affiliates of U.S. broker-dealers, it does not close the regulatory gaps that

exist for these OTC dealers.

3

In its proposed final rule, CFTC identified eight events that could have triggered ad hoc reporting.

4

CFTC Rule 1.12 established financial early warning reporting requirements for FCMs and introducing

brokers that are designed to provide advance notice of financial or operational problems. In addition

to incorporating the 20-percent reduction in net capital early warning requirement, CFTC also

incorporated three additional early warning requirements applicable to all FCMs. FCMs are also to

report (1) a planned reduction in excess adjusted net capital of 30 percent or more 2 business days

prior to the reduction, (2) a margin call that exceeds an FCM’s excess adjusted net capital that remains

unanswered by the close of the business day following the issuance of the call, and (3) whenever

excess adjusted net capital is less than 6 percent of the maintenance margin required to support

positions of noncustomers carried by the FCM unless the noncustomer itself is subject to CFTC’s

minimal financial requirements for an FCM or SEC’s minimum requirements for a securities

broker-dealer. These reporting requirements harmonize CFTC’s early warning reporting requirements

with industry self-regulatory organizations.

5

The DPG framework defines OTC derivative products for enhanced reporting purposes as interest

rate, currency, equity, and commodity swaps; OTC options; and some currency forwards.

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The Voluntary Framework

Provides Additional

Information to SEC and

CFTC

DPG firms voluntarily provide information on their unregulated OTC

derivatives affiliates that was not required under SEC and CFTC

risk-assessment rules. Since 1995, reporting DPG member firms have

provided SEC and CFTC quarterly reports on (1) credit concentrations

(specific information on individual counterparty exposures), (2) the credit

quality of their portfolios, (3) net revenue data, and (4) consolidated

volumes of derivatives activity.6 SEC and CFTC had received all agreed-upon

reports from the five reporting DPG firms through year-end 1995.7 SEC and

CFTC officials said that these reports augment the information they receive

through their risk-assessment rules and other financial and position

information and that the reports are being analyzed and integrated into

their risk assessments of broker-dealers and FCMs. These reports, like the

information collected by SEC and CFTC under their risk-assessment rules,

are confidential and not publicly available.

The credit concentration reports that the reporting DPG firms provided

were based on their affiliates’ top 20 current net credit exposures by

counterparty.8

 The firms provided the information without identifying

individual counterparties, but SEC and CFTC can request the names when

necessary. For each of the top 20 current net credit exposures, the firms

also reported information on the net replacement value, gross replacement

value, and potential additional credit exposure. According to SEC, the DPG

firms’ reported replacement value information is enhanced by the

notional/contract values they report under the risk assessment rules. SEC

believes this will provide a better understanding of the risks that the firms

incur and their level of trading. However, a CFTC official told us that

unnamed counterparty disclosures may not be useful in a market crisis

situation when it may be difficult to contact firms quickly.

The five reporting DPG firms also have provided separate quarterly reports

on the overall credit quality of their portfolios that includes information on

the net exposure, aggregate net replacement value, and gross replacement

value for all counterparties in the portfolio. The first report is segmented

by credit rating category and industry. The other report is segmented by

country for the top 10 geographic exposures. This type of information

6

As discussed in chapter 2, CS First Boston is not required to submit information to SEC or CFTC

because it has an OTC derivatives affiliate that is regulated by the Bank of England. However, SEC

officials told us that under their risk assessment rules, they receive copies of quarterly financial

reports that the affiliate files with the Bank of England.

7

SEC and CFTC officials told us that they had received all agreed-upon reports through August 1996.

8

Current net exposure equals the replacement value, less the effect of legally enforceable netting and

application of collateral.

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could be a useful monitoring tool if it identified potential vulnerabilities

from geographic and industry concentrations. However, industry segments

designated by the International Swaps and Derivatives Association (ISDA)

for reporting purposes may be too broad to identify credit concentrations

within specific industries.9 SEC and CFTC officials acknowledged that the

specific industry segments were not as useful as they could be because

they are so broad, but they said that this is the type of issue they intend to

evaluate in revising the DPG framework.

The DPG firms also provided a report to SEC and CFTC on monthly net

revenue data—trading profit/loss less interest and dividend

income/expense. The report included OTC derivatives and related activities

either by generic product type or by business unit categories,

incorporating one or more of the product types. The generic product types

consisted of four categories: interest rate products, currency and foreign

exchange products, equity derivatives, and commodity derivatives. Such

periodic revenue data can be useful for regulators when they are

monitoring a firm’s risk profile.

Further, the firms provided a report on the consolidated notional/contract

amount of outstanding OTC derivatives transactions and current net credit

exposures. This report was segmented by product for the holding

company group of which the unregulated OTC derivatives affiliate was a

member.

The DPG Framework

Suggested How to

Estimate Capital at Risk

but Did Not Establish

Capital Standards

The third component of the framework—evaluating risk in relation to

capital—has two parts. First, it suggests a way to estimate market and

credit exposures associated with OTC derivatives activities. Second, it

advocates an approach for evaluating those risks in relation to capital.

According to the DPG framework, “capital-at-risk” estimates are imperfect

measures of potential losses associated with market and credit risks.10

However, it noted that managers and supervisors can use them to gauge

capital adequacy and have agreed to report the estimates periodically to

SEC and CFTC.

Although DPG firms’ estimates of capital at risk for market and credit risks

are not intended to be capital standards, the estimates incorporate an

9

The DPG framework uses ISDA-designated segments, which are ISDA members and non-ISDA

members. These are broken down by corporates, financial institutions, government/supranationals,

and others.

10Capital at risk, as defined by DPG, is the maximum loss expected to be exceeded once in every 100

weekly intervals.

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approach similar to the one used by bank regulators in calculating capital

to incorporate market risk. The capital-at-risk estimate is to be generated

by the DPG reporting firm’s proprietary model, as is the value-at-risk

estimate used by U.S. bank regulators for certain capital calculation

purposes. Although DPG used an approach for estimating capital at risk for

market risks similar to the bank regulators’ value-at-risk approach, it

rejected the use of a multiplier to link capital at risk to capital levels.

Moreover, DPG firms rejected the use of add-ons to estimate potential

future credit risk because the add-on amounts are based on

notional/contract amounts, which they do not consider to be meaningful

measures of risk. (See ch. 3 for a discussion of such calculations.) The DPG

framework used a combination model- and formula-based approach to

estimate credit risk. DPG firms consider this to be an interim approach for

estimating current and potential credit risk. They noted in the framework

that they anticipate cooperating with requests by SEC and CFTC to compute

potential credit risk using other methodologies.

The DPG member firms developed minimum standards and audit and

verification procedures to ensure that performance characteristics of all

models used to estimate capital at risk for market risk are broadly similar

and rigorous. Because the potential for risk of loss beyond the

capital-at-risk estimate exists, DPG firms agreed to supplement these

estimates with other potential loss estimates resulting from defined stress

scenarios. The framework also outlines a common approach to audit and

verify technical and performance characteristics because it allows the DPG

firms to use proprietary models that may be unique. SEC and CFTC have

received annual reports from the DPG reporting firms that summarized

external auditors’ reviews of these models. However, because no generally

accepted criteria for modeling exist that would allow an external auditor

to assess compliance, the reports contained no opinions. SEC and CFTC

have been working with the DPG firms on how best to resolve this issue.

In the second part of the framework’s capital-at-risk component, the DPG

firms advocate, for a transitional period, an approach for evaluating

market- and credit-risk estimates in relation to capital levels. In an

evaluation of the adequacy of existing capital levels at DPG-member

affiliates, the framework advocates an oversight approach that encourages

regulators and senior managers to take into account the following factors:

the firm’s structure, internal control and risk management systems; quality

of management; risk profile and credit standing; actual daily loss

experience; ability to manage risks as indicated by the firm’s ability to

perform and document stress and contingency analysis; and overall

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compliance with the framework’s policies and procedures. The DPG firms

anticipate that as experience is gained with the overall DPG framework,

and depending on the evolution of thinking and policies among regulators

internationally, this approach may require further refinement or

modification.

DPG Offers Guidelines for

Counterparty

Relationships

The DPG framework also provides guidelines for its members’ relationships

with nonprofessional counterparties. The guidelines address a number of

subjects, including promotion of public confidence; provision of generic

risk disclosure statements; clarification of the nature of the relationship

between professional intermediaries and nonprofessional counterparties;

and preparation of marketing materials, transaction proposals, scenario or

other analyses, and valuations and quotations. The DPG firms agreed to

provide new nonprofessional counterparties with a written statement

identifying the principal risks associated with OTC derivatives activities and

clarifying the nature of the relationship between parties. We are not

discussing issues involving counterparty relationships, known as sales

practices issues, in detail in this report, because we are addressing them in

ongoing work.

Gaps in Regulation of

Securities and Futures

OTC Derivatives Dealer

Affiliates Remain

The DPG framework is a positive step toward having some federal

oversight of large OTC derivatives dealers that are affiliates of

broker-dealers or FCMs. However, compliance with the reporting

requirements is voluntary and has been limited to the five reporting DPG

member firms. Furthermore, neither SEC nor CFTC has explicit authority to

enforce operational changes, conduct routine examinations, or impose

capital requirements for the major OTC derivatives dealers that are

affiliates of U.S. broker-dealers or FCMs.

Through the DPG framework, the five reporting firms voluntarily report

periodic information to SEC and CFTC or have agreed to make available to

them certain information upon request. According to SEC, these five firms

accounted for over 90 percent of the total derivatives notional/contract

value for all U.S. securities derivatives dealers in 1995. The DPG

information provided to SEC and CFTC is consistent with our 1994 report

recommendation on information reporting. However, the reporting is

voluntary, and the framework contains no provisions for addressing

noncompliance. Withdrawal of a DPG member firm’s endorsement of the

framework, or its failure to provide the information agreed upon in a

timely manner, could leave SEC and CFTC without this information at

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critical times or for a large part of the market. SEC and CFTC officials told us

that their oversight of the parent securities and futures firms and the

threat of damage to a firm’s reputation provide an incentive for DPG

members to adhere to the framework.

SEC and CFTC

Continued Efforts to

Revise Capital

Standards

SEC and CFTC have continued efforts to revise their capital standards. SEC

officials stated that they were continuing to explore and evaluate whether

their capital rules should be modified in light of activities in the derivatives

markets and in the OTC market in particular. Likewise, CFTC was in the

initial phases of reviewing its capital standards and is considering whether

its minimum capital standards have kept pace with the changing financial

environment. An additional consideration in revising capital standards is

that existing capital standards may create incentives for some

broker-dealers and FCMs to conduct certain activities through their

unregistered affiliates to avoid capital requirements that apply only to

registered broker-dealers and FCMs. For example, under current SEC and

CFTC capital requirements, payments that are due a broker-dealer or FCM on

interest rate swaps, which are deducted from the firm’s net worth, are the

equivalent of a 100-percent capital requirement. However, if these swaps

were conducted in an unregistered affiliate, they would not be subject to

capital requirements.

SEC, with CFTC cooperation, is also exploring whether proprietary models

can be incorporated into the capital calculation process. DPG firms use

proprietary (internal) models in their capital-at-risk estimates, and

regulators plan to monitor the results of these estimates in evaluating

whether proprietary models can be used effectively to determine capital

adequacy. SEC officials told us that they monitored closely the

development of the Basle Accord amendment incorporating market risk

into international bank capital standards.

In September 1995, CFTC hosted a roundtable discussion on various issues

related to capital requirements. Issues discussed included the purposes of

capital requirements, the types of business that should be covered and the

degree to which they should be covered, the way risk should be measured,

and the way quality of capital should be determined. In addition to

reviewing the need for specific revisions to existing capital standards, CFTC

identified potential longer term projects that included developing a new

risk-based capital standard and aggregating SEC and CFTC capital

requirements for firms registered as both broker-dealers and FCMs.

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SEC and CFTC Took

Enforcement Actions

Against Dealer and

End-User Activities

SEC and CFTC have the authority to take enforcement actions against

institutions that fail to comply with the laws and regulations they are

responsible for enforcing.11 SEC and CFTC have worked together and

individually to bring actions against dealer and end-user activities

involving derivatives. As a result of the four enforcement actions we

reviewed, SEC and CFTC collected a total of $12.25 million in civil penalties.

SEC and CFTC Took

Actions Against a

Broker-Dealer

On December 22, 1994, BT Securities Corporation settled separate

administrative proceedings with SEC and CFTC and agreed to pay a fine of

$10 million. Both proceedings involved the sale of derivative products by

BT Securities to Gibson Greetings, Inc. According to CFTC’s action, BT

Securities, a broker-dealer registered with SEC, also acted as a commodity

trading advisor subject to CFTC jurisdiction because of its advisory

relationship with Gibson. SEC and CFTC both highlighted their cooperative

effort in bringing an action against BT Securities and said that they were

sending a strong message that SEC and CFTC will work together to police

the market against fraud involving derivatives.

In the SEC proceeding, BT Securities, without admitting or denying the

findings, consented to issuance of an SEC order finding that it caused

reporting violations by Gibson and violated antifraud provisions of federal

securities laws. SEC also found that BT Securities failed to supervise their

employees.12 The violations stemmed from OTC derivatives contracts BT

Securities sold to Gibson. The reporting violations were connected with

Gibson’s 1992 and 1993 financial statements filed with SEC. In preparing

those statements, according to SEC, Gibson relied on valuations of its

derivatives transactions provided by BT Securities. These valuations

understated Gibson’s losses by more than 50 percent from the values

recorded on Bankers Trust Company’s books.13 The SEC finding concerning

fraud violations involved two derivatives contracts BT Securities sold to

Gibson that SEC found were securities within the meaning of the federal

11Their enforcement authorities include court injunctions; temporary restraining orders; and various

administrative proceedings and sanctions (such as assessment of civil monetary penalties, censure,

suspension and revocation of registration, and issuance of cease and desist orders).

12Subsequent to the December 1994 BT Securities case, SEC took administrative actions against two

former BT Securities employees involved in the violations.

13Bankers Trust Company, a bank affiliate of BT Securities, was the counterparty to each derivative

product that BT Securities sold to Gibson. Bankers Trust Company maintained on its books certain

information relating to derivatives transactions with Gibson.

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securities laws.14 The finding stated that representatives of BT Securities

made material misrepresentations and omissions in the offer and sale of

these securities.

To avoid potential short-term dislocation of OTC derivatives markets and

direct regulatory consequences for OTC derivatives dealers, SEC issued a

temporary exemptive order concurrent with the order citing reporting and

antifraud violations of BT Securities. The exemptive order noted that the

complexity and rapid proliferation of derivative instruments raised

questions in the industry regarding the proper statutory and regulatory

designation of certain OTC contracts. These concerns were compounded by

a trend among dealers to conduct a range of OTC derivatives activities in

unregistered entities. To provide certainty to participants in the OTC

derivatives market concerning their registration obligations, the exemptive

order provided relief from broker-dealer registration in connection with

certain transactions involving individually negotiated, cash-settled OTC

options on debt securities or groups of indexes of such securities. The

transactions included were those that (1) are documented as swap

agreements and (2) satisfy the terms of CFTC’s swap exemptions. The

exemption was retroactive to June 6, 1934, the date of the enactment of

the Securities Exchange Act of 1934, and was to expire September 30,

1995. SEC subsequently extended this order to September 30, 1996.15

In the CFTC proceeding, BT Securities, without admitting or denying the

allegations, consented to the issuance of a CFTC order finding that BT

Securities violated the antifraud provision of the Commodity Exchange

Act related to commodity trading advisors in connection with swaps sold

to Gibson. From November 1991 to March 1994, BT Securities and Gibson

entered into a series of derivatives transactions, all of which were swaps.

Over time, the derivatives BT Securities sold to Gibson became

increasingly complex, risky, and intertwined. Many had leverage factors

that caused Gibson’s losses to increase dramatically with relatively small

changes in interest rates. CFTC found that representatives of BT Securities

had entered into an advisory relationship with Gibson sufficient to cause

BT Securities to have become a commodity trading advisor with respect to

14In its proceeding, SEC found that a Treasury-linked swap sold to Gibson was a cash-settled put

option based on the spread between the price of a Treasury security and the arithmetic average of the

bid and offered yields of a Treasury note. Another transaction, a knock-out call option sold to Gibson,

was a cash-settled call option based on the yield of a U.S. Treasury security. According to SEC’s

proceeding, Gibson entered into several amendments to the Treasury-linked swap and knock-out call

option proposed by Bankers Trust, and each “was a security within the meaning of the federal

securities laws.”

15See SEC Release No. 34-36270, CFR, Sept. 22, 1995 (Vol. 60, No. 188).

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its derivatives transactions with Gibson. Further, CFTC concluded that BT

Securities defrauded Gibson in violation of the Commodity Exchange Act.

In addition to the civil penalty, SEC and CFTC required BT Securities to

cease and desist from violating securities and futures laws and hire an

independent consultant to conduct a review of the firm’s OTC derivatives

business. They also required BT Securities to adopt recommendations that

the independent consultant made.

SEC Took Enforcement

Action Against an

End-User

In October 1995, SEC settled administrative proceedings against Gibson

Greetings, Inc., and two of its senior officers. SEC found that they violated

or caused violations of the securities laws in connection with derivatives

transactions between Gibson and BT Securities. Without admitting or

denying any wrongdoing, Gibson and the two officers consented to entry

of an order requiring them to permanently cease and desist from

committing or causing any violations of the reporting and books and

records provisions of federal securities laws. SEC found that in 1993 Gibson

engaged in a series of derivatives transactions with BT Securities that, for

accounting purposes, amounted to trading or speculation. According to

SEC, those transactions should have been recorded at market value with

changes recognized through the income statement, but instead they were

deferred. As a result, Gibson’s quarterly reports on SEC’s Form 10-Q16 for

the first three quarters of 1993 failed to disclose gains and losses from

derivatives to shareholders. SEC also found that Gibson failed to have

adequate books, records, and internal controls concerning its derivatives

transactions.

CFTC Took Enforcement

Action Against an FCM

On July 27, 1995, MG Refining and Marketing (MGR&M) and MG Futures,

Inc., (MGFI) agreed to pay $2.25 million in civil penalties to settle a CFTC

complaint that they violated the Commodity Exchange Act and various

CFTC regulations.17 MGFI is an FCM, a member of the New York Mercantile

Exchange, and a commodity trading advisor registered with CFTC.

According to the enforcement action, CFTC found that material

inadequacies in internal control systems at MGFI, as well as the risks

associated with its overall business, including its futures positions,

threatened the financial condition of MGFI. CFTC also found that MGFI failed

to notify it of these material internal control inadequacies and further

failed to file certified financial reports required by CFTC regulations. MGFI

16A quarterly report required by SEC of companies with listed securities.

17Metallgesellschaft, AG is the ultimate parent company of both MGR&M and MGFI.

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and MGR&M agreed to settle without admitting or denying any of the

findings. According to a CFTC official, the $2.25 million civil penalty against

MGFI and MGR&M represents the largest fine assessed for violations not

involving fraud in CFTC’s history. In addition to the fine, MGFI must comply

with additional requirements, which include providing certified financial

statements, establishing an interim special oversight committee, reforming

inadequate internal controls, reporting on internal control improvements,

providing an implementation plan, and providing a report by independent

auditors on its internal controls.

According to the settlement agreement, from at least December 1991 to

December 1993, MGR&M also marketed, offered, and sold illegal

off-exchange energy product futures contracts.18 Some market participants

were concerned that the language used in the agreement might implicate

contracts previously exempted by CFTC as swaps. However, CFTC

maintained that this enforcement case was a response to a serious failure

of MGR&M’s internal controls, and it was not intended to, nor did it, affect

the legality or enforceability of other contracts.

State Insurance

Regulatory Oversight

Remains Unchanged

Although the financial results of derivatives dealer affiliates are part of

consolidated insurance company financial reports to regulators, these

affiliates continue to have no capital or examination requirements.

Although the volume of derivatives activities of insurance companies was

small compared to that of the top seven bank dealers (see ch. 1), the

volume of their activities was measured in billions of dollars and increased

at a greater rate than either banks or securities firms in 4 of the 5 years

that we analyzed. Given the large asset size of these institutions, adequate

oversight remains important because of the systemic implications of a loss

at any large dealer and the potential loss to policyholders.

State insurance departments, not federal regulators, are responsible for

monitoring insurance companies both headquartered and licensed to

operate in the state. However, state insurance regulators do not directly

oversee the financial condition of affiliates of insurance companies that

are OTC derivatives dealers. As we reported in 1994, OTC derivatives dealer

affiliates of insurance companies are subject to minimal reporting

18CFTC deemed the contracts sold by MGR&M to be futures because they contained all the essential

elements of a futures contract. They called for making or taking delivery of a commodity in the future

at a price or pricing formula based at initiation; they could be satisfied either by delivery of the

commodity or by engaging in an offsetting transaction without delivery; and the purpose of the

transaction was primarily to speculate or hedge the risk of price change in the commodity without

actually acquiring the underlying commodity. CFTC deemed the contracts to be illegal because futures

contracts, unless specifically exempted, must be traded on an exchange recognized by CFTC.

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requirements, continue to have no capital requirements, and are not

examined. According to insurance regulators from Delaware, New Jersey,

and New York, they have made no changes in their oversight of derivatives

since our 1994 derivatives report. Insurance regulators in these states said

that they continue to receive audited consolidated financial statements for

the parent company or the holding company of the insurance company

and that this information also includes the activities of the derivatives

dealer affiliate.

NAIC, an advisory group that comprises insurance regulators from the 50

states, the District of Columbia, and 4 U.S. territories, has been actively

revising its suggested policies and procedures to improve derivatives

disclosures and examinations. However, NAIC’s proposals are not binding,

and each state decides the extent to which they will be applied. Further,

the three states that supervise insurance companies with derivatives

dealer affiliates have no statutory authority over the affiliates. Thus, even

if the states adopt the NAIC proposals, the resulting requirements would

apply only to the insurance companies, not to their derivatives dealer

affiliates.

NAIC included new derivatives disclosure requirements in its recommended

standard annual financial statement.19 NAIC suggested that these

requirements be effective with the December 31, 1994, statement prepared

by regulated insurers. NAIC has also changed its Financial Examiners

Handbook to provide better guidance to state insurance examiners on

what to look for when dealing with derivatives. Further, NAIC has made

changes that affect accounting for, and valuation of, derivatives to the

Accounting Practices and Procedures manuals and the Securities

Valuation Office Purposes and Procedures manuals, both used by state

insurance departments. The NAIC Life Risk-Based Capital Working Group is

also considering refinements to the formula used to calculate capital

requirements, which would better account for derivative products. Finally,

the NAIC Invested Asset Working Group, a study group that issues guidance

on invested assets of insurance companies, provides ongoing monitoring

of insurers’ derivatives activity.

Conclusions SEC and CFTC have made efforts to police the markets against fraud

involving derivatives as demonstrated by the enforcement actions they

have taken against derivatives dealers and end-users. SEC and CFTC have

19The standard annual statement is an annual report of the financial condition of insurance companies

required to be filed with the various state insurance commissioners.

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also taken positive steps, consistent with the recommendations in our

1994 report, to address gaps in the oversight of OTC derivatives activities

conducted through unregulated affiliates of broker-dealers and FCMs. For

example, CFTC’s risk assessment rules should provide better information

for CFTC to monitor the financial condition of FCMs. More importantly, SEC

and CFTC have begun to receive expanded information reported voluntarily

by the five reporting DPG members about their unregulated affiliates that

are OTC derivatives dealers. This information should allow SEC and CFTC to

better oversee the five DPG reporting firms and monitor them for potential

problems. Although the DPG framework is an important first step in the

evolution of oversight for the major OTC derivatives dealers that we

identified in our 1994 report, its voluntary nature does not provide

regulators authority to enforce operational changes they might

recommend. We also note that neither SEC nor CFTC has the authority to put

in place examination and capital requirements for the unregulated

affiliates of broker-dealers and FCMs.

Insurance companies’ OTC derivatives dealer affiliates remain virtually

unregulated. To the extent that states adopt the new NAIC proposals,

derivatives disclosures and examinations for insurance companies may

improve. However, because the states do not directly oversee insurance

companies’ derivatives dealer affiliates, the NAIC proposals will not apply

to them.

Chapter 5 MAY 1994 REPORT SUMMARY

Findings Accounting rules for derivatives, particularly those used for hedging

purposes by end-users of derivatives, were incomplete and inconsistent

and had not kept pace with business practices. FASB standards directly

addressed only two of the four basic types of off-balance sheet

derivatives—futures and forwards. No specific accounting rules had been

established by FASB for swaps or options. In the absence of accounting

rules for these derivatives, accounting practices of derivatives market

participants had been shaped by common industry practice and by the

adaptation of existing rules for similar financial products.

We found that in practice, derivatives used for trading purposes were

recorded at market value, while derivatives used for hedging purposes

were recorded consistent with the item being hedged, either at market

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value or at cost.1 If the hedged item was recorded at cost, then gains or

losses from changes in the market value of the derivatives were deferred

until the related gains or losses on the hedged item were realized, which

we referred to as deferral hedge accounting. If the hedge operated as

planned, the income statement effects of the derivative product and the

hedged item would theoretically offset each other. However, we found

that determining whether a hedge was operating effectively and thus

qualified for hedge accounting was difficult, not only because of the

complexities involved but also because of confusion about the definition

of hedging. Some believed that hedging meant activities to reduce, or

neutralize, exposure to risk of loss from changes in market conditions,

while others believed that hedging also encompassed activities that adjust

risk to take advantage of anticipated changes in market conditions. Since

existing accounting practice allowed for deferral of gains and losses from

derivatives activities designated as “hedging,” we stated that the

broadening of the definition of hedging to include risk adjustment enabled

inappropriate deferral of hedge gains and losses.

With regard to disclosure of derivatives activities in financial statements,

we reported that two existing FASB disclosure standards required

disclosure of information about the extent and nature of an entity’s

financial instruments, including derivative products, with

off-balance-sheet risk of accounting losses and about fair values2

 of

financial instruments. We reviewed the 1992 annual reports of 10 large U.S.

bank holding companies with significant derivatives activity and found

these institutions were generally complying with these standards, although

some variances in the extent and methods of disclosures existed. A

proposed disclosure standard, which was expected to be issued by the end

of 1994, required additional disclosures about derivatives and their fair

values. The proposed standard also contained amendments to the prior

two disclosure standards and included certain optional disclosure

requirements. Although the proposed standard was an improvement over

the existing requirements, it was our view that there were additional

disclosures that would provide financial statement users with a more

complete understanding of derivatives.

We concluded that market value accounting is ultimately the best solution

to accounting for all financial instruments, including derivatives, and

1

We use the term “market value” to refer to the amount at which an item could be exchanged between

willing parties.

2

FASB uses the term “fair value” to avoid the implication that the standards apply only to items traded

on active secondary markets.

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would result in financial statements being almost completely transparent

concerning the effectiveness and impact of financial risk management

activities. However, we also recognized that development of a new market

value accounting model would take time and thus might not be feasible in

the short term because authoritative accounting standards were needed

immediately.

Recommendations As a step forward, we recommended that FASB proceed expeditiously to

issue the exposure draft on disclosures of derivatives and fair value of

financial instruments. To more effectively deal with accounting and

disclosure issues, we also recommended that FASB proceed expeditiously

to develop and issue comprehensive and consistent accounting rules for

derivatives activities. As the best conceptual approach to accomplish this,

we recommended that FASB consider adopting a market value accounting

model for all financial instruments, including derivative products.

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to Be of Concern

To address accounting practices for derivatives hedging activities since

our 1994 report, we reviewed 12 banks and thrifts that were end-users of

derivatives. Our review of these 12 institutions showed that inadequate

accounting standards for derivatives hedging activities continued to be a

major unresolved problem that adversely affected the quality of

information available to users of financial statements. Further, in the case

of several entities that reported major losses from investment activities

involving securities with derivatives-like characteristics, we found that the

application of historical cost accounting rules for investment securities

allowed them to delay recording those losses in the financial statements.

We continue to believe that the adoption of comprehensive market value

accounting for all financial instruments would resolve many of the

accounting problems with derivatives and investment securities.

FASB, GASB, and SEC have taken steps to address these issues. FASB has

issued a disclosure standard that requires specific disclosures about

futures, forwards, swaps, options, and other financial instruments with

similar characteristics. FASB also issued a proposed standard that would

require all derivatives, including investment securities with derivatives-like

characteristics, to be recorded at fair value on the balance sheet. In

addition, GASB issued a proposed standard that would require state and

local governmental entities to record all investment securities at fair value.

Although these proposed standards would help resolve many of the

accounting issues we identified, they do not require comprehensive

market value accounting for all financial instruments. Therefore, they

would not resolve problems surrounding the use of historical cost

accounting for other types of financial instruments. In addition, neither

FASB nor GASB proposed or adopted standards requiring disclosure of

market risk. Such disclosure is key to understanding the impact of interest

rate and other market changes on derivatives and other financial

instrument holdings. SEC issued proposed reporting requirements that

include disclosure of market risk. However, the proposal, if adopted,

would be required only for public companies.

Hedging Practices of

Banks and Thrifts

Varied Considerably

and Were Sometimes

Speculative

Our review of the derivatives accounting practices at 12 end-user banks

and thrifts showed that such practices were inconsistent and, in some

cases, inappropriate. The problems we found centered around the use of

deferral hedge accounting, whereby gains and losses from these

derivatives activities are not recorded in income as they occur. We found

that more than half of the institutions used deferral hedge accounting for

risk-adjusting or, at least in one case, purely speculative, derivatives

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activity that was based on anticipated market movements.3 We believe that

deferral hedge accounting should be limited to activities intended to

decrease an entity’s exposure to risk of loss and should not be used when

an entity uses derivatives to attempt to profit or speculate on market

movements. Only 5 of the 12 institutions used deferral hedge accounting

appropriately for derivatives activities designed to neutralize their

exposure to interest or foreign exchange rate risk. Seven used deferral

hedge accounting for derivatives activities designed to adjust rather than

neutralize their risks and therefore, in our view, inappropriately delayed

recording gains and losses on these transactions.

Each of the 12 banks and thrifts we selected for review engaged in

activities using derivatives that they defined as “hedging.”4

 Each of the

institutions also used deferral accounting for these designated hedging

activities. However, we found that the hedging objectives for the group of

five risk-reducing institutions differed from those of the group of seven

risk-adjusting institutions. The criteria used by these 12 institutions to

justify hedge accounting, while reportedly based on the limited accounting

standards that do exist for derivatives, also varied significantly.5

 The

specific hedge objectives and related criteria of selected institutions in our

sample are described in appendix VII.

The hedging objective of all five risk-reducing institutions was to

neutralize the impact of potential loss from changes in interest or foreign

exchange rates on their operating income. For example, some employed a

hedging strategy to lock in a spread between interest earned on assets and

interest paid out on liabilities. Under this type of strategy, changes in the

market values of the assets and liabilities involved, when adjusted by

changes in market values of the derivatives used as a hedge, would

generally be offset, thereby neutralizing the effect of rate changes on the

institutions’ overall financial position. Changes in the market values of

assets and liabilities carried at historical cost are not recorded until they

are sold. The offset from changes in the market values of the derivatives is

accomplished by similarly deferring any realized hedge gains and losses on

the derivatives. The deferred hedge gains and losses would generally be

amortized over time and recognized as an adjustment to net interest

3

Examples of institutions’ use of deferred hedge accounting are included in appendix VII.

4

For purposes of examining these 12 institutions, we limited our review to their off-balance sheet

derivatives activities, primarily futures, forwards, options, and swaps. We did not specifically examine

their accounting practices for securities with derivatives-like properties, such as structured notes or

CMOs.

5

Existing accounting standards for derivatives address only futures and some types of forwards. These

standards are outlined in appendix VI.

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income related to the underlying assets and liabilities being hedged.6 Any

changes in net interest income caused by changes in interest rates would

be offset by amortization of the related hedge gains and losses.

The other seven institutions in our sample used strategies they labeled as

hedging that were risk-adjusting activities based on anticipated market

movements. For example, if an institution’s management believed interest

rates were going to decline, they would use derivatives to adjust their

exposure to interest rates so that they could profit from a decline in rates.

If rates increased rather than declined, such a strategy would generally

result in losses for the institution. In either case, neither the changes in

market values nor the impact on net interest income from the derivatives

would be offset by corresponding changes in the market values or net

interest income from the assets or liabilities purportedly being hedged. In

other words, the institutions used the derivatives to shift their exposure to

changes in interest rates rather than to protect against such changes.

Because deferral hedge accounting was applied by these institutions, the

gains or losses from these types of risk-adjusting activities were deferred

and not recorded in income until a later time.

In some cases it may be appropriate for institutions to position themselves

to take advantage of expected changes in interest rates. However, we

believe that the resulting gains and losses from these activities should not

be afforded deferral hedge accounting. Deferral of such gains and losses

can result in large accumulations, particularly of losses, that either get

deferred in the balance sheet, with no income statement recognition, or do

not show up in the financial statements (as is usually the case with swaps)

until the derivatives position is closed. The use of market value accounting

for derivatives and related financial instruments would preclude such

inappropriate accumulation of losses because changes in their market

values would be recognized in income as they occurred.

6

Hedge accounting for interest rate swaps differs in that the net interest differential paid or received on

the swap is amortized into income over the applicable interest period. However, the changes in market

value of the swap itself are not recorded on the financial statements.

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Accounting Practices

for Investment

Securities With

Derivatives-Like

Characteristics

Resulted in Delayed

Recognition of Losses

Some major losses reported by state and local government entities, a

credit union, and others have been the result of investments in securities

with characteristics similar to those of derivatives. Changes in market

value of these securities can be amplified by leveraging features that can

cause entities holding large portfolios to experience severe losses in

market value from changes in interest rates. These market value losses are

often not recorded by the entity because accounting rules allow many

investment securities to be carried at historical cost. In particular,

accounting practices followed by state and local governments allow

virtually all securities to be carried at historical cost. Further, accounting

rules do not require disclosures about the potential effects of changes in

interest rates on the market value of the investment portfolio. By

recording investment securities at historical cost and not disclosing

market risk, entities leave financial statement users without information

about the effects of changing market conditions, which could impede their

ability to make informed business decisions.

FASB-Issued Standards

Require Accounting for

Investment Securities on

the Basis of Entity Intent

In May 1993, FASB issued SFAS No. 115, Accounting for Certain Investments

in Debt and Equity Securities, in response to concerns about the use, by

some securities holders, of historical cost accounting for investments that

were regularly sold and traded.7 SFAS No. 115 permits some investment

securities to be carried at historical cost on the basis of the intent and

ability of an entity’s management to hold the instruments to maturity, but

other securities are to be carried at fair value. Although SFAS No. 115 does

not apply to derivatives, it does apply to investment securities that have

derivatives-like characteristics, such as structured notes and CMOs. As

stated in our December 1992 comment letter to FASB on the exposure draft

for SFAS No. 115, we continue to believe that the standard is too subjective

and difficult to verify. Market value accounting for all debt and equity

securities would eliminate the judgmental nature of SFAS No. 115 and

would provide for early exposure of portfolio declines.8

 Although market

value accounting has been criticized because it can cause earnings

volatility based on temporary changes in market values, we believe this

volatility, if it occurs, reflects the realities of the marketplace.

7

The requirements of SFAS No. 115 are outlined in appendix VI.

8

As discussed in appendix VI, SFAS No. 107 requires entities to disclose the fair value of all financial

instruments either in the body of the financial statements or the related footnotes. However, we do not

believe disclosure of these values effectively communicates the financial impact of changes in the

market value of the financial instruments because it does not result in the changes in the market

values being reflected in the financial condition and results of the entities’ operations.

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We believe that a market value approach to investment securities and

related liabilities and hedging instruments would help expose activities

that threaten an entity’s viability and facilitate more timely corrective

actions. In contrast, management’s ability to account for investment

portfolios and related activities at historical cost has allowed some

managers to avoid recognition of problems until they become so severe

that they require drastic action. An example of the dangers of such use of

historical cost accounting is illustrated by the major losses of Cap Corp.

As discussed in chapter 2 and appendix I, market conditions in 1994,

compounded by an aggressive investment and funding strategy, resulted in

large declines in the values of CMOs held by Cap Corp. In the fall of 1994,

many member credit unions began withdrawing shares they held in Cap

Corp. To avoid recording the losses on its CMO portfolio, Cap Corp funded

these withdrawals with additional borrowing rather than selling some of

its CMO portfolio. Once these borrowings resulted in violation of regulatory

borrowing limits, Cap Corp was forced to liquidate some of these

investments at substantial losses to fund credit union member

withdrawals. Yet, Cap Corp continued to record the vast majority of its

portfolio at historical cost, apparently taking advantage of the subjective

criteria of SFAS No. 115 that allow entities to carry such securities at cost if

they have the ability and intent to hold them to maturity. As of

September 30, 1994, Cap Corp’s internal reports showed that over 95

percent of its portfolio was carried at historical cost, which was

approximately $35 million greater than the market value of these securities

at that time. Had earlier recognition of these market value losses occurred

in Cap Corp’s financial reports, the negative effects of its investment

strategy would have surfaced sooner, perhaps in time for remedial action

that could have averted its failure.

Specific Accounting

Standards for Investments

Held by State and Local

Governments Do Not Exist

As of September 30, 1996, no specific GASB standards existed that

established rules for accounting for most types of investments held by

state and local government entities.9

 While GASB Statement No. 3, Deposits

With Financial Institutions, Investments (Including Repurchase

Agreements), and Reverse Repurchase Agreements, provides guidance for

investment and other disclosures by government entities, we believe

disclosures are no substitute for accounting rules that determine how the

investments should be recorded in the financial statements. In practice,

investment securities are usually recorded and carried on the books at

9

An exposure draft entitled “Accounting and Financial Reporting for Certain Investments and for

External Investment Pools” was issued by GASB on March 13, 1996. The provisions of this exposure

draft are summarized later in this chapter.

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their original cost, unless it is clear that the original cost cannot be

recovered. The lack of accounting standards can result in state and local

governments avoiding the recording of losses in market value until well

after the book value is permanently impaired.

In Orange County, CA, for example, despite rapidly decreasing values (see

ch. 2 and app. I), the county’s entire pool of securities was carried at

historical cost. This masked the volatility and riskiness of the investments

the County Treasurer was making. The severe decline in the value of the

portfolio became apparent when the county experienced a severe liquidity

squeeze caused primarily by margin calls. The county experienced

substantial losses thereafter as it liquidated portions of its investment

portfolio. Up until this point, the county continued to carry the portfolio at

historical cost.

As with Cap Corp, had earlier recognition of market value losses been

required, the county may have taken remedial action because the negative

effects of the investment strategy would have been made clear. Also, as

discussed later in this chapter, required quantitative disclosure of the

market risk being taken on investment securities would have provided

further warning of the sensitivity of Cap Corp’s and Orange County’s

investment portfolios to future changes in interest rates. The following

sections discuss standards proposed by FASB, GASB, and SEC that if adopted

would help resolve many of the accounting and disclosure inadequacies

regarding derivatives and other investment activities.

FASB’s Proposed

Standard Is a Positive

Step Toward

Addressing Problems

in Accounting for

Derivatives and

Similar Instruments

In June 1996, after considering and rejecting numerous proposals over

many years, FASB issued an exposure draft of a proposed standard,

Accounting for Derivative and Similar Financial Instruments and for

Hedging Activities. The proposed standard provides an approach to

accounting for derivatives and similar financial instruments that would

require entities to record such instruments in the balance sheet as assets

or liabilities measured at fair value. The accounting for gains and losses

resulting from changes in the fair value of derivatives would depend on the

entity’s intended use of the derivatives. The proposed standard has many

advantages over current practice and would help eliminate the types of

inappropriate practices we noted in our review of the 12 institutions.

However, strong opposition to the proposed standard exists that is due, in

part, to the fact that it eliminates much of the flexibility in current practice

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and does not easily accommodate macro-type hedging strategies.10 As we

have previously stated, we believe the only viable solution to

macrohedging issues, and the solution overall, is comprehensive market

value accounting for all financial instruments. FASB’s proposed standard is

a step toward this solution.

Summary of FASB’s

Proposed Standard

FASB’s proposed standard, which is described in detail in appendix IX,

applies to traditional derivatives, such as futures, forwards, options, and

swaps, and other financial instruments with derivatives-like

characteristics. The proposed standard would require all derivatives to be

recorded as either assets or liabilities in the balance sheet at their fair

value. The accounting for gains and losses resulting from changes in the

fair value of the derivatives would depend on the reason for the use of the

derivatives.

For derivatives designated as hedges of changes in fair value of existing

assets or liabilities, or contractually committed transactions (fair value

hedge), the gain or loss would be recognized in earnings along with the

offsetting gain or loss on the hedged item. For derivatives designated as

hedges of cash flows from forecasted (i.e., expected but not committed)

transactions (cash flow hedge), such as expected future inventory

purchases, the gains or losses on the derivatives would be reported as a

component of equity, called other comprehensive income.11 Cumulative

gains or losses on the derivatives would be moved from other

comprehensive income to earnings on the preestablished date that the

forecasted transaction was projected to occur. In the case of derivatives

not designated as hedges, the gain or loss would be recorded in earnings,

as is the current practice.

The proposed standard specifies a number of criteria that must be met for

derivatives to qualify as fair value or cash flow hedges. These criteria are

more restrictive than those used in current practice and are likely to limit

the types of activities that qualify for hedge accounting under the

proposed standard. All of these criteria are discussed in appendix IX, and

a discussion of selected criteria follows.

10Macrohedging is hedging of an entire portfolio as opposed to individual assets or liabilities. Often this

is accomplished by an entity’s hedging its net exposure to changes in interest rates or other market

factors.

11Comprehensive income is defined as the change in equity of a business entity during a period from

transactions and other events and circumstances from nonowner sources. It includes all changes in

equity during a period except those resulting from investments by owners and distributions to owners.

Other comprehensive income represents all components of comprehensive income other than net

earnings.

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For a derivative to qualify as a fair value hedge, formal documentation of

the hedging instrument, the hedged item, and the risk being hedged must

exist, and the use of the derivative must be consistent with the entity’s

established policy for risk management. In addition, the item being hedged

must be specifically identified as a single asset or liability or a portfolio of

similar items sharing common characteristics; the hedged item must be

reliably measurable at fair value, and changes in the fair value must be

expected to be substantially offset by changes in the derivative; and the

hedged item individually must present an exposure to price changes that

could affect reported earnings.

The criteria for a cash flow hedge also require that formal documentation

of the hedging instrument, the hedged item, and the risk being hedged

exist and that the use of the derivative be consistent with the entity’s

established policy for risk management. In addition, for a cash flow hedge,

the forecasted transaction must be probable, be part of an established

business activity, and represent an exposure to price changes that could

affect reported earnings. Further, the net cash flows from the derivative

must be expected to substantially offset all of the changes in net cash

flows of the hedged forecasted transaction that are attributable to the risk

being hedged.

The proposed standard also includes specific disclosure requirements for

derivatives and similar financial instruments. For all derivatives, each

entity is required to distinguish among derivatives designated as fair value

hedges, cash flow hedges, hedges of the foreign currency exposure of a

net investment in a foreign operation,12 and all other derivatives. The

entity must disclose

• its objectives for holding or issuing the instruments,

• the context needed to understand those objectives,

• its strategies for achieving those objectives, and

• the notional or contract amount of the derivatives when necessary for an

understanding of the objectives.

For derivatives designated as hedges, the entity must provide

• a description of the entity’s risk-management policy for such hedges,

including a description of the items whose risks are being hedged and the

classes of derivatives used to hedge those risks;

12See appendix IX for discussion of this type of hedge.

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• the amount of gains or losses on the derivatives and the items being

hedged, if applicable, that were recognized in earnings during the

reporting period as well as a description of where those gains and losses

and the related hedged items are reported in the financial statements; and

• the cumulative amount of derivatives gains or losses that have not yet

been recognized in earnings and a description of where they are reported

in the financial statements.

In addition, for fair value hedges, the entity must also disclose the amount

of gains and losses recognized in earnings when performance under a

hedged-firm commitment is no longer probable. For cash flow hedges, the

entity also must disclose the designated reporting periods in which the

forecasted transactions are expected to occur and the deferred amounts to

be recognized in earnings.

Proposed Standard Has

Many Advantages Over

Current Practice

The proposed standard has many advantages over current hedge

accounting practices. For example, as outlined in appendix VI, current

accounting standards for derivatives address only certain types of

derivative instruments, while the proposed standard applies to all

derivatives and to financial instruments with characteristics similar to

derivatives. Derivatives held by end-users for hedging purposes are

currently not reflected on the balance sheet. Under the proposed

approach, all derivatives would be recorded as assets or liabilities in the

financial statements and measured at fair value. Under existing hedge

accounting, gains and losses on a qualifying derivative hedging instrument

are deferred to offset the change in value of the underlying asset or

liability being hedged (the hedged item). These changes in fair values are

not recorded in earnings.13 Under the proposed standard, gains or losses

on a derivative used as a fair value hedge would be included in earnings,

and offsetting losses or gains on the hedged item would be accelerated

and recognized in earnings in the same period. Accelerating the gain or

loss on the hedged item generally has the added benefit of adjusting the

historical cost amount of that asset or liability toward its fair value.14

FASB’s proposed standard would help eliminate the inappropriate uses of

deferral hedge accounting that we noted among the 12 institutions we

13Any realized gain or loss on the derivative is deferred and added to the basis of the underlying asset

or liability being hedged on the balance sheet.

14The amount of gain (or loss) accelerated is limited to the lesser of the loss (or gain) on the derivative

or the unrecognized gain (or loss) on the hedged item occurring subsequent to the inception of the

hedge. Therefore, the adjusted value of the hedged item will not reflect its actual fair value to the

extent that the gains or losses on the hedged item exceed those of the derivative.

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reviewed (see app. VII). Many of these institutions incurred large declines

in the values of their derivatives, which were not reflected in their

financial statements. Had the proposed standard been in place, such

derivatives would have been required to be reported on the balance sheet

at fair value; the related losses would have been reflected in the financial

statements, either in earnings or in other comprehensive income.

We also note in appendix VII that the 12 institutions varied widely in their

application of hedge criteria. For example, they differed significantly in

how they determined whether there was high correlation between changes

in the market value of a derivative and changes in market value of the

underlying hedged asset or liability—a requirement under current hedge

accounting. Under the proposed standard, calculating correlation becomes

essentially unnecessary since both hedge and nonhedge gains and losses

are required to be reported in earnings.15 An ineffective hedge would result

in little or no offsetting losses or gains from the hedged item, with the net

accounting effect being the same as if the derivative had not been

designated as a hedge. In addition, the proposal requires discontinuance of

hedge accounting if a hedge fails to meet any of the previously listed

criteria.

There also are inconsistencies in the hedge criteria established in the

current standards. For example, as described in appendix VI, SFAS No. 52

and SFAS No. 80 differ in the allowed use of hedge accounting for

anticipated, or forecasted, transactions. The proposed standard would

eliminate such inconsistencies by establishing one set of standards for all

derivatives and superseding prior standards that caused such

inconsistencies.

Proposed Standard Would

Not Accommodate

Macrohedging

The 12 institutions in our sample used both micro- and macrohedging

strategies.16 These strategies are described in detail in appendix VII. FASB’s

proposed standard requires derivatives to be designated as a hedge of a

specific asset, liability, or forecasted transaction or as a hedge of a

portfolio of similar assets or liabilities. Because of this, the proposed

standard generally does not easily accommodate macrohedging. As many

institutions currently use macrohedging strategies, the limitations imposed

15As previously discussed, cash flow hedge gains and losses are initially reported in comprehensive

income but flow through to earnings on the projected date of the forecasted transaction.

16A microhedge requires linking qualifying derivatives to particular assets or liabilities, while a

macrohedge is not necessarily related to identifiable assets or obligations but instead hedges the

entity’s net risk exposure.

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on such strategies under the proposed standard have caused concern and

opposition to the proposed approach. In our sample institutions, eight

used macrohedging strategies. Of those eight, six were risk-adjusting

rather than risk-reducing strategies. As previously discussed, we do not

believe risk-adjusting strategies should qualify for special hedge

accounting treatment. The proposed standard would help eliminate the

ability of entities to inappropriately use hedge accounting for

risk-adjusting strategies; however, it would also limit the ability to use

hedge accounting for valid macrohedging risk-reducing strategies.

We believe the only viable solution to these macrohedging issues is

comprehensive market value accounting of all financial instruments,

because it is the only reliable way that offsetting gains and losses in the

portfolio and in the derivative instruments can be matched up. Under

comprehensive market value accounting, the results of any hedging

strategies would be clearly reflected in earnings. Effective risk-reducing

macrohedging strategies would generally result in minimal volatility in

earnings, while macrohedging risk-adjusting strategies would often result

in significant earnings fluctuations.

However, we recognize that adoption of a market value accounting model

would require the resolution of significant implementation issues and

therefore may not be a feasible solution in the short term. Officials from

most of the 12 banks and thrifts in our sample told us they were opposed

to market value accounting for all financial instruments. They expressed

concerns about how to determine market values for financial instruments

with no ready market, the treatment of intangible assets, and the overall

volatility in the financial statements that may result from temporary shifts

in the financial markets. They also indicated that it would be very

burdensome to determine market values for commercial loan portfolios on

a regular basis. These and other issues will need to be addressed before

full market value accounting can be feasibly implemented.

Comprehensive Market

Value Accounting Was

Considered by FASB but

Not Adopted

On the basis of our review of FASB Board minutes leading up to the

issuance of the proposed standard as well as the background information

accompanying the proposed standard, nearly all FASB members said that,

ultimately, a comprehensive market value approach for all financial

instruments is the most conceptually sound solution to the problems

surrounding derivatives and other financial instruments that FASB has been

grappling with for years. In developing the proposed standard, FASB made

several fundamental decisions about how to account for derivatives. One

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of those decisions was that fair value is the most relevant measure for all

financial instruments and the only relevant measure for derivatives. In the

background information accompanying the proposed standard, FASB

acknowledged its belief that fair values for financial assets and liabilities

provide more relevant and understandable information than cost or

cost-based measures and that with the passage of time, historical prices

become irrelevant. It also acknowledged that a fair value approach would

have been simple and readily understandable to financial statement users,

would have increased comparability for identical balance sheet positions

between entities, and would have eliminated the need for special

accounting for hedges of financial instruments.17

In further reviewing the background information, we noted that in keeping

with this belief, FASB considered measuring all financial instruments at fair

value in the proposed standard. Some FASB members indicated that

changing the accounting model so that all financial instruments are carried

at fair value is the only conceptually consistent solution to hedging issues.

However, a number of FASB members chose not to pursue such a model for

various reasons. In general, many FASB members did not believe that this

could be accomplished in one step. Some FASB members were concerned

that a substantial amount of time would be needed to fully address and

agree upon the implementation issues of such a model. These include

conceptual issues about the valuation of financial assets and liabilities and

the reliability of measuring the fair value of some financial instruments. In

addition, some FASB members were concerned about the significant impact

the requirement would have on financial reporting practices. Because

many preparers of financial statements oppose FASB’s proposed

requirement that all financial instruments be measured at fair value and

because pressure exists to present a solution to the long-standing

derivatives problem, FASB opted to develop an interim solution. However,

this interim solution is also facing much resistance due, in part, to the

reduced flexibility that entities would have compared with accounting

practices used under limited existing standards.

17A fair value approach for financial instruments would not, however, have addressed the need for

special accounting for fair value hedges of nonfinancial assets and liabilities and would not

accommodate the current practice of hedging forecasted transactions.

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Some Improvements

Made in Derivatives

Disclosures, but

Enhancements Are

Needed

Current derivatives disclosures are specifically dictated by SFAS No. 119,

Disclosure About Derivative Financial Instruments and Fair Value of

Financial Instruments, which was effective for fiscal years ending after

December 15, 1994.18 Although this statement will be superseded by the

proposed standard, it continues to be in effect until the proposed standard,

if adopted, becomes effective. The effective date of the proposed standard

is expected to be for fiscal years beginning after December 15, 1997. We

believe that although SFAS No. 119 is an improvement over prior disclosure

requirements, it does not provide for adequate disclosure of the nature and

risks of derivatives activities.

We reviewed the disclosure practices of 37 banks and thrifts that were

active in the derivatives market and found that they generally made

disclosures beyond those required by SFAS No. 119. These additional

disclosures were prompted, in part, by SEC’s request for more disclosures

about derivatives by public companies. These SEC-requested disclosures,

as well as subsequent formally proposed disclosure requirements by SEC,

were in response to the shortfalls in SFAS No. 119. However, the SEC

disclosure requirements, if adopted, would apply only to public

companies, thus leaving other derivatives market participants without

adequate disclosure requirements. FASB’s new proposed standard would fill

some, but not all, of this void.

FASB’s Current Disclosure

Requirements Have

Improved but Could Be

Enhanced

FASB issued a disclosure standard for derivatives, SFAS No. 119, in

October 1994. This standard requires disclosures about futures, forwards,

swaps, options, and other financial instruments with similar

characteristics.19 It amends two previously existing disclosure standards,

SFAS No. 105 and SFAS No. 107, for financial instruments. The required

disclosures and the amendments are summarized in appendix VI. Although

SFAS No. 119 will be superseded by the proposed standard, if adopted, it

continues to be in effect through the end of 1997.

To obtain information on actual derivatives disclosure practices, we

reviewed the 1993 and 1994 annual report disclosures of 37 banks and

18Disclosure requirements of two other standards also affect derivatives disclosures. These two

standards, SFAS No. 105 Disclosure of Information About Financial Instruments With

Off-Balance-Sheet Risk and Financial Instruments With Concentrations of Credit Risk; and SFAS No.

107, Disclosures About Fair Value of Financial Instruments, are discussed in appendix VI.

19SFAS No. 119 does not apply to commodity contracts or structured notes.

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thrifts that were active in the derivatives market.20 In general, these

disclosures complied with generally accepted accounting principles at that

time, including SFAS No. 119 requirements, which were effective for fiscal

years ending after December 15, 1994.

The one exception to this general level of compliance was the disclosure

of the impact of derivatives with leverage features. Only 2 of the 37

institutions provided detailed disclosure about the impact of leveraged

instruments, 8 others disclosed that they did not hold any such

instruments, and 27 provided no disclosure. FASB also found a similar lack

of disclosure of the impact of leveraged derivatives in its December 1995

report on derivatives disclosures in 1994 annual reports.21 FASB reported

that only 4 of 27 entities reviewed—17 financial institutions and 10 large

derivatives dealers—clearly acknowledged the use of derivatives with

leverage features. This overall lack of disclosure may have occurred

because derivatives with leverage features were not held by the

institutions reviewed, or the institution determined they were not material

and thus did not disclose them. However, the lack of disclosure may also

have resulted from the fact that the requirement is contained in a footnote

of SFAS No. 119 and may have been overlooked. We noted that guidance

provided by some accounting firms for financial statement preparers did

not address the requirement for disclosures on leveraged instruments.

The majority of institutions that we reviewed disclosed information

beyond that required by SFAS No. 119, including quantitative market risk

information and further distinctions among types of activities. Only 10

institutions, however, provided specific information on the criteria used to

justify hedge accounting.

We continue to support FASB’s efforts to improve derivatives disclosures.

However, additional disclosures not required by SFAS No. 119 but

voluntarily provided by some institutions would provide investors more

detailed and timely explanations of the risks of firms’ derivatives activities.

These include

• quantification of interest rate or other market risks of derivative products

and related financial instruments (SFAS No. 119 encourages but does not

require such disclosures),

20We also compared derivatives disclosure practices of major bank dealers with those of major

securities firm and insurance company dealers and found that the banks had the most extensive

disclosures (see app. VIII).

21Special Report: Review of 1994 Disclosures About Derivative Financial Instruments and Fair Value of

Financial Instruments (Financial Accounting Standards Board, Dec. 1995).

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• further distinctions among types of derivatives,

• the impact of using deferral hedge accounting on the reported balance

sheet and income statement amounts, and

• the criteria used by an entity to justify deferral hedge accounting.

The disclosure requirements in FASB’s proposed standard discussed earlier

would address some but not all of these additional needed disclosures.

Specifically it would require distinguishing the types of activities that

derivatives are being used for and the impact of derivatives activities on

the financial statements. In addition, it would standardize the criteria used

to justify hedge accounting. SEC has also taken steps, which are discussed

in the following sections, that would address all of the additional needed

disclosures.

SEC Has Requested

Additional Disclosures

In 1994, SEC specifically requested its public companies to provide certain

disclosures in an effort to improve annual report disclosures of derivatives

activities. The disclosures requested by SEC included

• a discussion of the nature of trading activities, including the business

purpose of trading, the tolerable risk levels, and the types of contracts

traded;

• the amount of trading income recognized in the income statement for each

major type of financial instrument;

• a disaggregated description of outstanding derivatives contracts held for

end-user activities, including a description of the type, amount, expected

maturity, and fair value of each class of contract;

• a reconciliation of the notional or contract amounts of derivatives held for

end-user activities from the beginning of the period to the end of the

period for each income statement presented;

• the amount of deferred gains and losses from hedging or risk- adjusting

activities and the expected amortization of such amounts on a

period-by-period basis; and

• the impact of derivatives activities on net interest income (for financial

institutions or insurance companies) or income from continuing

operations (for commercial and industrial entities) for each period for

which an income statement is presented.

Figure 5.1 indicates the number of institutions in our sample of 37 banks

and thrifts that provided SEC-requested disclosures in their 1993 (prior to

request) and 1994 (after request) annual reports. As shown, a number of

institutions significantly improved their derivatives disclosures as a result

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of SEC’s request. The additional disclosures provided useful information for

a reader of an entity’s financial statements to better understand its

derivatives activities.

Figure 5.1: SEC-Requested

Disclosures Number of entities

0

5

10

15

20

25

30

35

40

Trading

nature andrisk

Trading income by

financial instrument

Outstanding contract description

Reconciliation of

notional amounts

Deferred gains/losses from hedging

Impact on net

interest income

Disclosures requested by SEC

1993

1994

Source: GAO review of institution annual reports.

SEC Issued Proposed

Disclosure Requirements

In continuing its efforts to improve derivatives disclosure practices, SEC

reviewed the 1993 and 1994 annual reports of about 500 public companies.

As a result of these reviews, SEC staff concluded that although SFAS No. 119

had a positive effect on the quality of disclosures, further requirements

were needed.

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In December 1995, SEC released for comment proposed derivatives

disclosure requirements for public companies to supplement SFAS No. 119.

The proposed requirements are intended to clarify and expand disclosures

about public companies’ accounting policies for derivative products. They

also would require disclosure outside the financial statements of

qualitative and quantitative information about market risk inherent in

derivatives and other financial instruments.22

SFAS No. 119 requires entities to disclose the related accounting policies

used to account for their derivatives. However, SFAS No. 119 does not

provide an explicit indication of what entities must disclose in their

footnotes on accounting policies. SEC’s proposal would require registrants

to distinguish between accounting policies for trading derivatives and

those for derivatives used for other purposes. It would require disclosure

of each method used to account for derivatives by type, the hedge criteria

required to be met for each accounting method used, the accounting

method used if the criteria are not met, the accounting method for

terminated derivatives or terminated hedges, and when and where

derivatives and their related gains and losses are reported in the financial

statements. It also would extend those requirements to commodity

derivatives.

SEC’s proposed quantitative and qualitative disclosures are to provide

information outside the financial statements about the impact of changes

in interest or other market rates on the registrants’ financial results. The

proposal provides three alternatives for quantitative disclosures, with the

expectation that registrants are to develop quantitative disclosures that

best reflect the market risk inherent in their business activities. The

proposed qualitative information about market risk would include a

discussion of the public companies’ primary market risk exposures as they

existed at the end of the current reporting period. It would also include the

way the public companies managed these exposures. In general, this

disclosure would include a description of the objectives, strategies, and

instruments used to manage the exposures. SEC expects that consensus on

the most effective way to portray market risk will evolve on the basis of

industry practice.

We believe that the SEC proposed requirements for enhanced qualitative

and quantitative disclosures effectively address the shortfalls of SFAS No.

22The SEC proposal pertains to derivatives and other financial instruments with similar characteristics.

It defines derivatives as futures, forwards, swaps, and options. It defines other financial instruments as

including investments, loans, structured notes, mortgage-backed securities, indexed debt instruments,

interest-only and principal-only obligations, deposits, and other debt obligations.

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119. FASB’s proposed standard includes similar qualitative disclosure

requirements but does not adequately address the quantitative market risk

disclosure. Disclosure of market risk continues to be optional under FASB’s

proposed standard23 and is not addressed in GASB standards. We believe

this is an important disclosure for all entities. However, because SEC

requirements apply only to public companies, not all entities would be

required to disclose market risk without a change in FASB’s and GASB’s

standards.

GASB Proposed

Standard Addresses

Accounting for

Investments

In response to the Orange County bankruptcy filing and other large

investment securities losses reported by state and local governmental

entities, GASB issued a proposed standard in March 1996 that provides

accounting and disclosure requirements for investments. The investments

included under the proposed standard are interest-earning investment

contracts; all debt and equity securities, purchased options, stock

warrants, and stock rights with readily determinable fair values; and

investments in mutual funds and investment pools. With limited

exceptions, the proposed standard requires that all investments be valued

at fair value. However, investments purchased with remaining maturities

of 90 days or less could be valued at amortized cost subject to certain

general restrictions. The proposed standard also would require that

governmental entities recognize all changes in fair value in the operating

statement (or other statement of activity). In addition, the proposed

standard would require that the valuation of investment pool

participations be based on the pool type. Participants in SEC-registered

mutual funds would value their position at current share price and

disclose the investment type as an SEC-registered mutual fund. Participants

in any pool that is not SEC-registered (whether administered by a

government or not) would normally value their position at the fair value

per share of the pool’s underlying investments.

GASB has scheduled the issuance of the final standard during the fourth

quarter of 1996. In conjunction with this project, we have encouraged GASB

to consider requiring disclosures that quantify market risk. Even if

investments are reported at market value, such disclosure is needed

because it provides information about the sensitivity of those market

values to future changes in interest rates.

23The optional disclosure about market risk is included as an amendment to SFAS No. 107 under the

proposed standard.

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The proposed standard does not address accounting for off-balance sheet

derivatives, and no GASB standards currently address this issue. As state

and local governmental entities are increasing their involvement with

derivatives, it is essential that standards are developed to avoid

inconsistent and potentially inappropriate accounting practices for these

activities. By extending the market value accounting principle to

derivatives, GASB’s proposal would include comprehensive market value

accounting for virtually all financial instruments used by state and local

governments. We have also advised GASB, in a letter dated March 15, 1996,

of our views on this matter.

Conclusions Serious shortcomings in accounting standards continue to be exposed as

entities experience major losses from market-sensitive financial

instruments, with seemingly little warning. Such losses are often allowed

to build without being recorded in an entity’s financial statements,

because the use of the historical cost accounting model does not require

such losses to be recorded. In our 1994 report, we recommended that FASB

consider adopting a market value accounting model for all financial

instruments, including derivatives. This recommendation is even more

important today, for both FASB and GASB, as unexpected losses from

investment securities as well as derivatives have caused financial disasters

for various entities and a deterioration of investor confidence.

FASB’s proposed standard is a significant step in the right direction. For the

first time, all derivatives would be recorded in the financial statements at

their fair values. Accelerating recognition of the offsetting gains or losses

on underlying assets or liabilities and adding them to the basis of these

assets or liabilities would also have the effect of adjusting their historical

cost toward their fair value.

FASB’s inclusion in its proposed standard of financial instruments with

characteristics similar to derivatives is also a major positive step.

However, FASB has yet to address the problems with the use of historical

cost accounting for other financial instruments. It also does not effectively

deal with accounting for macrohedging activities. These issues will be

resolved only when a comprehensive market value accounting model is

adopted for all financial instruments.

We recognize that problems exist in adopting a market value accounting

model for all financial instruments. In addition, many financial statement

preparers oppose this approach. We also recognize that it will take time to

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develop and gain acceptance for a new accounting model and that some

type of short-term solution is needed. Therefore, we support FASB’s

proposed standard as a reasonable interim accounting solution. As part of

this interim solution, bolstering disclosure requirements for derivatives

and other financial instruments with similar risks, as has been proposed

by SEC, would help provide forewarning of potential losses from these

types of instruments. However, we continue to believe that market value

accounting for all financial instruments would more readily respond to the

need for financial information that reflects the realities of today’s volatile

financial markets.

Chapter 6 MAY 1994 REPORT SUMMARY

Findings In each of the seven countries we reviewed (Australia, France, Germany,

Japan, Singapore, Switzerland, and the United Kingdom), we found that

major OTC derivatives dealers were subject to regulation. However,

regulators in two countries—Australia and Switzerland—acknowledged

that derivatives activities by some financial institutions were not subject to

direct regulation. All of the regulators obtained some information about

derivatives on a monthly or quarterly basis to assess the volume and risks

of derivatives activities, but some regulators collected more detailed

information than others. Four of the seven countries—Australia, Japan,

Singapore, and the United Kingdom—had different capital requirements

for banks and securities firms. In France, Germany, and Switzerland,

financial institutions conducting securities activities must also be licensed

as banks, requiring all institutions to meet bank capital requirements.

Capital requirements for banks in these countries met the Basle

requirements, but some regulators had placed additional requirements on

banks conducting derivatives activities.

International coordination efforts were generally mixed. Among the most

important efforts were the projects to develop minimum capital standards

for banks and securities firms. Bank regulators successfully created

international capital standards for credit risk, but market risk

requirements were not final. Although efforts to develop international

capital standards for securities firms had been under way since 1987,

securities regulators had not agreed on certain aspects of the standards.

The lack of agreement among the securities regulators prevented the

harmonization of international capital standards for both banks and

securities firms. International accounting organizations had also proposed

new accounting and disclosure standards.

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Recommendation We recommended that U.S. financial regulators provide leadership in

working with industry representatives and regulators from other major

countries to harmonize disclosure, capital, and legal requirements,

including netting enforceability, and examination and accounting

standards for derivatives.

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U.S. banking, securities, and futures regulators have been working with

their international counterparts, primarily through the Basle Committee on

Banking Supervision and the Technical Committee of IOSCO, to improve

regulatory harmonization and coordination and have addressed many of

the issues raised in our 1994 report. Further, like U.S. regulators,

regulators in the six countries we contacted had taken or proposed steps

to enhance their oversight of derivatives, through a variety of approaches.

Barings’ failure directly resulted in various written agreements and

guidelines to ensure that all concerned parties have access to the

information they need. Barings’ failure also focused regulators’ attention

on the need to formalize international coordination.

International

Coordination Efforts

Have Continued

Since our May 1994 derivatives report was issued, international banking,

securities, and accounting organizations have undertaken major initiatives

intended to improve derivatives regulation. The Basle Committee on

Banking Supervision and IOSCO have undertaken initiatives that address

risk management for OTC derivatives, public disclosure of market and

credit risks, and regulatory reporting of derivatives activities. The Basle

Committee on Banking Supervision also amended international banking

capital standards to include broader recognition of bilateral netting

agreements, to adjust the calculation of potential future credit exposures,

and to incorporate market risk from trading activities into the risk-based

capital calculation for internationally active banks. However, harmonizing

capital standards for securities firms has, so far, been unsuccessful. The

International Accounting Standards Committee (IASC) approved a new

international accounting standard that addresses disclosure and

presentation of derivatives activities.1

International Initiatives

Have Addressed Risk

Management, Public

Disclosure, and Regulatory

Reporting

Since May 1994, international coordinating bodies, such as the Basle

Committee on Banking Supervision and IOSCO working groups, have issued

numerous discussion papers, recommendations, and guidelines

specifically related to derivatives. These initiatives addressed the need for

overseeing the risk-management process, ensuring adequate public

disclosure, collecting information on the global derivatives market,

harmonizing regulatory reporting, and providing supervision. These

voluntary initiatives represent international efforts to enhance and

1

IASC was formed in 1973. Its role is to contribute to the establishment of sound, internationally

comparable accounting principles, especially in developing countries. Professional accountancy

groups of about 50 countries are members. However, national standards-setting bodies are

independent of IASC and under no obligation to adopt international accounting standards as a

requirement within their countries.

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harmonize the regulation of derivatives activities as financial markets

become more closely linked and international barriers are removed.

In July 1994, the Basle Committee on Banking Supervision and the

Technical Committee of IOSCO issued guidelines for regulators on

supervising risk-management systems of banks and securities firms

involved in OTC derivatives activities.2

 Although the specifics of these

guidelines differ, banking and securities regulators share the common

objective of promoting sound internal risk-management practices for

managing OTC derivatives. Both sets of guidelines focus on the role of

regulators in determining how best to promote the development of sound

management control policies and procedures in the banks and securities

firms they regulate. The guidelines draw on the best practices of IOSCO and

the Basle Committee on Banking Supervision member countries.

In September 1994, a Working Group of the Euro-currency Standing

Committee of the Central Banks of the Group of Ten countries released a

discussion paper on public disclosure of market and credit risks.3

 The

paper discusses the need for sufficient information about the risks and

returns of derivatives to ensure that investors and counterparties can

make informed investment decisions. It warns that if a disconnect exists

between the actual trading and risk-management activities of derivatives

dealers and what is disclosed to investors, capital misallocation and the

potential for heightened market distress can result.4

 The paper also

discusses the possible role of adequate disclosure in correcting and

adjusting risk-management procedures.

In February 1995, a working group established by the central banks of the

Group of Ten countries issued a report that identified existing derivatives

information-reporting requirements of central banks.5

 The report is part of

a larger international effort of regulators to develop a framework for

2

These guidelines were: “Risk Management Guidelines For Derivatives,” the Basle Committee on

Banking Supervision, July 1994; and “Operational and Financial Risk Management Control Mechanisms

For Over-the-Counter Derivatives Activities of Regulated Securities Firms,” the Technical Committee

of IOSCO July 1994.

3

“Public Disclosure of Market and Credit Risks by Financial Intermediaries,” prepared by a Working

Group of the Euro-currency Standing Committee of the Central Banks of the Group of Ten countries,

Sept. 1994.

4

The paper states that during periods of market stress, lack of information transparency can cause

rumors alone to impair a firm’s market access and funding.

5

“Issues of Measurement Related to Market Size and Macroprudential Risks in Derivatives Markets,”

prepared by a working group established by the central banks of the Group of Ten countries,

Feb. 1995.

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improved regular monitoring of the size and structure of the global

derivatives markets. The report identified a broad range of information

that bank regulators need and made recommendations about how they

should collect this information.

The report recommended two interrelated ways for regulators to collect

information that could be used to monitor global OTC derivatives activities.

One of these recommendations was for regulators to conduct occasional

surveys of a large number of participants. BIS conducted the first survey of

derivatives market activity in 26 countries in April 1995. (We discuss some

of the results of this survey in ch. 1.) The second recommendation was for

regulators to develop a system of regular derivatives market reporting

limited to primary institutions. The survey data would be used by

regulators to determine the size and distribution of the global derivatives

market. Adequate data such as those provided by this survey are vital if

regulators are to understand the global financial environment in which

regulated institutions operate. In July 1996, a working group developed a

proposal for regular collection of derivatives information on a global basis,

which is to be implemented at the end of 1997.6

In May 1995, the Technical Committee of IOSCO and the Basle Committee

on Banking Supervision issued a joint framework on regulatory reporting.7

 The framework consisted of two parts. The first part was a catalogue of

data identified as important for an evaluation of derivatives risks that

could be used by regulators as they continue to expand their

information-reporting requirements. The second part was a subset of

information that should be collected at a minimum for all large

internationally active banks and securities dealers that have substantial

derivatives activities. If this framework was implemented, harmonization

of information reporting among regulators could improve along with

oversight of the global derivatives market.

The recommended framework encourages regulators to draw on

information that banks and securities firms generate for internal purposes

to limit the regulatory burden. The catalogue of information identified by

the committees revolved around four broad areas: credit risk, market risk,

liquidity risk, and earnings. According to the joint framework, periodic

6

“Proposals For Improving Global Derivatives Market Statistics,” prepared by a working group

established by the Euro-currency Standing Committee of the Central Banks of the Group of Ten

countries, July 1996.

7

“Framework for Supervisory Information about the Derivatives Activities of Banks and Securities

Firms,” the Basle Committee on Banking Supervision and the Technical Committee of IOSCO,

May 1995.

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information in those four broad areas should include current credit

exposure, potential credit exposure, credit enhancements, concentration

of credit risk, counterparty credit quality, market liquidity risk, funding

risk, value-at-risk, trading activities, nontrading activities, unrealized or

deferred losses, and valuation reserves and actual credit losses. While

many regulators may already collect some of the information called for in

the framework, others do not. In the United States, SEC and CFTC receive

detailed quarterly information on the top 20 net credit exposures for

individual counterparties from 5 of the 6 firms included in DPG. (See ch. 4.)

However, U.S. bank regulators do not collect comparable information on a

routine basis.

The framework also lists a subset of information that regulators should

collect at a minimum for large internationally active banks and securities

firms with significant derivatives activities. This information covers broad

risk categories (such as interest rate or foreign exchange risk) by type of

contract (such as swaps or forwards). According to the framework,

regulators should also collect information on the purpose for holding

derivative products, such as trading versus nontrading, as well as

information on notional/contract amounts, market values, potential credit

exposure, counterparty credit quality, and past-due amounts.

In July 1995, the Tripartite Group of Banks, Securities, and Insurance

Regulators issued a report titled “The Supervision of Financial

Conglomerates.”8

 The report focuses on supervisory issues and capital

adequacy. It identifies broad areas of agreement among participating

regulators from the three groups and makes recommendations on ways to

improve the supervision of financial conglomerates. It also identifies areas

that regulators should focus on in the future. These areas include

developing a groupwide perspective on capital adequacy; fostering

intensive cooperation among regulators responsible for different entities

within a conglomerate; and addressing the need for regulators to obtain

adequate information on the conglomerate’s structure. The report also

identifies numerous other issues, such as regulators’ ability to access

information about nonregulated entities within a conglomerate.

In November 1995, the Basle Committee on Banking Supervision and the

Technical Committee of IOSCO issued a joint report on the public disclosure

8

The Tripartite Group was formed in 1993 at the initiative of the Basle Committee on Banking

Supervision to address issues relating to the supervision of financial conglomerates. It consists of

bank, securities, and insurance regulators from 12 countries. The group defines a conglomerate as “any

group of companies under common control whose exclusive or predominant activities consist of

providing significant services in at least two different sectors (banking, securities, insurance).”

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of trading and derivatives activities of a sample of large banks and

securities firms worldwide.9

 The report compared 1993 and 1994 annual

report disclosure of trading and derivatives activities in 79 of the largest,

internationally active banks and securities firms in the Group of Ten

countries. The Basle Committee on Banking Supervision and IOSCO found

general improvements and significant voluntary innovation in the annual

report disclosures. However, despite encouraging advances in disclosure

practices, they found that “many institutions” continued to disclose very

little about their trading and derivatives activities. The report

recommended that banks and securities firms disclose additional

qualitative information about their risks and management controls and

their accounting and valuation models. It also recommended greater

quantitative disclosure of market activity, credit risk, market liquidity,

market risk, and earnings information. While these recommendations were

aimed at banks and securities firms, the Basle Committee on Banking

Supervision and IOSCO “hope that other financial institutions and

non-financial companies with significant trading and derivatives activities

will consider the concepts and recommendations presented in the report.”

International Bank Capital

Standards Were Amended

to Recognize Additional

Types of Risk

International bank supervisors’ efforts to expand risk-based capital

standards have produced positive results. In December 1994, U.S. and

foreign bank regulators amended the Basle Accord to recognize legally

enforceable bilateral netting agreements for risk-based capital purposes.

Previously, banks were restricted to netting only obligations denominated

in the same currency and due on the same date. The amendment allows

banks to net together all obligations on their derivatives contracts with

each counterparty with whom they have entered into legally enforceable

netting agreements. In addition, in April 1995, bank regulators amended

the Basle Accord to allow broader recognition of legally enforceable

bilateral netting agreements in the calculation of capital for potential

future credit exposure amounts. The amendment also expanded the

coverage and increased the maximum level of credit conversion factors

used to calculate the add-on amount. (See ch. 3 for additional detail on

implementation in the United States.)

In addition to finalizing amendments to the Basle Accord on netting and

expanding the conversion factors, the Basle Committee on Banking

Supervision continued to work on incorporating market risk from trading

activities into risk-based capital calculations for large internationally

9

“Public Disclosure of the Trading and Derivatives Activities of Banks and Securities Firms,” joint

report by the Basle Committee on Banking Supervision and the Technical Committee of IOSCO,

Nov. 1995.

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active banks in major countries. In January 1996, the Committee amended

the Basle Accord to incorporate market risks. Specifically, this

amendment addressed interest rate and equity-price risk in trading

activities and foreign-exchange risk and commodities risk throughout a

bank. As stated in the amendment, the new capital standards for market

risk should be implemented by the Group of Ten supervisory authorities

by year-end 1997, at the latest. In implementing this amendment’s capital

standards requirement for market risk, central banks can allow the

reporting banks to use either a standardized model or their internal model;

those banks wishing to use their own models are required to adhere to

certain standards.10 Regulators also are to play a role in ensuring that the

internal models used by banks are adequately measuring market risk. The

Committee also incorporated backtesting requirements and established a

framework for regulators to use when interpreting the results of

backtesting. (See ch. 3 for details.)

Efforts to Develop

Common Approaches to

International Capital

Standards for Securities

Firms Have Continued

International efforts to develop common minimum capital standards for

securities firms, which have been ongoing since 1987, have not produced

final results. IOSCO issued a report in June 1995 that discussed the use of

value at risk by securities firms. The report proposed that IOSCO conduct

additional joint work with the Basle Committee on Banking Supervision to

test value-at-risk models for calculating capital for market risk. It also

recognized the growing importance of these models for securities firms

and the need to explore further the possibility of using such models for

capital purposes. However, IOSCO did not set a timetable to incorporate the

use of models to calculate market risk for capital standards. The reasons it

cited for not rushing such development included (1) the lack of data

regarding the reliability of models in practice; (2) the importance of

appropriate market risk capital for securities firms; and (3) the need to

await the results of current initiatives, such as DPG in the United States.

IASC Issued an Accounting

Standard on Disclosure

and Presentation of

Financial Instruments

In March 1995, the IASC Board approved International Accounting Standard

32, Financial Instruments-Disclosure and Presentation. The new standard

applies to all types of entities and covers most types of financial

instruments, including derivatives.11 It requires that entities subject to its

standards provide information about, among other things, accounting

10As discussed in chapter 3, U.S. bank regulators require that banks use their internal (proprietary)

model.

11International Accounting Standard 32 does not deal with the recognition and measurement issues

covered in an exposure draft on financial instruments previously issued by IASC, as the IASC Board

has decided those issues require further work.

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policies and methods applied, the entities’ exposure to interest rate risk

and credit risk from financial assets and liabilities, and the fair value of

financial assets and liabilities.

The standard provides financial statement preparers with considerable

latitude to tailor the format in which information is provided. It also

encourages enterprises to provide a discussion of the extent to which they

use financial instruments, the associated risks, and the business purposes

served. The new standard, effective for financial statements covering

periods beginning on or after January 1, 1996, should provide financial

statement users better information about the derivatives activities of the

preparers.

Derivatives

Regulation Continued

to Vary Globally

Although differences remained in their oversight of derivatives, each of the

11 regulators we contacted in 6 different countries had taken action or had

plans underway to enhance their oversight activities since 1994. These

enhancements were consistent with the recommendations we made to

U.S. financial regulators in our 1994 report. Regulators in three of the six

countries expanded the amount of information they collected on a regular

basis. Regulators in all six countries had made revisions to or planned to

revise their capital standards to better address the risks derivatives pose.

The regulators had also expanded oversight of or guidance for the risk

management of derivatives. They also noted that efforts to improve

accounting and disclosure guidance for derivatives were ongoing in their

respective countries.

Foreign Regulators

Expanded Information

Collected to Assess the

Extent and Risk of

Derivatives Activities

As with U.S. regulators, some foreign regulators had begun to collect more

information on derivatives for regulatory reporting purposes. As described

in table 6.1, we found that regulators in three of the six countries had

expanded their required regulatory reporting. In Japan, regulators now

receive information on contract amounts and counterparty risk amounts

monthly for certain types of derivatives. In Singapore, banks are now

required to provide a monthly breakdown by product type, volume, and

profit/loss. Previously, they were required to provide only a combined

total for exchange-traded and OTC derivatives. In the United Kingdom, the

Bank of England, as a result of the EU Capital Adequacy Directive (CAD),

required new reporting forms to capture market risk, as well as other risks

on all trading instruments—cash and derivatives.12 The Securities and

12CAD sets out the minimum capital requirements for credit institutions and investment firms for the

market and other risks associated with their trading activities.

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Futures Authority Ltd. (SFA) also changed its reporting standards as a

result of CAD. Regulators in the other three countries were in the process

of reviewing, or had plans to improve, their regulatory reporting

requirements.

Table 6.1: International Changes to

Reporting Requirements Country Changes in reporting requirements

Australia No changes; however, reporting requirements are under

review.

Germany No changes, but reporting requirements are likely to be

reviewed in the near future in connection with CAD.

Japan Detailed information on forward rate agreements (contract

amounts and counterparty risk amounts) are now to be

collected monthly as part of the capital adequacy report.

Additional information is also to be reported monthly on

forward rate agreements and yen interest rate swaps.

Singapore Banks are now required to report monthly to their bank

regulator the notional/contract amount of their derivatives

transactions by type of product, volume, and profit/loss.

In addition, Singapore is reviewing its reporting system to

capture information in a more standardized format.

Switzerland Reporting requirements for market risk are likely to be

reviewed with the implementation of new capital

requirements for market risk.

United Kingdom The Bank of England introduced new reporting forms to

cover market risk when CAD was implemented on

January 1, 1996. SFA replaced its position and

counterparty risk document and started collecting from

some firms more detailed information on the breakdown

of profit and loss accounts/turnover from trading activities.

By year-end 1997, SFA plans to require reports to be

made of all transactions in all financial instruments (cash

and derivatives). Eventually, this will include reporting the

identity of counterparties.

Source: Compiled from information provided by Australia, the Australian Securities Commission

and the Reserve Bank of Australia; Germany, the Deutsche Bundesbank and the Federal Banking

Supervisory Office; Japan, the Bank of Japan and the Ministry of Finance; Singapore, the

Monetary Authority of Singapore; Switzerland, the Federal Banking Commission; and the United

Kingdom, the Bank of England, the Securities and Investments Board, and SFA.

Capital Requirements Have

Evolved as Regulators

Attempted to Address

Additional Types of Risk

International efforts to standardize capital requirements have continued

with some countries’ capital standards covering more types of risks than

others, depending on the type of institution. According to Australian

officials, their securities and futures regulator was in the process of

reviewing its capital standards, which may result in changes to better

address the risks that derivatives pose. In Germany, the central bank plans

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to implement CAD. In Japan, regulators amended capital standards to

reflect the changes to the Basle Accord concerning bilateral netting and

the calculation of potential future credit exposure. Following Barings’

failure, Singapore’s regulators further tightened the capital requirements

for futures brokers. Singapore is in the process of changing its capital

requirements for futures brokers from the present system that is based on

amounts of customer-segregated funds to a risk-based system in which the

regulatory capital maintained should better reflect the risks of positions

carried by futures brokers. Effective February 1995, Switzerland revised

its capital requirements to bring them in line with the Basle Accord, in

general, and to introduce the methods for calculating credit risk

equivalents of off-balance sheet items and bilateral netting. The United

Kingdom implemented CAD, which resulted in new market risk capital

requirements for banks. SFA said that securities and futures firms in the

U.K. had been subject to market risk capital requirements for at least 10

years.

New International

Guidance Results in

Expanded Focus on Risk

Management

In all of the countries we contacted, at least one regulator had expanded

oversight of or guidance for risk management involving derivatives

activities. In Australia, although no new programs were initiated by its

securities regulator, securities firms were encouraged to adopt the G-30

recommendations on derivatives risk management. In December 1994, the

Reserve Bank of Australia implemented a new program of on-site visits to

banks to focus on how the banks measure their market risks. In Germany,

the central bank started a program of (1) on-site inspections to review

risk-management models for capital purposes; and (2) inspections of

trading activities, including derivatives. Its Federal Banking Supervisory

Office also issued minimum requirements for trading activities of credit

institutions.

In Japan, the Bank of Japan took further measures to set up its on-site

examination function to assess banks’ risk. For example, it introduced an

overall credit exposure review system, which includes derivatives, and

established a “Risk Assessment Team” to support the on-site

examinations. In April 1995, Singapore’s bank regulator issued specific

new guidance to banks on ensuring adequate risk management. In

Switzerland, the Swiss Bankers Association’s “Risk Management

Guidelines for Trading and the Use of Derivatives” became effective on

July 1, 1996. Although the Swiss Bankers Association is purely

self-regulatory, the Federal Banking Commission has decided that external

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auditors have to ensure a bank’s compliance with these guidelines and

report on it in their annual reports to the Federal Banking Commission.

In the United Kingdom, the Bank of England established a team of experts

in 1994 before implementing CAD to review the models that banks wish to

use in calculating capital requirements. The Bank of England uses detailed

questionnaires followed by on-site visits to assess the models and their

control environment. SFA already had a similar team that reviewed options

and swap pricing models at securities firms. In fall 1994, SFA reorganized

the division that monitors compliance with its rules to enhance oversight

into five specific groups.13 It now focuses more detail on monitoring the

specific risks proposed by each type of business. In 1995, the U.K.

Securities and Investments Board, along with the U.S. SEC, announced a

joint initiative to conduct in-depth studies of financial, operational, and

management controls used by selected securities firms that conduct

significant cross-border derivatives and securities activities.14

Efforts to Improve

Accounting and Disclosure

Guidance Are Ongoing

All of the regulators we contacted noted that efforts to improve

accounting and disclosure guidance are ongoing in their respective

countries. In Australia, current disclosure standards are being

reconsidered by the Australian Accounting Standards Board. In Germany,

reporting for derivatives has been further improved by banks, especially

through disclosure of value-at-risk estimates that were introduced in Basle

Committee on Banking Supervision and IOSCO Technical Committee

papers. In Japan, legislation was passed that enabled financial institutions

and securities companies to use current value accounting for trading

securities and derivatives. In July 1996, regulators in Japan issued a

“Ministerial Ordinance,” which makes all derivatives transactions subject

to disclosure requirements. In April 1995, regulators in Singapore issued

guidance that required commercial and merchant banks to disclose the

nature, material terms and conditions, and derivatives risks in their

risk-disclosure statement. In Switzerland, by revising the Swiss Banking

Ordinance, regulators adapted accounting and disclosure requirements to

improve derivatives coverage. In addition, regulators now require Swiss

13The five groups are: (1) firms that deal mainly in commodities and exchanges traded

futures;(2) multinational firms that deal in all types of financial instruments; (3) merchant banks and

corporate finance firms; (4) private client stock brokering firms; and (5) other institutional brokers

and firms led or regulated by, for example, the Bank of England.

14This joint initiative builds on the March 1994 joint statement previously issued by SEC, CFTC, and the

Securities and Investments Board. The initiative identified several areas where regulators can

cooperate in their oversight of the OTC derivatives market. By year-end 1995, several joint reviews had

been conducted.

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banks to provide replacement cost and notional/contract values for all

off-balance-sheet items, including derivatives. Regulators also required

banks to provide written comments on business policies and risk

management.

In the United Kingdom, new disclosure standards, effective January 1,

1995, require U.K.-listed companies to include in their financial statements

acknowledgement by the board of directors that they are responsible for

internal controls, an explanation that internal controls offer no absolute

assurance against misstatement or loss, a description of key procedures

established to provide effective internal control, and confirmation that the

effectiveness of internal controls has been reviewed. Directors are also

required to comment when internal control weaknesses have resulted,

among other things, in material losses. In addition, a statement of

recommended accounting practice on derivatives was published for banks

in February 1996. This sets out recommendations on the accounting

treatment and disclosure of derivatives in U.K. banks’ accounts. The

Accounting Standards Board also published proposals designed to lead to

a new code on disclosure for other companies, as well as banks, by 1998.

Barings’ Failure

Illustrated the

Importance of

International

Coordination and

Sparked Coordination

Efforts

The Barings failure focused new attention on the potential for systemic

risk and the importance of international coordination. Regulators

concerned about containing Barings’ losses closely followed the unfolding

crisis to determine whether the crisis would spread. Barings’ failure did

not lead to widespread international failures of other financial institutions.

Although the crisis was managed through informal coordination among

regulators internationally, Barings spurred additional efforts to enhance

international coordination. Futures regulators, acknowledging that more

formal coordination was needed, worked to develop the Windsor

Declaration, which outlines steps to improve international coordination.

Likewise, the industry responded with the Futures Industry Association’s

(FIA) Global task force on national and cross-border issues related to the

structure and operation of the international markets for exchange-traded

and/or cleared futures and options. As a result of the Windsor Declaration

and FIA task force recommendations, futures exchanges, clearinghouses,

and regulators in many major countries signed companion agreements to

share large exposure information. In addition, U.S. clearing organizations

signed an agreement to promote greater cooperation and information

sharing among securities and futures clearing organizations.

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The Windsor Declaration

Was a Regulatory

Response to Barings’

Failure

Following the failure of Barings, regulatory authorities responsible for

supervising the world’s major futures and options markets met in

May 1995 in Windsor, England. Regulators from 16 countries attended the

meeting hosted by the U.K. Securities and Investments Board and the U.S.

CFTC.

15 The regulators outlined steps they proposed to take to improve

(1) cooperation between market authorities; (2) protection of customer

positions, funds, and assets; (3) default procedures; and (4) regulatory

cooperation in emergencies. In addition, the regulators agreed to

• improve communication of information relevant to material exposures and

other regulatory concerns;

• review and, as necessary, enhance the adequacy of existing arrangements

to minimize the risk of loss through insolvency or misappropriation;

• facilitate the liquidation and/or transfer of positions, funds, and assets

from failing members of futures exchanges; and

• improve existing mechanisms for international cooperation and

communication among market regulators.

The regulators agreed that the work identified in the Windsor Declaration

should be coordinated through various working groups of IOSCO’s

Technical Committee. IOSCO has been involved in follow-up work relating

to the areas identified by the regulators and has issued reports on some of

these issues. For example, in March 1996, the Technical Committee issued

the “Report on Cooperation Between Market Authorities and Default

Procedures.”

The FIA Task Force

Recommendations Were an

Industry Response to

Barings’ Failure

The events surrounding the Barings failure prompted market participants

to consider certain national and cross-border issues related to the

structure and operation of the international markets for exchange-traded

and/or cleared futures and options. The FIA Global Task Force on Financial

Integrity was organized in March 1995 to address these issues. The task

force included representatives of major international

exchanges/clearinghouses, brokers/intermediaries (including FCMs and

other brokers), and customers from 17 jurisdictions.

The objectives of the task force were similar to those of the international

regulatory authorities that issued the Windsor Declaration in May 1995.

The task force issued 60 recommendations covering financial integrity

issues; exchange/clearinghouse risk assessment, reporting, and

15Regulatory authorities from the following countries participated in the meeting: Australia, Brazil,

Canada, France, Germany, Hong Kong, Italy, Japan, the Netherlands, Singapore, South Africa, Spain,

Sweden, Switzerland, the United Kingdom, and the United States.

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coordination; legal/regulatory issues; risk management for

exchanges/clearinghouses, clearing brokers, and depositories; risk

management for customers; risk management for internal controls; legal

relationships with brokers/intermediaries; risk assessment of

brokers/intermediaries; risk management of exchanges/clearinghouses;

and internal risk-management procedures. According to FIA, the most

significant of these issues included the mechanisms that exist for

protecting participants’ assets; the internal controls and risk-management

procedures employed by exchanges/clearinghouses,

brokers/intermediaries, and customers; and the communication of

information regarding the activities of market participants by

exchanges/clearinghouses and regulatory authorities.

U.S. and Foreign

Exchanges and Regulators

Have Signed Information

Sharing Agreements

On March 15, 1996, 49 exchanges and clearing organizations signed a

multilateral information-sharing agreement on large exposures. On the

same date, 14 regulatory agencies signed a separate companion

information-sharing agreement. These agreements could help prevent and

manage another crisis similar to that created by the Barings collapse.16 The

agreements were an outgrowth of recommendations outlined in the

Windsor Declaration and by the FIA task force. Participating exchanges

and regulators agreed to share information on exposures to unusual risks

of their common member firms. One objective of the agreements is to

reduce threats to the system by enabling regulators to better monitor

firms’ exposures on multiple markets to reduce threats to the system. As

described by a CFTC official, the agreements represent an unprecedented

exercise in cooperation among international futures exchanges, clearing

organizations, and regulators. However, some countries, such as

Switzerland and Japan, have legal restrictions preventing certain

regulators from signing such agreements. Therefore, these regulators have

not signed the agreement but may sign if the legal restrictions can be

overcome.

As written, the terms of the agreements could be triggered by a number of

events. For example, an exchange or regulator could request details of a

member firm’s positions in various markets if that firm has experienced a

sizable reduction in its capital, unusually large cash flows in its proprietary

trading account or those of its customers, or a concentration of positions

in a particular futures contract. However, concerns about protecting the

privacy of market participants and their activities in some countries may

limit the potential effectiveness of these agreements. Further, exchanges

16Since March 15, 1996, at least seven exchanges and one regulator have signed on to the agreements.

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have varying levels of controls and procedures; therefore, the availability

of information varies. Regulators have attempted to address the legal and

confidentiality concerns about exchanges sharing information through

their agreement, which contains additional provisions that allow

regulators to share information if commercial or legal restrictions prohibit

exchanges from acting. A CFTC official noted that this is a critical

component of the regulators’ companion agreement. However, in order for

these types of provisions to be effective, the exchanges must be willing to

go to their regulator to get the needed information to the appropriate

parties.

U.S. Securities and Futures

Clearing Organizations

Agreed to Greater

Cooperation and

Information Sharing

On September 7, 1995, clearing organizations for 19 stock, stock options,

and futures exchanges in the United States, called the Unified Clearing

Group, signed an agreement to foster greater cooperation and information

sharing among securities and futures exchanges. According to the

Chairman of CFTC, the information-sharing agreement should enable trade

clearing officials at major U.S. financial markets to “better assess the risk

carried by brokerage firms that buy and sell exchange-listed futures,

securities, and stock options.” According to the agreement, the purpose of

the Unified Clearing Group is to improve the clearance and settlement

process of securities and futures transactions; to ensure that securities,

futures, funds, and other collateral, which are in the custody or control of

members, or for which members are responsible, are safeguarded; remove

impediments that prevent prompt and accurate clearance and settlement;

and protect investors and public interests. The group plans to meet as

needed and to appoint a task force on issues as they arise.

Conclusions Consistent with recommendations in our 1994 report, U.S. and foreign

financial regulators, working independently and through various

committees and working groups, have issued guidelines and

recommendations that, if adopted by member countries, could help

harmonize risk management, disclosure, reporting, and accounting for

derivatives. However, many of these initiatives are not legally binding and

have not been adopted by all regulators. In addition, most coordination

among regulators still occurs informally. The Barings crisis spurred efforts

to improve international regulatory coordination, primarily through formal

information-sharing agreements. While these agreements may result in

greater information sharing, their effectiveness depends on continued

cooperation among regulators and market participants, which may be

hampered by issues of privacy and confidentiality.

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Flawed Corporate Governance Systems

Contributed to Significant Losses

We reviewed four highly publicized losses from derivatives activities in

recent years. A common factor in each of these losses was a weak

corporate governance system that did not establish effective risk

management and internal controls. Frequently, those responsible for

corporate governance, including boards and senior management, did not

• provide effective oversight of their entities’ use of derivatives and monitor

the exposure these products represent;

• ensure that effective risk-management and control policies and

procedures were established;

• ensure that qualified personnel and comprehensive systems were used to

initiate derivatives activities and monitor their exposure; or

• ensure that comprehensive audits and reviews were conducted to

independently assess compliance with established policies, limits, and

controls.

As a result of these weaknesses, risks and exposures associated with

derivatives were not properly managed.

Bankers Trust and Its

Client, Gibson

Greetings

Bankers Trust had been known among federal regulators for the high

quality of its internal control systems over derivative products. However,

according to Federal Reserve Bank of New York officials, when Bankers

Trust started its new line of leveraged derivative products, it did not treat

this line as a new and riskier business and, therefore, did not make any

adjustments to its existing internal controls. Subsequently, Bankers Trust’s

practices were questioned by SEC and CFTC for possible violations of

securities and commodities laws related to these leveraged transactions,

and Bankers Trust was sued by several clients.

The regulators’ inquiries revealed weaknesses in Bankers Trust’s

risk-management and internal control systems, including improper

conduct in the marketing, offer, and sale of its leveraged derivatives

transaction business and failure to reasonably supervise its employees

involved in this business. In December 1994, Bankers Trust entered into

agreements with the Federal Reserve, SEC, and CFTC to enhance internal

controls to prevent future violations and to pay a $10 million fine imposed

jointly by SEC and CFTC.

1

 In a public release of the agreement with the

Federal Reserve Bank of New York, Bankers Trust noted that its control

mechanisms needed to be strengthened and agreed to correct them. These

1

These agreements do not affect Bankers Trust’s overall derivatives business but are limited

specifically to its leveraged derivatives transactions activities.

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corrections included enhancing its management and supervision process

and establishing a committee of its board of directors to monitor

compliance with the agreement.

The leveraged nature of Bankers Trust’s derivatives contracts caused one

of its clients, Gibson Greetings, Inc., to incur losses that multiplied quickly

as interest rates rose in early 1994. Gibson decided not to honor its

obligations and sued Bankers Trust. SEC investigated Gibson for possible

violations of SEC reporting requirements. The investigation showed that

Gibson did not have adequate internal controls associated with its

leveraged derivatives contracts. Flaws in Gibson’s control environment,

including a failure by Gibson officials to establish proper accounting and

internal controls over its derivatives activities, allowed Gibson to incur a

reported loss of about $23 million.2

Two Gibson officials initiated its derivatives investments by purchasing

interest rate swaps, intending to reduce Gibson’s borrowing costs. From

November 1991 to March 1994, Gibson, through Bankers Trust, entered

into about 30 derivatives transactions, including interest rate swaps and

related restructurings that became increasingly complex, risky, and

intertwined. Many of the derivatives had leverage factors that caused

Gibson’s losses to increase dramatically with relatively small changes in

interest rates. Gibson’s officials were not adequately experienced or

trained to fully understand derivatives. The derivatives background of

Gibson’s primary official responsible for its derivatives activities was

limited to a few seminars focused on the use of derivatives and on-the-job

training obtained in working with Bankers Trust. Without knowledge of

derivatives and lacking systems to value them, Gibson officials were

unable to exercise controls over the acquisition of the derivative products

or to monitor whether these products were serving the intended purpose

of reducing Gibson’s debt costs.

SEC’s investigation also showed that the derivatives Bankers Trust sold to

Gibson were customized contracts that did not trade on any market and

thus were difficult to price. Gibson relied totally on Bankers Trust to

establish market values for use in preparing Gibson’s financial statements

and periodic reports filed with SEC. They did not use independent sources

to verify the market values that Bankers Trust provided. As a result,

Bankers Trust representatives were able to mislead Gibson about the

value of the company’s derivatives positions by providing values that

significantly understated the magnitude of the losses. Gibson remained

2

Subsequent litigation by Gibson against Bankers Trust reduced the amount of its loss.

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unaware of the actual extent of its losses from derivatives transactions

and continued to purchase additional derivatives from Bankers Trust.

These conditions could not have existed had Gibson’s board and

management exercised appropriate oversight of the company’s derivatives

activities and insisted on having independent means to determine the

value of their derivatives holdings.

Orange County, CA Orange County managed a pool of about $7.5 billion for 187 separate

governmental agencies, including school, water and sewer districts, and

other municipalities, as well as about 400 individuals. The County

Treasurer managed the pool and historically reported high interest

earnings. The Treasurer’s investment strategy stressed yield over liquidity

or security at a time when the county Board of Supervisors faced

increasing budgetary pressure to fund county government services from

investment earnings instead of tax increases. The percentage of the budget

generated from tax revenues was declining. The Treasurer operated the

investment pool with little oversight from the Board of Supervisors.

From January 1991 to November 1994, the Treasurer substantially

increased risk by mismatching the investment pools’ assets and liabilities.

He purchased volatile, long-term structured notes and used short-term

liabilities (reverse repurchase agreements) to fund the purchases.3

 For

example, as of November 30, 1994, the Orange County investment pool

included large investments in structured notes that averaged nearly 4 years

to maturity.4

 The Treasurer’s strategy made the investment pool even more

vulnerable by entering into reverse repurchase agreements at short-term

rates. When combined with the volatility of structured notes, this

leveraging strategy produced an investment portfolio highly sensitive to

interest rate movements. By November 30, 1994, an estimated $7.5 billion

of original investments in the pool had been leveraged to over $20 billion,

a large portion of which was in inverse floaters. Overall, from 1983 to late

1993, this strategy yielded greater returns than most investment funds of

the California State Treasurer and other county treasurers.

3

A reverse repurchase agreement is an agreement in which the entity transfers securities to the broker

in exchange for cash and promises to repay the cash plus interest in exchange for the same securities

at a later date certain or on demand by the broker.

4

Many of these notes provided a rate of return that was equal to a fixed rate minus a floating rate

index. These notes are called “inverse floaters” because, as interest rates go down, the amount of

interest they pay goes up. For example, if the fixed rate of interest on the note is 32 percent, and the

floating rate is the multiple of 4 times LIBOR of 7 percent, the interest to be paid would be 4 percent. If

LIBOR goes down to 6 percent, the new interest rate to be paid would be 8 percent.

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As rates increased in 1994, the returns on long-term investments no longer

exceeded the cost of funds borrowed to acquire them. In addition, the

market values of the long-term investments that were used as collateral

declined. On December 6, 1994, the county did not meet a substantial

obligation under one of its reverse repurchase agreements. This resulted in

the liquidation of the county’s collateral. Other entities also began selling

Orange County’s collateral subject to reverse repurchase agreements.

These sales resulted in about $1.7 billion in losses. The losses precipitated

Orange County’s filing for bankruptcy.

Despite concerns about the county’s investment activities and questions

about its ability to repay debt securities, which it had also used to fund the

investment pool, the Board of Supervisors failed to carry out its public

responsibilities to effectively supervise the county’s investment activities

and to oversee related debt offerings. The Board failed to require the

County Treasurer to submit monthly reports on changes in the County’s

investments, which is required by California law, and failed to ensure that

actions were taken to prevent the recurrence of internal control

weaknesses in the Treasurer’s office.

The county’s investment losses were heightened by the control

weaknesses in the County Treasurer’s office. Similar weaknesses were

noted in several County Auditor’s reports issued over a period of years

before the bankruptcy filing, but these weaknesses continued to occur. In

one report, the Auditor characterized one of these weaknesses as creating

the perception of a loose control environment and recommended that

risky or unusual transactions be prudently entered into with documented

decisions made by an investment committee and with advice, if

appropriate, from County Counsel. This lack of oversight allowed the

Treasurer to invest in risky transactions without accountability to other

county officials.

Even though the County Auditor’s reports on the Treasurer’s office were

addressed to the Board of Supervisors, they were routinely marked “not

for Board agenda.” As a result, the internal control weaknesses in the

Treasurer’s office did not come up for public discussion. Although

questions have been raised in a report on Orange County’s bankruptcy

filing about this and other practices of the County Auditor, the Auditor’s

performance does not excuse the county’s Board and management from

exercising their responsibility to address control weaknesses and prevent

their recurrence.

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In other reports related to the county’s budget, the County Auditor also

raised concerns about the county’s reliance on investment income to fund

a significant portion of its budget and warned in one report that it was not

fiscally responsible to continue budgeting in this manner. In addition, the

Auditor had informed the Board that investment income projections

contained in the budget were based on increased amounts of borrowing.

Despite these warnings, on numerous occasions the Board approved

requests to issue bonds and notes without public discussion. The

Treasurer then used the bond proceeds to increase the investment pool.

After the county’s bankruptcy, an outside consultant studied the internal

controls and operational effectiveness of the Treasurer’s office and

continued to identify weaknesses that in our judgment contributed to the

collapse of the county’s investment pool. For example, the consultant

found that the county’s investment policy did not define a diversification

strategy or establish limits on levels of high-risk investments.

In January 1996, SEC reported that the Board lacked sufficient information

on the county’s investment pool and the impact of the Treasurer’s

investment strategy on both the county’s financial condition and its ability

to repay investors. In addition, SEC found that despite the Board’s

knowledge that the county’s discretionary budget was increasingly

dependent on the pool’s interest income and that this income was

connected to the county’s increased debt offerings, the Board failed to

ensure that this material information was disclosed to potential investors.

SEC concluded that in authorizing the offer and sale of debt in 1994, the

Board failed to meet its statutory responsibilities to ensure proper

disclosure when it approved the county’s misleading disclosure

documents.

Orange County’s losses illustrate the vulnerability of state and local

governments to losses resulting from weaknesses in internal controls.

Without a responsible oversight body to develop and implement policies

governing the nature and extent of derivatives use and to provide effective

oversight of internal controls and derivatives activities, entities have

greater vulnerability to significant losses. Both Orange County and the

state of California have instituted corrective actions. For example, the

Board established a Treasury Oversight Committee, which consists of five

financial experts, to assist the Board in improving accountability to the

public on county investments and evaluating internal controls in the

Treasurer’s office. California enacted legislation requiring local treasurers

to have oversight committees, annual written investment policies, and

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annual compliance audits. It also enacted legislation restricting portfolios

to certain types of investments.

Capital Corporate

Federal Credit Union

The Capital Corporate Federal Credit Union, which is known as Cap Corp,

was formerly one of the nation’s largest corporate credit unions. Over the

6-year period 1989 to 1994, Cap Corp invested an increasing portion of its

assets in CMOs in an apparent attempt to increase the return paid to its

member credit unions. Although Cap Corp’s investments in CMOs increased

substantially during this 6-year period, Cap Corp did not develop and

implement a risk-management system that was capable of effectively

monitoring and responding to rapid and unanticipated changes in CMO

market values.5 In particular, Cap Corp lacked a financial model to test the

overall sensitivity of its investment portfolio to potential changes in

interest rates and was unable to react readily to the growing mismatch

between its assets and liabilities.6

 In January 1995, the National Credit

Union Administration placed Cap Corp into conservatorship because it

could not meet its financial obligations to its members. As of

February 1995, Cap Corp’s losses totaled $61 million.

Cap Corp’s board of directors not only failed to ensure that an adequate

risk-management system was established and functioning, it also did not

appear to adequately oversee Cap Corp’s investment activities. For

example, virtually all responsibility for Cap Corp’s investment activities

was delegated to an investment committee comprising Cap Corp’s senior

management, and the board showed little interest in the decisions this

committee made. Until late 1993, the committee did not maintain minutes

of its meetings that would have documented investment decisions. In late

1994, only after National Credit Union Administration examiners insisted,

minutes of the investment committee were formally presented to the

board on a monthly basis. However, the board did not appear to discuss or

question the investment committee’s strategy or activities.

In addition, the supervisory committee of the board of directors, which

was responsible for oversight of the audit function and related review of

internal controls, did not establish an internal audit function at Cap Corp.

Instead, the supervisory committee relied solely on the annual financial

5

The market value of a CMO tends to be more volatile than traditional corporate investments, such as

U.S. Treasury obligations, in part because changes in interest rates affect the time pattern of mortgage

prepayments. When interest rates rise, people prepay mortgages at a slower rate, and the average

maturity of these assets lengthens.

6

Financial modeling, including stress testing, is important because it shows the sensitivity of asset and

liability values to potential changes in interest rates.

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statement audit performed by the external auditor to provide information

about the status of internal controls. The objective of a financial statement

audit is for an external auditor to provide an opinion on the fairness of the

information appearing in the financial statements. Therefore, the purpose

of these audits is different from audits that focus on the adequacy of

internal controls. Although the annual external audit may have contributed

to the committee’s oversight, it did not take the place of a specific review

of controls that an internal or external auditor could have performed to

ensure Cap Corp’s compliance with established policies and procedures.

Without this type of review, the Board of Directors did not have adequate

information to understand the seriousness of the risk associated with Cap

Corp’s investment activities.

Barings PLC In February 1995, Baring Brothers & Co., Ltd, a British investment bank

owned by Barings PLC, collapsed after losing over $1 billion by trading

financial futures on exchanges in Singapore and Japan. According to the

British Board of Banking Supervision Inquiry, Barings’ management failed

at various levels to institute a proper system of internal controls; to

enforce accountability for all profits, risks, and operations; and to

adequately follow up on a number of warning signals over a prolonged

period. For example, a 1994 internal audit report highlighted that one

individual had an excessive concentration of power and that this

concentration was a significant internal control weakness. That weakness

allowed the individual responsible for initiating trading transactions, often

referred to as “front” office activities, to also be responsible for recording

and reconciling these activities. The latter, referred to as “back” office

activities, also included settling any account differences. Permitting one

individual to be responsible for both front and back office activities

increases the likelihood that unauthorized transactions could occur and go

undetected. The employee’s unauthorized transactions were concealed by

false trading transactions and accounting entries, the submission of

falsified reports, and the misrepresentation of trading profitability. Despite

the seriousness of this lack of basic separation of duties, Barings’

management did not take any action or follow up on the internal audit

report.

The Banking Supervision Inquiry also showed that other warning signs

existed and were ignored by management. For a relatively risk-free trading

strategy to generate such apparently large profits should have raised

questions. Further, the trading activities required a high level of funding. In

early 1994, the employee had requested some of the funds used to finance

Page 126 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix I 

Flawed Corporate Governance Systems

Contributed to Significant Losses

his trading positions from the bank as loans to fund client positions.

Because the employee requesting the funds was responsible for both front

and back office transactions, he was able to conceal from Barings’ credit

department the fact that he was characterizing the transactions as loans.

Since this department was not informed of the loans, it made no attempt to

verify whether any clients existed (none did). Barings’ inattention to key

internal controls, such as the segregation of duties, demonstrates its lack

of effective corporate governance and a generally weak overall control

environment.

Page 127 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix II 

Results of GAO Review of Key Internal

Controls at 12 Banks and Thrifts

We judgmentally selected a sample of 12 banks and thrifts that were large

end-users of derivatives to obtain an understanding of their corporate

governance, risk management, and internal controls.1

 At each of the

institutions, we discussed the formal assessment of internal controls

required by FDICIA, whether management perceived benefits from these

FDICIA requirements, and the reasons for their perceptions. This appendix

also discusses the extent to which certain key controls over derivatives

activities were designed into these institutions’ systems of internal

controls.

Officials at most of the financial institutions told us that the formal

assessment was beneficial. Some officials told us the process provided

them an opportunity to thoroughly think through their internal control

structures or to heighten their awareness of internal controls. Some of the

officials noted that the process identified areas needing improvement or

increased their staffs’ awareness of the importance of controls. Although

some officials said that in its first year of application the process was

either costly or time-consuming, many others said that it will take less

time or effort in subsequent years to update the information previously

obtained.

To determine whether key internal controls related to derivatives were

designed into the internal control systems at the 12 institutions, we

reviewed available documentation and discussed specific controls with

management, internal auditors, or regulatory examiners.2

 The

documentation included bank examination working papers and, when

available, internal control documentation related to derivatives that had

been prepared by management to satisfy FDICIA requirements. We

developed the list of key internal controls related to derivatives after

reviewing various guidance documents prepared by market participants,

regulators, and others. Most of the controls we considered key were

included in guidance issued by more than one of these sources and were

also contained in derivatives guidance issued by COSO. However, our

1

At the time of selection, the banks and thrifts had at least $1 billion in total assets and notional

amounts of derivatives exceeding 25 percent of the amount of total assets. We selected at least two

institutions regulated by each of the four bank and thrift regulatory agencies. We excluded the seven

largest bank OTC derivatives dealers discussed in our May 1994 report.

2

Subsequent to our review of the 12 banks and thrifts, as discussed in chapter 3, the Federal Reserve

issued examination guidance stating that the board of directors, as well as management, should

approve risk limits. See Federal Reserve Board Letter SR 95-17 (SUP), “Evaluating the Risk

Management and Internal Controls of Securities and Derivatives Contracts Used in Nontrading

Activities”; and Federal Reserve Board Letter SR 95-51 (SUP), “Rating the Adequacy of Risk

Management Processes and Internal Controls at State Member Banks and Bank Holding Companies.”

Page 128 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix II 

Results of GAO Review of Key Internal

Controls at 12 Banks and Thrifts

review did not evaluate or test the effectiveness of the key internal

controls at the 12 institutions.

Table II.1 summarizes the results of our review of key derivatives controls

in the system of internal controls at the 12 institutions. For each key

derivatives control, the table identifies the number of institutions that

(1) had designed the internal control into their systems; (2) had designed

the internal control into their systems, but for which examiners or internal

auditors had noted the need for improvements; and (3) had incomplete

data with which to verify that the control was designed into the system.

Page 129 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix II 

Results of GAO Review of Key Internal

Controls at 12 Banks and Thrifts

Table II.1: Summary of Results at 12 End-User Financial Institutions

Key internal control

Key control

designed into

system

Key control

designed into

system/but

improvements

still needed

Incomplete

data to verify

that key

control was

designed into

system

The overall objective of the hedging program is defined, and this objective is

approved by the board of directors. 9 1 2

Written policies clearly set risk limits and are approved by management. 6 6 0

A committee meets regularly to oversee the hedging program, report to the board

of directors, and maintain documentation of its decisions and actions. 6 4 2

Trading limits are set for specific market risks. 9 2 1

Credit limits are established for counterparty exposure. 8 4 0

Policies exist to execute trades through authorized brokers. 8 1 3

Policies exist to ensure that persons have appropriate knowledge to manage

derivatives activities. 5 2 5

The board of directors has a policy to ensure that sufficient capital is maintained

to support risk exposures. 8 3 1

Procedures are designed to segregate the trading function from the credit

function in order to separate placing an order, recording the transaction, and

verifying the confirmation of the trade. 10 2 0

Policies are established that authorize separate employees to set hedge strategy,

change hedge strategy, change trading limits, and execute trades. 11 1 0

Backup procedures exist when key employees are absent. 3 1 8

Procedures exist to monitor risk limits and exposures on a daily or regular basis. 7 3 2

A system of communication exists between the back office management and

senior management concerning changes to hedging strategies. 8 0 4

Established subsidiary accounting records exist for futures contracts. 9 0 3

Procedures exist to periodically reconcile subsidiary records to the general

ledger. 9 1 2

Documentation exists to support (1) the objective and strategy of each hedge;

and (2) key accounting information for options, futures, and swaps transactions. 9 2 1

Sequential numbering of transactions is used. 6 0 6

Procedures exist to require trade verification by (1) agreeing executed trade to

broker’s confirmation, (2) agreeing key accounting data to broker’s statements,

and (3) accounting for the sequence of numbered transactions. 9 1 2

Internal audit function exists so that periodic reviews of derivatives activities and

policies and procedures established by management could be done. 8 1 3

Management receives reports on a regular basis of the results of hedging and

trading activities. 7 3 2

Sources include: OCC Banking Circular BC-277; Federal Reserve Board Letter SR 93-69;

Derivatives: Practices and Principles, Global Derivatives Study Group, Group of Thirty,

Washington, D.C., July 1993; An Integrated Bank Regulatory Approach to Derivatives Activities,

Institute of International Finance, May 1993; and Audits of Savings Institutions, AICPA accounting

and audit guide.

Page 130 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix III 

Prototype Guidelines for Roles and

Responsibilities of Boards of Directors

The following represent suggested guidelines for boards of directors

presented by GAO to SEC for its consideration in responding to the

recommendations in our May 1994 report. These guidelines were

accumulated from existing guidance issued in OCC Banking Circular

BC-277; Federal Reserve Board SR 93-69; the Canadian Deposit Insurance

Corporation’s Interest Rate Risk Management paper; and The CPA Letter

article entitled “Questions About Derivatives,” issued by AICPA in

July/August 1994.

Boards of Directors should

• approve all significant policies and activities relating to derivatives and

related risk-management activities; and ensure that these policies and

activities are consistent with the organization’s broader business

strategies, capital adequacy, expertise, and the overall willingness to take

risk.

Specifically, the boards should consider and approve

• a description of the relevant financial products, markets, and business

strategies;

• the costs of establishing sound and effective risk-management systems

and of attracting and retaining professionals with expertise in derivatives

transactions;

• an analysis of the reasonableness of the proposed activities in relation to

the entity’s overall financial condition and capital levels;

• an analysis of the risks that may arise from the activities;

• the procedures the entity will use to measure, monitor, and control risks;

• the relevant accounting guidelines (the appropriateness of such guidelines

should be discussed with the external auditors as a basis for approval);

and

• an analysis of any legal restrictions and whether the activities are

permissible.

In addition, Boards of Directors should

• regularly reassess the adequacy of the financial condition of the entity and

the competency of designated professional personnel to support the

derivatives and related risk-management activities;

• regularly re-evaluate (at least annually) significant derivatives and related

risk-management policies and procedures;

• approve any significant changes in derivatives activities;

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Appendix III 

Prototype Guidelines for Roles and

Responsibilities of Boards of Directors

• review the appropriateness of established risk limits and controls

whenever significant changes occur in the size and scope of the entity’s

activities or market conditions, or if the entity experiences significant

reductions in earnings or capital that were not anticipated at the time the

limits and controls were established;

• receive relevant information about credit exposure arising from

derivatives activities on a periodic and timely basis;

• receive reports that accurately present the nature and level(s) of risk

taken and compliance with approved policies and limits;

• ensure compliance with the risk-management program by receiving

sufficient information in periodic reporting by management and internal

and external auditors;

• ensure that an internal audit function reviews risk operations to ensure

that the entity’s risk-management policies and procedures are being

adhered to; and

• conduct and encourage discussions between its members and senior

management, as well as between senior management and others in the

entity, regarding the entity’s risk-management process and risk exposure.

Page 132 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix IV 

Prototype Report on Internal Controls Over

Derivatives and Related Risk-Management

Activities

At SEC’s request, we prepared this prototype report on internal controls

over derivatives activities to illustrate the kind of public reporting we were

recommending. This report describes an entity’s derivative products, the

establishment of its risk limits and related controls, and its involvement of

the board of directors and the board’s audit committee. This report is only

illustrative and could well be shortened, simplified, or broadened to

include a wider range of important internal controls. We presented this

report to SEC for its consideration in responding to the recommendations

in our May 1994 report.

As described further in Note XX to the financial statements, the Company uses financial

derivatives as an efficient way to manage its various market risks, including adverse

changes in interest rates, foreign exchange rates, and commodity prices. The Company

uses derivatives to protect against price volatility in the raw materials of the products it

manufactures. In addition, the Company uses derivatives and related risk-management

products to synthetically alter the interest rate and maturity characteristics of its debt

instruments to better match the characteristics of the related assets being funded by those

instruments. In certain instances, the Company may use derivatives to protect itself against

foreign currency movements in connection with its overseas operations. Derivative

instruments used include futures contracts, foreign exchange forwards, options, and

interest rate swaps.

The Company’s Board of Directors has approved the risk-management policies and

procedures that management uses to carry out its risk-management activities. These

policies and procedures reflect the Company’s objectives to hedge virtually all of its market

risk exposure. However, the Board-approved policy allows management to maintain

nonhedged market risk exposures not to exceed X percent of the Company’s planned gross

profit.

Management has established a system of internal control to provide reasonable assurance

that the derivatives and related risk-management policies and procedures are being carried

out and, in so doing, that reliable financial reporting of these activities is achieved and that

assets are protected from losses due to unauthorized acquisition, use, or disposition of

derivatives. The control system for derivatives contains self-monitoring mechanisms,

including risk-management group reporting directly to senior management and the Board

of Directors. As a result, actions are taken to correct deficiencies as they are identified.

However, an effective internal control system, no matter how well designed, has inherent

limitations—including the possibility of the circumvention or overriding of controls.

Management has assessed the operation of its control system for derivatives as of

December 31, 19XX, using the criteria for effective internal control described in “Internal

Control - Integrated Framework” issued by COSO. The assessment included an in-depth

Page 133 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix IV 

Prototype Report on Internal Controls Over

Derivatives and Related Risk-Management

Activities

analysis of all departments of the Company responsible for derivatives and related

risk-management activities. A separate task force consisting of members of mid-level

management and internal audit had overall responsibility for the assessment and, at the

conclusion, reported to senior management. The documentation of the assessment in the

form of checklists, flowcharts, and questionnaires provides evidence of this review. In

addition, the Company’s independent auditors reviewed the assessment in connection with

their annual audit procedures but have not been asked to express an opinion on the

effectiveness of the system. Management reviewed its assessment of the effectiveness of

the control system for derivatives, including the methodology used to perform the

assessment, with the Audit Committee of the Board of Directors. Management also

reviewed with the Audit Committee all weaknesses identified in the assessment and the

corrective actions taken. All identified weaknesses were corrected as of December 31,

19XX.

On the basis of the assessment described, Management believes that as of December 31,

19XX, its approved policies and procedures for risk management using financial derivatives

are being carried out and that they provide reasonable assurance that published financial

statements reliably report these activities and that Company assets are safeguarded against

loss due to unauthorized acquisition, use, and disposition of derivatives.

Page 134 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix V 

Quantitative Standards for Market Risk

Amendment

In September 1996, U.S. bank regulators issued a final rule to incorporate

market risk into risk-based capital standards for internationally active

dealer banks and bank holding companies with significant trading

activities. The final rule requires that, by January 1, 1998, these banks use

their internal (proprietary) value-at-risk models to calculate the amount of

regulatory capital to be held for market risk. Banks have used these

models primarily as management tools to produce estimates for evaluating

their trading positions, limits, and strategies, rather than for evaluating

capital adequacy. The final rule imposes several qualitative and

quantitative requirements to adapt these models for regulatory capital

purposes.

The qualitative requirements include rigorous stress testing, an

independent risk control unit, active involvement of senior management,

and an independent review of the risk measurement system. The

quantitative requirements include

• daily calculation;

• an assumed holding period of 10 business days;1

• a 99 percent confidence level to estimate maximum loss;2

• allowance for correlations among broad risk categories (interest rates,

exchange rates, equity and commodity prices) only if based on empirical

analysis and if the regulator agrees that the measurement system is

sound;3

• use of at least 1 year of historical data in the models of future price and

rate changes;4

• updates at least every 3 months of the underlying data used in the models;

1

Most institutions assume a 1-day holding period in estimating value at risk in their trading portfolios.

That would cover the amount of adverse price move that might be expected the next day. A longer

assumed holding period, such as 10 days, will generate a larger potential price movement and

therefore a larger value at risk. Bank regulators do not expect banks to hold losing positions for that

period; instead they use the 10-day calculation as a way of ensuring that banks’ value-at-risk shows the

potential impact of a stressful shock, such as an instantaneous price move of a magnitude that

ordinarily might occur only over 10 days.

2

This constraint establishes that the value at risk will be set on the basis of an adverse rate or price

movement large enough so that in 99 out of 100 10-day periods, price moves are expected to be less

adverse than this.

3

If two market prices or rates move in a clearly defined relationship to each other, and if this

relationship is stable, these market prices or rates are said to have a defined numerical correlation. As

an example, if currency A and currency B always move together, then a firm could reduce its value at

risk by having an asset position in one and a matching liability position in the other.

4

Some banks use data from periods as short as 30 to 60 days, while others use periods as long as

several years. The regulators’ 1-year constraint is intended to make value-at-risk estimates more

comparable among banks.

Page 135 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix V 

Quantitative Standards for Market Risk

Amendment

• at least six different maturities of interest rates included in the models of

interest rates for each major currency;

• all material risks measured by the bank’s model; and

• nonlinear price characteristics of options5 adequately addressed.

5

The relationship of the value of an option to the price of the underlying is not constant, and banks’

models must allow for the different factors that move options prices.

Page 136 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix VI 

Current Accounting and Disclosure

Standards for Derivatives and Related

Financial Instruments

Accounting standards establish the rules that entities must follow in

recognizing and measuring transactions for reporting in the body of the

financial statements. Disclosure standards establish the rules that entities

must follow in providing additional information beyond what is reported

in the financial statements, usually in the accompanying footnotes.

Accounting and disclosure standards promulgated by FASB are generally

applicable to nongovernmental entities, and those issued by GASB apply to

state and local governmental entities. FASB began a financial instruments

project in 1986 to develop standards to aid in resolving financial

accounting and reporting issues about various financial instruments,

including derivatives. Standards affecting derivatives that have been

issued since the project began focus on disclosures. No new accounting

standards for derivatives have been issued since 1984. However, an

accounting standard for certain investments in debt and equity securities

was issued in 1993. There are no specific GASB pronouncements that

address accounting for derivatives held by state and local governmental

entities. The following is a discussion of existing accounting and

disclosure standards as well as other guidance from authoritative sources.

Accounting

Requirements

Currently, two FASB statements prescribe specific accounting requirements

for derivative instruments:

• Statement of Financial Accounting Standards (SFAS) No. 52, Foreign

Currency Translation, issued in 1981, applies to foreign currency

transactions including foreign currency futures, forwards, and swaps.

• SFAS No. 80, Accounting for Futures Contracts, issued in 1984, applies to

futures contracts, except foreign currency futures.

SFAS No. 52 allows the use of hedge accounting treatment, provided the

hedging instrument is so designated and is effective as a hedge of a

specific commitment or transaction, and the commitment is firm. SFAS No.

80 allows the use of hedge accounting treatment provided (1) the item to

be hedged exposes the entity to price or interest rate risk; (2) the hedging

instrument and the hedged item, which may be either an individual item or

an identifiable group of essentially similar items, are specifically identified

by management and the relationship between them is designated as a

hedge; and (3) the hedging instrument reduces the entity’s exposure to

price or interest rate risk and continues to do so throughout the hedge

period.

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Appendix VI 

Current Accounting and Disclosure

Standards for Derivatives and Related

Financial Instruments

Some similarities exist in the hedge criteria specified in both statements.

For example, both require the specific hedging instrument and the hedged

item to be identified and designated as a hedge, and both require an

ongoing demonstration of effectiveness or correlation to demonstrate the

hedge is working as intended. However, there are significant differences

between the statements as well. For example, SFAS No. 80 allows the use of

hedge accounting when the hedging instrument is designated against an

anticipated transaction, provided the significant characteristics and

expected terms of the anticipated transaction are identified and

occurrence is probable.1 SFAS No. 52 allows hedging only against firm

commitments.2 SFAS No. 80 requires the hedging instrument to reduce the

entity’s overall exposure to interest rate risk, while SFAS No. 52 requires

only reducing the risk of the designated hedged item. As a result, these

two statements do not provide consistent guidelines to those seeking to

apply them to instruments for which there are currently no standards.

Although FASB in the past had considered undertaking a project focusing

on reconciling both statements, due to questions raised about the

appropriateness of hedge accounting in general, it decided instead to

address hedging more broadly in its ongoing hedge accounting project.

In May 1993, FASB issued SFAS No. 115, Accounting for Certain Investments

in Debt and Equity Securities, in response to concerns about the

appropriateness of previous accounting practices in which historical cost

accounting was used for investments that were regularly being sold and

traded. Although SFAS No. 115 does not apply to derivatives, it does apply

to financial instruments that may have derivatives-like characteristics. SFAS

No. 115 requires most investment securities to be classified in three

categories and accounted for as follows:

• Debt securities that the entity has the positive intent and ability to hold to

maturity are classified as “held-to-maturity securities” and reported at

amortized cost.

• Debt and equity securities that are bought and held principally for the

purpose of selling them in the near term are classified as “trading

securities” and reported at fair value, with unrealized gains and losses

included in earnings.

• Debt and equity securities not classified as either held-to-maturity or

trading securities are classified as “available-for-sale securities” and

1

SFAS No. 80 defines an anticipated transaction as one that an entity expects, but is not obligated, to

carry out in the normal course of business.

2

A firm commitment is an agreement, usually legally enforceable, under which performance is

probable because of sufficiently large disincentives for nonperformance.

Page 138 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix VI 

Current Accounting and Disclosure

Standards for Derivatives and Related

Financial Instruments

reported at fair value, with unrealized gains and losses excluded from

earnings and reported in a separate component of shareholders’ equity.

In addition, SFAS No. 115 requires that for securities classified as

available-for-sale or held-to-maturity, an entity must record in income any

declines in fair value that are deemed to be other than temporary.

Disclosure

Requirements

Since the financial instruments project began in 1986, FASB has issued

three disclosure statements:

• SFAS No. 105, Disclosure of Information About Financial Instruments with

Off-Balance-Sheet Risk and Financial Instruments with Concentrations of

Credit Risk, which applies to all financial instruments with the stated

risks;

• SFAS No. 107, Disclosures About Fair Value of Financial Instruments, which

generally applies to all financial instruments; and

• SFAS No. 119, Disclosure About Derivative Financial Instruments and Fair

Value of Financial Instruments.

SFAS No. 105 and SFAS No. 107, which were issued in 1990 and 1991, do not

make a distinction between hedge versus nonhedge instruments. SFAS No.

105 established requirements for all entities to disclose information

principally about financial instruments that have an off-balance-sheet risk

of accounting loss.3

 For all applicable financial instruments, entities must

disclose the extent, nature, and terms of such instruments, including the

credit and market risks they carry, the potential accounting loss that may

result from the credit risk regardless of any offsetting collateral or

security, and information about the entity’s collateral policy and program

to better indicate the extent of credit risk. In addition, entities are to

disclose all significant concentrations of credit risk arising from all

financial instruments.

SFAS No. 107 requires all entities to disclose the fair value of financial

instruments, both on-balance sheet and off-balance sheet, for which it is

practicable to estimate fair value, as well as the method(s) and significant

assumptions used to estimate the fair value in either the body of the

financial statements or the related footnotes. If estimating fair value is not

practicable, the standard requires disclosure of descriptive information

pertinent to estimating the value of a financial instrument.

3

SFAS No. 105 defines an off-balance-sheet risk of accounting loss as the risk of loss beyond what is

currently recognized in the balance sheet due to credit and/or market risk directly resulting from the

rights and obligations of a financial instrument.

Page 139 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix VI 

Current Accounting and Disclosure

Standards for Derivatives and Related

Financial Instruments

SFAS No. 119, issued in October 1994, established new disclosure

requirements and included revisions to SFAS No. 105 and SFAS No. 107.

Specifically, for all derivative financial instruments, SFAS 119 requires

disclosure of the following information either in the body of the financial

statements or in the accompanying footnotes:

• the amounts, nature, and terms of derivative financial instruments that are

not subject to SFAS No. 105 because they do not result in off-balance-sheet

risk of accounting loss;

• average fair value and net trading gains or losses for derivative financial

instruments held or issued for trading purposes;

• the objectives for holding or issuing derivative financial instruments held

other than for trading, the strategies for achieving those objectives, and

how the instruments are reported in the financial statements; and

• information about hedges of anticipated transactions, including firm

commitments, such as a description of the classes of derivative financial

instruments used to hedge those transactions, the amount of hedging gains

and losses deferred, and a description of the transactions or other events

that result in recognition of the deferred gains or losses in earnings.

The statement also amended SFAS No. 105 to require disaggregation of

information about financial instruments with off-balance-sheet risk of

accounting loss by class, business activity, risk, or other category that is

consistent with the way the entity manages those instruments.

Additionally, the statement amends SFAS No. 107 to require that fair value

information be presented without combining, aggregating, or netting the

fair value of derivative financial instruments with the fair value of

nonderivative financial instruments and be presented together with the

related carrying amounts in the body of the financial statements, a single

footnote, or a summary table. SFAS No. 119 also encourages, but does not

require, quantitative information about market risks of derivative financial

instruments and other related assets and liabilities that is consistent with

the way the entity manages or adjusts those risks and that is useful for

comparing the results of applying the entity’s strategies to its objectives

for holding or issuing the derivative financial instruments.

Other Guidance The accounting and financial reporting provisions of AICPA Audit and

Accounting Guides generally describe authoritative literature or describe

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Appendix VI 

Current Accounting and Disclosure

Standards for Derivatives and Related

Financial Instruments

practices for a specific industry where no such literature exists.4 Although

the guides describe existing principles and practices, they do not establish

accounting standards themselves. One guide—Audits of Investment

Companies—contains limited information about the accounting for

derivatives by those entities. In general, this guide briefly describes

current accounting practice for derivatives by those entities for various

derivative products. Another guide, Audits of State and Local

Governmental Units, contains limited information on the accounting for

investments of governmental funds by these entities but does not

specifically address derivatives. A recently issued guide, Banks and

Savings Institutions, and a proposed guide, Audits of Brokers and Dealers

in Securities, contain more extensive discussion of derivatives and related

accounting and auditing guidance. AICPA anticipates issuing the proposed

guide in the fourth quarter of 1996.

Additional guidance on derivatives issues is contained in various FASB

Emerging Issues Task Force (EITF)5 consensus positions concerning hedge

accounting. For example, EITF Issue No. 90-17, Hedging Foreign Currency

Risk with Purchased Options, addresses the appropriateness of hedge

accounting for purchased foreign currency options under various

circumstances and EITF Issue No. 91-1, Hedging Intercompany Foreign

Currency Risks, addresses whether intercompany transactions present

foreign exchange risk that may be hedged for accounting purposes.

Although EITF has dealt with a variety of issues related to certain

derivatives, it has not dealt with them comprehensively. Instead, EITF

decisions generally deal with somewhat narrow accounting issues.

Consequently, they do not provide guidance that can be applied

universally to derivatives or other transactions.

In 1994 the GASB staff issued Technical Bulletin No. 94-1, Disclosures

About Derivatives and Similar Debt and Investment Transactions, to

4

Statement of Auditing Standards No. 69, The Meaning of Present Fairly in Conformity with Generally

Accepted Accounting Principles in the Independent Auditor’s Report, describes the hierarchy of

sources of established accounting principles that are generally accepted in the United States. The

highest category, officially established accounting principles, includes all FASB and GASB statements,

such as SFAS Nos. 52 and 80. AICPA Industry Audit and Accounting Guides, consensus positions of the

FASB Emerging Issues Task Force, and GASB Technical Bulletins are described in Statement of

Auditing Standards No. 69 as accounting principles but are lower in the hierarchy than FASB and

GASB statements. FASB maintains the responsibility for setting principles with broad applications and

thus limits the scope of these additional sources. AICPA Issue Papers are listed in the hierarchy as

other accounting literature to be considered in the absence of established accounting principles.

5

FASB established EITF in 1984 to assist FASB in the early identification of emerging issues affecting

financial reporting and of problems in implementing authoritative pronouncements. Its membership

consists of representatives from the major public accounting firms as well as representatives of major

associations of preparers of financial statements, such as the Financial Executives Institute and the

Business Roundtable.

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Appendix VI 

Current Accounting and Disclosure

Standards for Derivatives and Related

Financial Instruments

address financial statement disclosures about derivatives and similar

transactions. Technical Bulletin No. 94-1 calls for certain disclosures if a

governmental entity directly or indirectly uses, holds, or writes (sells)

derivatives or similar transactions during the period covered by the

financial statements. These disclosures should explain the nature of the

transactions and the reasons for entering into them, including relevant

discussion of exposure to credit risk, market risk, and legal risk.

Although there are no authoritative accounting standards for option-based

derivatives, AICPA Issues Paper 86-2, Accounting for Options, addresses

issues related to the accounting for options. However, the 1986 issues

paper contains certain viewpoints that differ from the conclusions in SFAS

Nos. 52 and 80. For example, the paper states that an option that hedges

either an asset stated at cost or a liability stated at proceeds cannot qualify

for hedge accounting. However, SFAS No. 80 permits hedge accounting for

futures contracts that hedge such assets or liabilities. The advisory

conclusions expressed in the issues paper are not authoritative, and FASB

has advised that the existing authoritative accounting pronouncements

should be followed.

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Appendix VII 

Derivatives Activities of 12 Banks and

Thrifts

This appendix describes the use of derivatives by the 12 end-user banks

and thrifts we reviewed as well as examples of the hedging strategies of

these institutions. The information that follows is based on our analysis of

bank examination workpapers, annual reports, regulatory reports, and

discussions with regulatory and institution management and staff at each

of the 12 institutions. We generally obtained data for each institution as of

December 31, 1993. In two cases, however, we obtained detailed

derivatives data as of the most recent regulatory examination at those

institutions. For institutions F and K, data are as of September 30, 1994,

and June 30, 1994, respectively.

Extent and Use of

Derivatives

We found that while all 12 of the institutions we reviewed were using

derivatives for what they identified as end-user risk-management or

hedging activities,1

 most of them were also using derivatives for dealing

and for proprietary trading. As shown in figure VII.1, nine institutions were

using derivatives for dealing and/or proprietary trading in addition to their

hedging activities.

1

As discussed in chapter 5, some institutions used deferral hedge accounting strictly for risk-reducing

activities, while others used deferral hedge accounting for risk-adjusting activities, which some

referred to as risk-management activities. Throughout this appendix, we use the term hedging to refer

to all transactions for which the institutions are using deferral hedge accounting, where the underlying

asset or liability is carried at historical cost, whether the activities are risk-reducing or risk-adjusting.

Hedging or hedge accounting also refers to situations where the derivative is used to hedge an

underlying asset or liability carried at market value.

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Figure VII.1: Notional/Contract Amount of Derivatives Held by Purpose of Activity, as of December 31, 1993

Dollars in billions

0

10

20

30

40

50

60

70

ABCDEF GHI J KL

Financial institutions

Trading

Dealing

Hedging

Note: Institutions H and J show combined dealing and trading activities under “dealing.”

Source: GAO analysis based on reviews of bank and thrift examination reports and workpapers,

internal and external financial reports, and discussions with bank and thrift examiners and

management.

Although all of the institutions were using derivatives for hedging, the total

notional/contract amount of derivatives used for hedging was much less

than that used for dealing and trading. Only 27 percent of the total

notional/contract amount of derivatives held by these 12 institutions was

identified as being used for hedging compared with 73 percent for dealing

and/or trading. In all cases the derivatives used for dealing and for trading

were carried at market value.

Figure VII.2 shows the extent to which these institutions used interest rate

derivatives versus their use of foreign exchange rate instruments.

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Figure VII.2: Notional/Contract Amounts of Interest and Foreign Exchange Rate Derivatives, as of December 31, 1993

Dollars in billions

0

10

20

30

40

50

60

70

ABCDEF GHI J KL

Financial institutions

Foreign exchange

Interest rate

Source: GAO analysis based on reviews of bank and thrift examination reports and workpapers,

internal and external financial reports, and discussions with bank and thrift examiners and

management.

As a whole, 64 percent of the notional/contract amounts of the derivatives

held were interest rate derivatives, and 36 percent were foreign exchange

rate instruments. About 42 percent of the interest rate derivatives were

used for hedging, while less than 1 percent of the foreign exchange rate

derivatives were used for hedging purposes. Only two institutions were

hedging with foreign exchange rate instruments. Institution H also used

nominal commodity and equity futures for dealing/trading.

As shown in figure VII.3, the institutions we reviewed used a variety of

derivative products.

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Figure VII.3: Notional/Contract Amount of Derivatives by Type of Contract, as of December 31, 1993

Dollars in billions

0

10

20

30

40

50

60

70

ABCDEF GHI J KL

Financial institutions

Forwards

Futures

Options

Swaps

Note: Institutions F, H, and J reflect combined futures and forwards amounts under futures.

Source: GAO analysis based on reviews of bank and thrift examination reports and workpapers,

internal and external financial reports, and discussions with bank and thrift examiners and

management.

Swaps were the only type of derivatives used by all 12 institutions. Despite

this, about 57 percent of the total notional/contract amount of derivatives

held by these 12 institutions was in futures and forwards, while 27 percent

was in swaps and 15 percent in options. This distribution was due in large

part to the fact that most of the derivatives held by the institutions in our

sample were used for dealing and/or trading purposes.

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As figure VII.4 shows, interest rate swaps were clearly the predominant

derivative instruments that these institutions used specifically for hedging

purposes.

Figure VII.4: Notional/Contract Amount of Hedging Derivatives by Type of Contract, as of December 31, 1993

Dollars in billions

0

10

20

30

40

50

60

70

ABCDEF GHI J KL

Financial institutions

Forwards

Futures

Options

Swaps

Source: GAO analysis based on reviews of bank and thrift examination reports and workpapers,

internal and external financial reports, and discussions with bank and thrift examiners and

management.

The widespread use of interest rate swaps for hedging is not surprising

because insured depository institutions are inherently vulnerable to

changes in interest rates, and swaps can be customized to enable the

institutions to better match the interest rate sensitivity of their assets to

their liabilities. As a group, 54 percent of these institutions’ hedging

instruments were interest rate swaps, followed by interest rate futures at

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Derivatives Activities of 12 Banks and

Thrifts

31 percent. In contrast, foreign exchange futures and forwards together

accounted for almost half of the total derivative instruments used for

dealing and trading purposes. Overall, 99 percent of the hedging

instruments that the institutions in our sample used were interest rate

instruments, while instruments used for dealing and proprietary trading

were about evenly split between interest rate and foreign exchange rate

products.

Hedging Strategies The institutions we reviewed used a variety of hedging strategies to

manage their interest rate risk. Each institution’s specific strategy was

unique because of factors such as the size and type of the institution, the

nature and mix of its assets and liabilities, and its management’s tolerance

for risk and anticipation of market movements.

Risk-Adjusting Strategies Seven of the institutions we reviewed used a risk-management strategy

based on adjusting, but not necessarily reducing, their interest rate risk

exposure. In general, these institutions had limits on the maximum

acceptable level of risk; however, their managements were free to adjust

risk up or down within these limits. In some cases, institutions’ strategies

were built largely upon speculation about anticipated market movements.

Following are selected examples of institutions using risk-adjusting

strategies.

Example 1 One institution used deferral hedge accounting for all of its derivatives,

even though its strategy for these derivatives was primarily speculative.

The institution was engaged in swaps that required it to make interest

payments based on a variable, or floating, interest rate and receive

payments based on a fixed interest rate. These swaps, which were entered

into in 1992 and 1993, were not being used to hedge particular assets or

liabilities but as a means of generating income at a time of declining

interest rates. These swaps were quite profitable for the institution at a

time when interest rates were falling, because they yielded a fixed return

while the payment obligation, which was based on a floating interest rate,

declined as interest rates declined.

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In anticipation of interest rates rising, the institution entered into caps and

collars to protect its swap positions.2

 However, these caps and collars

were not to become effective until 1995, leaving 1994 exposed. As rates

increased faster than expected in 1994, the institution terminated some of

its existing swaps and began investing in swaps that required the

institution to make fixed rate interest payments while receiving floating

rate interest payments in order to limit its losses. Although the institution

greatly increased its investment in derivatives in 1994, the fair value of its

portfolio greatly decreased. On the basis of our review of the institution’s

annual report footnote disclosures, the estimated fair value of its

derivatives fell during 1994 from a positive position at the beginning of the

year to a negative position by the end of the year. As the institution used

deferral hedge accounting on these instruments, this decline in value was

deferred and not recorded in its 1994 financial statements.

Example 2 This institution categorized the majority of its derivatives as hedging

instruments. However, upon closer examination it appeared that virtually

all of the hedging derivatives were being used to circumvent compliance

with SFAS No. 115, which specifies the accounting treatment for certain

security investments. Although the institution’s purpose for engaging in

these swaps was not speculative, we believe it was still an inappropriate

use of hedge accounting, since the institution had no intent to neutralize

its interest rate risk exposure.

This institution had a portfolio of fixed income securities that it classified

as available-for-sale (AFS). Under SFAS No. 115, such securities are required

to be measured at fair value, with unrealized holding gains and losses

reported in shareholders’ equity. In late 1993, after SFAS No. 115 was

issued, this institution began implementing a series of swaps that required

the institution to make interest payments based on a fixed interest rate

and receive payments based on a floating interest rate. Institution

management stated these original swaps were being used to hedge the AFS

securities, and thus the institution used hedge accounting for these swaps.

Since SFAS No. 115 requires AFS securities to be marked to market value

through equity, the swaps were also recorded in this manner under SFAS

No. 80. By doing so, the changes in the market value of the AFS portfolio

2

Caps, floors, and collars are interest rate options that function to protect the entity from interest rate

fluctuations, although they may also be used for speculation. A purchased cap protects the holder from

rate increases above the cap rate, and a purchased floor protects the holder from rate decreases. A

collar is the equivalent of purchasing a cap and selling a floor, which allows an entity to protect against

rising rates while reducing the cost of buying the cap by the premium the entity receives from selling

the floor.

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Derivatives Activities of 12 Banks and

Thrifts

were netted against the offsetting changes in the market value of the

swaps, resulting in little net balance sheet impact.

The institution also entered into a series of offsetting swaps—in some

cases, simultaneously with the original swaps described earlier—on which

it was required to make interest payments based on a floating interest rate

and receive fixed rate interest payments. However, it did not value these

offsetting swaps at fair value and, therefore, did not recognize the related

gains and losses. Although economically the institution was in virtually the

same position it would have been had it not entered into the original and

the offsetting swaps, the net accounting effect was to defer recognition of

the gains or losses on the AFS securities, thereby circumventing SFAS No.

115. This was because the original swaps were marked to market value,

with the resulting gains and losses recorded in the period incurred, while

the gains and losses on the offsetting swaps were deferred. According to

information from the institution’s 1994 annual report,3

 the estimated fair

value of these offsetting swaps declined in 1994 to a negative fair value.

Since this decline in value was deferred, it was not reflected in the bank’s

financial statements.

Example 3 In this example, the institution’s hedging portfolio included interest rate

swaps, options (caps and floors), and futures. At the time of our review,

the institution’s assets were repricing faster than its liabilities, making it

asset-sensitive.4

 Instead of using derivatives with the goal of eliminating

the mismatch as much as possible, management opted instead to adjust

the institution’s interest rate risk profile to create a liability-sensitive

position in order to take advantage of declining interest rates.

Management explained that it allowed the institution’s interest rate risk

exposure to be adjusted up or down within a defined “band of risk.”

Management was not required to neutralize risk but was allowed to adjust

it depending on anticipated market movements as long as the institution’s

overall risk exposure remained within this band. Specifically, it could

adjust risk up or down provided its overall interest rate risk exposure did

not exceed a 5-percent negative impact on net interest income over 12

months for a 100-basis point movement in interest rates. This is an

3

All of the institutions discussed in our examples, except example 1, consolidated their financial

statements into the annual reports of their respective bank holding companies.

4

For a given asset or liability, the repricing date is the next date on which its rate could be reset or

when the item would mature. When more assets than liabilities reprice within a given period, the entity

is said to be asset-sensitive because the assets are more vulnerable to changes in interest rates than

the liabilities. This situation generally presents an opportunity to earn more net interest income in a

rising interest rate environment. Conversely, when more liabilities than assets reprice within a given

period, a liability-sensitive position results, which would generally be beneficial in a declining interest

rate environment.

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example of using derivatives to adjust interest rate risk rather than to

attempt to eliminate it.

To create the liability-sensitive position, the institution primarily used

interest rate swaps that required it to make interest payments based on a

floating interest rate and receive payments based on a fixed interest rate,

similar to the institution in example 1. Although the institution’s policy

required designating these swaps against specific asset and liability groups

for hedge accounting purposes, on an overall enterprise basis these swaps

were actually being used to create a planned asset/liability imbalance

toward a liability-sensitive position.5

 The estimated fair value of hedging

derivatives declined from a positive value at the end of 1993 to a negative

value at the end of 1994. This decline was deferred and not reflected in the

institution’s financial statements. A portion of this amount relates to the

imbalance position and, therefore, was inappropriately deferred.

Example 4 This institution’s overall hedging objective was to limit its interest rate risk

exposure while allowing for imbalances that could enable it to profit from

favorable market conditions. For example, in 1993 the institution

purposely maintained a pricing imbalance between its assets and liabilities

in order to benefit from a declining interest rate environment. Similar to

the institution in example 3, this institution also adjusted risk within

specified limits. Its allowable risk-adjusting activities were controlled by

limits on net interest revenue at risk and market value sensitivity limits

based on various interest rate scenarios. The institution’s controller stated

this allowed the institution to take advantage of rising and falling interest

rates; however, he acknowledged that there is no clear definition as to

when a strategy moves from being one of managing risk to one of

speculation. This institution disclosed in its 1994 annual report a decline in

the market value of its interest rate hedging derivatives. Since deferral

hedge accounting was being applied, this decline was not reflected in the

bank’s financial results. A portion of this deferred amount related to the

imbalance position and, therefore, was inappropriately deferred.

Risk-Reducing Strategies Five of the institutions we reviewed used risk-reducing hedging strategies.

The primary goal of these institutions’ strategies was to reduce overall

interest rate risk exposure. As a result, these institutions’ strategies tended

to be more conservative than the risk-adjusting strategies institutions used

and followed more closely the hedging criteria specified in SFAS No. 80.

5

This type of overall adjustment of risk is referred to as macrohedging, in contrast to microhedging,

which requires designating the hedging instrument against a specific asset or liability or group of

similar assets or liabilities.

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Such risk-reducing strategies demonstrate that, when used properly,

derivatives are a very useful and viable means of protecting an institution’s

exposure to interest rate risk. Following are two examples of these

strategies.

Example 5 This institution’s balance sheet was primarily naturally hedged; that is, the

interest rate risk of the assets offset the corresponding interest rate risk of

the liabilities. As a result, it did not need to use derivatives extensively for

hedging. Its hedging derivatives included interest rate swaps that required

the institution to pay interest based on a fixed rate and receive interest

payments based on a floating interest rate. These swaps were being used

to hedge a portfolio of municipal securities. The rest of the swaps were

primarily basis swaps, which required a floating rate interest payment

while receiving a different, floating rate interest payment. These were

entered into in 1993 primarily to hedge specific prime based loans.

Example 6 Over 80 percent of this institution’s hedging instruments were interest rate

futures, with the remainder primarily interest rate swaps. Bank

management stated its strategy was one of “risk elimination,” as it had

experienced financial difficulties in the past and had made a conscious

decision to maintain a very conservative, controlled hedging environment.

This institution used both micro- and macrohedges for risk reduction. It

placed microhedges on all individual loans (assets) over a pre-established

threshold as they were made. All remaining loans were then consolidated

and hedged weekly. Then, the total asset/liability pricing mismatch was

calculated and hedged monthly. Although this institution used a

combination of micro- and macrohedges, the macrohedges were of

discrete segments of the portfolio since most of the large items were

already hedged before the monthly mismatch was calculated and,

therefore, the monthly mismatch was relatively small. This institution

maintained a very active yet controlled hedging program that it said

allowed it to successfully neutralize its exposure to interest rate risk.

Hedge Criteria As mentioned in chapter 5, most institutions used SFAS No. 52 and SFAS No.

80 by analogy in formulating their own hedge criteria for derivatives, even

though these standards specifically apply only to foreign currency

transactions and futures contracts, respectively. Despite their common

basis in these standards, the institutions we reviewed varied in their views

and practices on what types of transactions and strategies should be

allowed to qualify for deferral hedge accounting.

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Macro- Versus

Microhedges

One view is that qualifying derivatives should be linked to particular assets

or liabilities, such as to residential mortgage loans or variable rate

deposits. Such a direct linkage between the hedging instrument and the

hedged item, which we refer to as a microhedge, requires an entity to

identify, designate, and hedge specific items that it has identified as

exposing the entity to interest rate risk. Others maintain that the hedge

contracts need not necessarily be related to identifiable assets or

obligations but instead should be considered “macrohedges” of the entity’s

net exposure. Both SFAS No. 52 and SFAS No. 80 require designation of the

hedge.

In developing SFAS No. 80, FASB concluded that, with respect to futures

contracts, hedge accounting should not be permitted for macrohedges

because without direct linkage there is no objective method of gauging the

effectiveness of the hedging instruments or ultimately recognizing the

hedge results in income. The 12 institutions we reviewed varied widely in

their use of micro- and macrohedges. While four institutions used solely

microhedges in their hedging programs, one used solely macrohedges, and

seven used a combination of micro- and macrohedges. Although

management at some of these institutions stated they were required to link

the derivatives to specific items in order to qualify for hedge accounting

treatment and did so for accounting purposes, the derivatives were not

being used to hedge the identified assets and liabilities but instead were

being used to hedge a net exposure on a macro basis.

Correlation SFAS No. 80 requires that at the inception of the hedge and throughout the

hedge period, high correlation between changes in the market values of

the futures instrument and the hedged item shall be probable so that the

results of price or interest rate changes on the hedging instrument will

substantially offset those of the hedged item. If high correlation has not

occurred, the entity must cease accounting for the contract as a hedge and

recognize a gain or loss for the amount that has not been offset. Similarly,

SFAS No. 52 requires the designated foreign currency transaction to be

effective as a hedge of a specific foreign currency commitment. However,

neither SFAS No. 52 nor SFAS No. 80 specifies how correlation or

effectiveness is to be determined or the level or degree of correlation

required. As a result, the 12 institutions we reviewed used a variety of

different measures and criteria for determining correlation. For example,

one institution simply tracked changes in the associated interest rate

indexes, which can be done without specific identification of assets and

liabilities, while others used various calculations depending on the type of

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Derivatives Activities of 12 Banks and

Thrifts

derivative product used. Some examined effectiveness monthly, others

quarterly, still others semiannually. Management at one institution stated

that since swaps are synthetic instruments, they do not have to meet any

correlation tests.

One objective of an ongoing test of correlation like that in SFAS No. 80 is to

avoid a buildup of deferred hedging losses (or gains) that are not

counterbalanced with unrealized gains (or losses). Another objective is to

determine which hedges should be afforded hedge accounting treatment.

However, without reliable and consistent standards for measuring

correlation, these objectives may not be met. The institution management

we interviewed were mixed in their desire for more definitive correlation

guidance in any future hedge accounting standards. Although some stated

they felt more specific correlation guidance was needed, they also said

they feared such guidance might be too restrictive and not allow the

flexibility needed to adjust to each institution’s own unique situation.

Management at another institution added that although correlation

guidance was needed, poor guidance would be worse than no guidance at

all. For example, management stated that a minimum correlation

requirement, such as 80-percent correlation, without good guidance on

how to calculate it would be worse than no such requirement at all.

Anticipated Transactions One of the significant inconsistencies between SFAS No. 52 and SFAS No. 80

is in the allowed use of hedge accounting for anticipated transactions. As

discussed in appendix VI, SFAS No. 52 only allows hedging against firm

commitments, which it defines as agreements that are usually legally

enforceable and for which performance is probable because of sufficiently

large disincentives for nonperformance. However, SFAS No. 80 allows the

use of hedge accounting, subject to certain criteria, for instruments

designated against anticipated transactions.6

 It defines anticipated

transactions as those an entity expects, but is not obligated, to carry out in

the normal course of business. For example, a bank may anticipate issuing

certificates of deposit to replace certificates that will mature at a future

date. SFAS No. 119—which specifies disclosure requirements—further adds

to the conflict by defining anticipated transactions to include both firm

commitments and forecasted transactions for which no firm commitment

exists.

6

Under SFAS No. 80, hedge accounting treatment is allowed for hedges of anticipated transactions

provided the instruments meet the hedge criteria, the significant characteristics and expected terms of

the anticipated transaction are identified, and the likelihood of the anticipated transaction occurring is

probable.

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In practice, the results of applying the criteria of SFAS No. 80 for hedges of

anticipated transactions have been mixed. Disputes have arisen about how

well the characteristics and terms of certain anticipated transactions have

been and possibly can be identified in advance. Others blamed the vague

criteria for leading to cases of inappropriate deferral of losses pending

transactions that never occurred or proved insufficiently profitable to

offset the deferred hedging loss.

At the 12 institutions we reviewed, management at half of the institutions

stated they did not hedge anticipated transactions, while three said they

did so on occasion, and three said they did so regularly. However, part of

the variance in their responses may be due to the difficulty of defining an

anticipated transaction. For example, management at one institution

viewed anticipated transactions very broadly and stated virtually all of its

hedging was anticipatory. Management stated that hedges of deposits are

anticipatory because of assumptions that the deposits will remain with the

institution. At the same time, they stated that hedges of loans are

anticipatory because of assumptions that new loans will be generated to

offset loan payoffs and prepayments. However, other institutions used

derivatives to hedge similar assets and liabilities and did not consider any

of them to be anticipatory.

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Appendix VIII 

Voluntary Disclosure of the 15 Major U.S.

Derivatives Dealers in 1994 Annual Reports

We reviewed the annual reports of the 15 major U.S. derivatives dealers for

fiscal year 1994 to compare their disclosure practices. As noted in the text,

these 15 firms included 7 banks, 5 securities firms, and 3 insurance

companies. We generally found that the banks’ disclosures were more

extensive than those of securities firms and insurance company dealers.

The results are summarized in table VIII.1.

We found that eight of the firms disclosed their internal estimates of their

value at risk in their derivatives trading activities. Value at risk is the

amount by which an institution’s derivatives trading portfolio could

decline due to general market movements over a given holding period,

measured with a specified confidence level. This group included all seven

of the banks, one of the three insurance companies, and none of the

securities firms. These eight firms also disclosed the holding periods and

confidence levels that defined their value-at-risk estimates, which may

help users of annual reports assess these figures. However, because these

parameters varied from firm to firm, they are not comparable among firms.

Of the eight firms that disclosed their value-at-risk estimates, six provided

information on their full trading activities, covering not only their

exposure to losses on derivatives trading but also losses on trading of

securities. It should be noted, however, that value at risk is not a measure

of the largest possible market risk loss the firm could face in its trading

activities. It is only a measure of the expected maximum loss at the

specified confidence level. Largest potential losses are better estimated

not by value at risk but by stress tests. None of the major dealers disclosed

the results of their stress tests for their trading activities.

Six of the firms (four of the banks, one securities firm, and one insurance

company) revealed their actual gains and losses on their trading activities,

either as absolute dollar amounts or in comparison to the firms’

value-at-risk estimates. We counted only those firms that disclosed daily or

weekly information, that is, information that is not mandatory and that is

measured on a basis comparable to value at risk. Mandatory reporting of

quarterly or annual trading revenues did not merit a “yes” entry in table

VIII.1.

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Voluntary Disclosure of the 15 Major U.S.

Derivatives Dealers in 1994 Annual Reports

Table VIII.1: Voluntary Annual Report Disclosure

Market risk in trading activity Credit exposure on derivatives

Institution Value at riska

Actual gains and

lossesb

Potential future

exposurec

Breakdown by credit

qualityd

BankAmerica Corp. yes no no yes

Bankers Trust New York

Corp.

yes yes no yes

The Chase Manhattan

Corp.

yes yes no no

Chemical Banking Corp. yes yes no no

Citicorp yes no yes yes

First Chicago Corp. yes no yes no

J.P. Morgan & Co., Inc. yes yes no yes

The Goldman Sachs

Group, L. P.

no no no no

Lehman Bros. no no no yes

Merrill Lynch & Co., Inc. no yes no yes

Morgan Stanley Group, Inc. no no no yes

Salomon, Inc. no no no yes

American International

Group, Inc.

no no no yes

General Re Corp. yes yes no no

The Prudential Insurance

Company of America

no no no yes

aWe entered a “yes” only if the firm provided quantitative information on its exposure to losses on

its trading risk. The information was either in absolute dollar amounts or stated as a dollar amount

that was not exceeded, or as a percentage of equity, allowing the reader to calculate a dollar

amount.

bWe entered a “yes” only if the firm provided very specific information; for example, monthly

averages of daily figures, weekly figures, or if it stated that losses did not exceed the quantified

value at risk.

cA “yes” was entered if the firm presented its own estimate of this item. U.S. bank call reports to

the regulators contain a measure of this, but it is merely the application of a regulatory formula,

not the bank’s own estimation.

dThe firms grouped this information according to equivalent credit ratings used by the major

rating agencies. However, the counterparties did not necessarily have these ratings from the

rating agencies themselves, because the ratings were the internal assessments of the reporting

dealers.

Source: 1994 annual reports.

Public companies in the United States are required to report their current

credit exposure on derivatives contracts. However, this credit exposure

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Voluntary Disclosure of the 15 Major U.S.

Derivatives Dealers in 1994 Annual Reports

could increase in the future if market rates or prices moved in a way that

increased expected payments from the derivatives counterparties to the

firms. Of the 15 major dealers, only 2 (both of them banks) disclosed their

estimates of the potential future credit exposure on their derivatives

contracts.

Credit exposure on derivatives, just as on traditional loans, poses a risk of

loss that varies depending on the soundness of the counterparty. Ten of

the major derivatives dealers provided at least some information on the

creditworthiness of their derivatives counterparties. This group included

four of the banks, four of the five securities firms, and two of the three

insurance companies. In some cases this was simply a statement of the

portion of the counterparties that were equivalent to “investment grade,”

and others provided a more detailed breakdown. No firm disclosed its

exposure to individual counterparties.

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Appendix IX 

Description of FASB’s Proposed Standard

In June 1996, FASB issued an exposure draft of a proposed standard,

Accounting for Derivative and Similar Financial Instruments and for

Hedging Activities. The proposed standard applies to traditional

derivatives, such as futures, forwards, options, and swaps, as well as

certain financial instruments that do not meet the definition of a derivative

but have characteristics similar to those of derivatives, such as leveraged

instruments.1

 Throughout the proposed standard, both derivative financial

instruments and similar instruments included in the statement are referred

to collectively as derivatives, and the proposed standard’s requirements

would apply to both.

Under the proposed standard, which would be effective for fiscal years

beginning after December 15, 1997, all derivatives would be recognized as

either assets or liabilities in the balance sheet and measured at fair value.

The accounting for gains and losses resulting from changes in the fair

value of a derivative would depend on the intended use of the derivative

and resulting designation. All derivatives would fall into one of the

following four categories for purposes of determining the accounting

method for the gains and losses:

(1) Fair value hedge: For a derivative designated as a hedge of the

institution’s exposure to changes in the fair value of an asset, liability, or

firm commitment,2

 the gain or loss would be recognized in earnings in the

period of change together with the offsetting loss or gain on the hedged

item. Gains or losses on the hedged item would be recognized in the

period of change only to the extent of offsetting losses or gains on the

derivative.

(2) Cash flow hedge: For a derivative designated as a hedge of the

exposure to variable cash flows of a forecasted transaction,3

 the gain or

loss would be reported as a component of “other comprehensive income”

(component of equity) until the projected date of the forecasted

1

As part of its proposed standard, FASB developed a working definition of a derivative financial

instrument, including the characteristics of such instruments. Of note, FASB has also included

nonfinancial commodity-based instruments in the definition, which FASB had not considered as

financial instruments in the past.

2

A firm commitment is a contract that obligates two unrelated parties to make an exchange and

specifies the price and quantity to be exchanged.

3

A forecasted transaction is one that the entity anticipates but is not obligated to carry out, such as

future sales or the anticipated acquisition of inventory.

Page 159 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix IX 

Description of FASB’s Proposed Standard

transaction.4 On that date, the entity would recognize in earnings the

accumulated “other comprehensive income” for that derivative.

(3) Foreign net investment hedge: For a derivative designated as a hedge

of the foreign currency exposure of a net investment in a foreign

operation,5

 the portion of the change in fair value equivalent to a foreign

currency transaction gain or loss would be reported in “other

comprehensive income,” together with the offsetting cumulative

translation adjustment resulting from the exposure per SFAS 52. Any

remaining change in fair value would be recognized in earnings.

(4) Nonhedge: For a derivative not designated as a hedge, the gain or loss

would be recognized in earnings in the period of change.

The proposed standard lays out the specific hedge criteria that must be

met in order for a derivative instrument to qualify for designation as a fair

value or cash flow hedge. The common hedge criteria for these two types

of hedges require that at inception of the hedge, there must be formal

documentation of the hedging instrument, the hedged item, and the risk

being hedged; the use of the derivative must be consistent with the entity’s

established policy for risk management; and the hedging instrument may

not be a net written option.6

 Furthermore, the combination of a net written

option and any other nonoption derivative cannot be designated as a

hedging instrument. To qualify as a fair value hedge, the following

additional criteria must also be met:

• The hedged asset, liability, or firm commitment is specifically identified as

a single asset or liability, or a portfolio of similar items sharing common

characteristics, or a specific proportion thereof.

• The hedged item has a reliably measurable fair value, and substantial

changes in the fair value of the derivative are expected, both at inception

and on an ongoing basis, to offset substantially the changes in the fair

value of the hedged item that are attributable to the risk being hedged.

4

FASB also issued an exposure draft of another proposed standard, Reporting Comprehensive Income,

in June 1996. The specific reporting requirements for derivatives hedging gains and losses in

comprehensive income would be determined by this proposed standard.

5

For foreign net investment hedges, an entity may designate a foreign currency-denominated

nonderivative financial instrument (in addition to those nonderivative leveraged instruments included

in the scope of this proposed standard) as a hedge of the foreign currency exposure of a net

investment in a foreign operation.

6

The proposed standard states that a combination of options entered into contemporaneously (for

example, a collar), whether freestanding or embedded in a derivative, shall be considered a net written

option if either at inception or over the life of the contract a net premium is received in cash or as a

favorable rate or term.

Page 160 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix IX 

Description of FASB’s Proposed Standard

• The hedged item individually presents an exposure to price changes that

could affect reported earnings and can be allocated any general reserves,

deferred fees or costs, or purchase premiums or discounts established for

a group of items of which the hedged item is a part.

• The hedged item is not (1) a debt security that is classified as

held-to-maturity in accordance with SFAS No. 115, Accounting for Certain

Investments in Debt and Equity Securities; (2) oil or gas in the ground,

unmined mineral ore, an agricultural product in the process of growing, or

similar item; (3) an intangible asset; (4) an investment accounted for by

the equity method; (5) mortgage servicing rights that have not been

recognized as assets in accordance with SFAS No. 122, Accounting for

Mortgage Servicing Rights; (6) a lease, as defined in SFAS No. 13,

Accounting for Leases; or (7) a liability for insurance contracts written.

• At inception, any variable cash flows related to the hedged item are not

being hedged as a cash flow hedge.

To qualify as a cash flow hedge, the common criteria and the following

additional criteria must be met:

• The forecasted exposure is a transaction (an external event involving the

transfer of value between two or more entities), probable, part of an

established business activity, and presents an exposure to price changes

that could affect reported earnings.

• Both at inception and on an ongoing basis, the derivative financial

instrument is expected to have cumulative net cash flows that will offset

substantially the changes in cash flows of the hedged forecasted

transaction attributable to the risk being hedged. In addition, the

contractual maturity or repricing date of the derivative is on or about the

same date as the projected date of the forecasted transaction.

• The forecasted transaction is not the acquisition of an asset or incurrence

of a liability that will be measured at fair value subsequent to acquisition

or incurrence with changes in fair value reported in earnings.

• At inception, the variable cash flows being hedged do not relate to an item

being hedged as a fair value hedge.

The proposed standard also includes specific disclosure requirements for

derivatives and similar financial instruments. For all derivatives, each

entity is required to distinguish between derivatives designated as fair

value hedges, cash flow hedges, hedges of the foreign currency exposure

of a net investment in a foreign operation, and all other derivatives. It must

disclose

Page 161 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix IX 

Description of FASB’s Proposed Standard

• its objectives for holding or issuing the instruments,

• the context needed to understand those objectives,

• its strategies for achieving those objectives, and

• the face or contract amount of the derivatives when necessary to

understand the objectives.

For derivatives designated as hedges, the entity must provide

(1) a description of its risk-management policy for such hedges, including

a description of the items whose risks are being hedged and the classes of

derivatives used to hedge those risks;

(2) the amount of gains or losses on the derivatives and the items being

hedged that were recognized in earnings during the reporting period, and a

description of where those gains and losses and the related hedged items

(if applicable) are reported in the financial statements; and

(3) the cumulative amount of unamortized derivatives gains or losses that

have not yet been recognized in earnings and a description of where they

are reported in the financial statements.

In addition, for fair value hedges the entity must also disclose the amount

of gains and losses recognized in earnings when performance under a

hedged firm commitment is no longer probable. For cash flow hedges, the

entity must also disclose the designated reporting periods in which the

forecasted transactions are expected to occur and the deferred amounts to

be recognized in earnings.

For derivatives not designated as hedges, the entity must disclose (1) a

description of the purpose of the activity; and (2) the amount of gains and

losses on the derivatives arising from the activity during the reporting

period disaggregated by class, business activity, risk, or other category

consistent with the management of that activity, and a description of

where those gains and losses are reported in the financial statements. If

the disaggregation is other than by class, the entity shall also describe for

each category the classes of derivatives from which the gains and losses

arose.

The proposed standard amends SFAS Nos. 52 and 107; supersedes SFAS Nos.

80, 105, and 119; and modifies or nullifies related EITF consensus positions

as follows:

Page 162 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix IX 

Description of FASB’s Proposed Standard

• SFAS No. 52, Foreign Currency Translation, is amended primarily to

eliminate duplicate coverage of foreign currency derivatives between the

two Statements, eliminate the allowability of deferral hedge accounting,

and update the definition of derivatives consistent with the definition

provided for in the proposed standard.

• SFAS No. 107, Disclosures About Fair Value of Financial Instruments, is

amended primarily to include commodity-based contracts in the definition

of derivatives, update the definition of fair value, and incorporate portions

of SFAS Nos. 105 and 119—which are superseded—into the proposed

standard. Specifically, requirements for disclosure about concentrations of

credit risk are incorporated from SFAS No. 105, and encouraged disclosure

about market risk of all financial instruments is incorporated from SFAS

No. 119 into the proposed standard.

Page 163 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix X 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Thomas J. McCool, Associate Director

Michael A. Burnett, Project Director

Gerald C. Schober, Project Manager

Orice M. Williams, Deputy Project Manager

Cody J. Goebel, Senior Evaluator

James R. Black, Senior Evaluator

Leslie F. Siddeley, Evaluator

Kiki Theodoropoulos, Evaluator (Communications Analyst)

Cecile O. Trop, Assistant Director, Advisor

John H. Treanor, Banking Management Expert

Accounting and

Information

Management Division,

Washington, D.C.

Donald H. Chapin, Chief Accountant

Robert W. Gramling, Director

Linda M. Calbom, Director

Marcia B. Buchanan, Assistant Director

Clayton T. Clark, Project Manager

Boston Regional

Office

Nancy S. Barry, Evaluator

Nicolas F. Deminico, Evaluator

Lester P. Slater, Jr., Site Senior

Thomas S. Taydus, Evaluator

Alfred R. Vieira, Regional Assignment Manager

Chicago Regional

Office

Lenny R. Moore, Evaluator

John A. Wanska, Evaluator

Susan R. Bradshaw, Evaluator

Melvin Thomas, Evaluator

New York Regional

Office

Richard G. Schlitt, Senior Evaluator

Raymond L. Gast, Evaluator

San Francisco

Regional Office

Doreen S. Eng, Evaluator-in-Charge

Jack W. Erlan, Regional Management Representative

Yola Lewis, Evaluator

Page 164 GAO/GGD/AIMD-97-8 Financial Derivatives
Appendix X 

Major Contributors to This Report

Office of General

Counsel, Washington,

D.C.

Lorna MacLeod, Attorney

Office of Special

Investigations,

Washington, D.C.

Donald G. Fulwider, Assistant Director

(233468) Page 165 GAO/GGD/AIMD-97-8 Financial Derivatives
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