Derivatives – Bank Activities and Supervisory Responses | Bulletin – May 1995 (2024)

Introduction

In March of this year, Barings Bank Plc collapsed as a result of losses incurredby its subsidiary, Barings Futures (Singapore), on equity derivatives positionstaken on the Singapore and Osaka futures exchanges. This episode follows severalwell publicised losses associated with derivatives which involved other financialinstitutions and some corporate and government bodies abroad. These losseshave refocussed attention on the risks involved in derivatives activities andon the responses of supervisory agencies.

This article offers some comments on derivatives from the perspective of the ReserveBank, in its capacity as supervisor of the Australian banking system. First,it looks briefly at the functions of derivatives and the risks associated withthem. Second, it summarises developments in the Bank's supervision of derivativesactivities, referring to international initiatives where relevant. Finally,it mentions some issues relating to the financial system as a whole.

Derivatives – Roles and Risks

In simple terms, derivatives are financial contracts the values of which depend onthe value of some other instrument or asset. They fall into a number of broadcategories – such as forward rate agreements, futures, swaps and options– but are all constructed from one of two basic building blocks:

• the forward contract, which is an agreement to buy or sell a commodity or financialinstrument at a particular price at some time in the future; and
• the option contract, which gives the purchaser the right, but not the obligation,to buy or sell an asset at some time in the future.

Simple derivatives have been a feature of the financial landscape for many years(centuries in fact), but their growth and development have been rapid overthe past decade. This has reflected two main factors:

• increased volatility of prices in cash and other markets which has created a demandby financial institutions, private companies and public sector bodies forinstruments which help in the management of their exposures to price movements;and
• on-going innovation in financial markets (supported by developments in computer technology)which has led to an increase in the range and complexity of financial instrumentsand in the capacity of markets to handle large trading volumes.

Derivatives, of themselves, do not add to the risks associated with fluctuating marketprices. Rather, they permit those risks to be transformed and transferred inways that were not readily available, or not available at all, previously.Transactions in derivative products can be characterised as ‘zero-sumgames’ where those seeking to reduce their risk exposure (to, for instance,a rise in the exchange rate) pay another party to accept that risk. The secondparty may have a different perception of the risk or greater tolerance of it.The presence of both parties, ‘sellers’ and ‘acceptors’of risk, is necessary for an effective and efficient hedging market. Derivativesclearly contribute to the efficiency of the financial system to the extentthat they allow the shifting of risks to those more able and willing to bearthem.

As the largest group of financial institutions, banks have always played a prominentrole in the derivatives market. They use derivatives extensively to managethe risks in their trading activities, as well as in their more traditionalborrowing and lending activities. The funding of medium-term fixed rate loanswith short-term deposits, for example, exposes banks to movements in the differentialbetween long-term and short-term interest rates. Similarly, differences inthe currency composition of banks' assets and liabilities expose them tothe possibility of significant losses in the event of foreign exchange fluctuations.Banks can use derivatives to offset, or at least limit, such risks and protecttheir incomes from the effects of volatility in financial markets.

Banks also use derivative products to provide risk management services to their customers.Sometimes, where the bank chooses to be the risk ‘acceptor’, thiswill leave it with a risk exposure; in other cases, the bank will match thisrisk by an offsetting derivatives position with another customer. On occasionsbanks might also choose to ‘accept risk’ in their own right whenthey feel that a market price is likely to move one way or another. Such activitiesare a natural extension of the traditional business of banks, which includesthe provision of specialist financial services and the acceptance of risk ata price.

Such activities in derivatives markets need not be viewed as fundamentally differentfrom banks' other activities. Ultimately, the important issue for banks– and for their supervisors – is how well they identify and measurethe risks arising in the totality of their activities, and how prudently thoserisks are priced and managed.

Derivatives do, however, warrant particular attention. The main reason is that manyof them – especially the more exotic varieties – are complex andcan be difficult to value and to hedge. It can be difficult also to measurethe extent to which the risks in some products are correlated with the risksin others. Because of such complexities, the operational risks (ensuring control over payments flows, preventingfraud, maintaining the integrity of accounting systems) in a sophisticatedtrading operation can be substantial. This raises the possibility that bankscould find themselves with unanticipated types and amounts of risk. Anotherproblem is that, because of their newness, there are unresolved issues in thelegal and accounting treatment of derivatives which might expose banks to risk.

It is, in part, because of these characteristics of derivatives that so much supervisoryattention is being given to the adequacy of banks' risk management systems(see next section).

Through its prudential supervision of banks, the Reserve Bank oversees a high proportionof activity in derivatives, although that activity does extend significantlybeyond the banking system. Problems with derivatives could arise elsewherein the financial system and could spread to other sectors, including banks.While this can be true of financial activities generally, some features ofderivatives – such as the complex linkages they can create between marketsand the possibility of liquidity drying up if a major participant got intodifficulty – are thought to pose particular risks to financial systemstability.^[2]This potential puts a premium on effective co-ordination among the variousregulatory agencies and self-regulatory bodies with an interest in derivatives(including in other countries), and on mechanisms which would help reduce thespread of a problem in one area to others. These points are taken up in thefinal section.

Bank Supervision and Derivatives

Capital Requirements

A fundamental element of bank supervision is the requirement that banks have shareholders'funds and other capital commensurate with the risks in their business. Since1988 Australian banks have had to hold a minimum amount of capital againstthe risks of counterparty failure in derivatives trading, as part of the internationalCapital Accord on credit risk. Over recent years, the Basle Committeeon Banking Supervision has been working to expand these capital adequacy arrangementsto cover also the risks arising from price movements as they applyto banks' trading activities in debt instruments, equities, commoditiesand their foreign exchange exposures. This would include all related derivativesexposures.

Draft proposals for a capital charge related to market risk were released by theBasle Committee for public comment in April 1993. They were subjected to extensiveanalysis and testing internationally, including in Australia. The Reserve Bankalso sought comments from Australian banks. A detailed submission, settingout the Bank's views on the proposals was provided to the Basle Committeein January1994;^[3]we endorsed strongly the general thrust of the proposals, but made a numberof recommendations regarding their detail.

The Basle Committee further developed and refined its proposals, taking into accountcomments from supervisors and banks, and issued a revised set of guidelinesin April 1995. Unlike the earlier version, the latest version includes an optionwhich, subject to some quite stringent qualifications, will permit banks withsophisticated management systems for market risk to use those systems (ratherthan the standard model) to determine a capital charge for supervisory purposes.After a brief period for final comments, these proposals are expected to befinalised at the end of 1995, with a ‘settling in’ period of upto two years for banks to comply fully.

The Bank has distributed the new proposals to Australian banks and will be holdingdiscussions with them on questions of detail, and on the approach to be followedin implementing these domestically.

On-Site Visits

Recognising the importance of sound management systems, in 1994 the Bank commenceda program of on-site visits to banks which have focused on how they identify,measure and manage market risks, including derivatives.

The program involves a team from Bank Supervision Department visiting banks on aregular basis and holding detailed discussions with senior management in tradingand treasury operations, and in other areas which have responsibility for themanagement of market risk in the balance sheet as a whole. The operation ofthe various trading desks (money market, fixed interest, foreign exchange)is typically one focus of attention, as are the various operational and backoffice areas of the banks' trading operations. Given the differences insize, structure and business activities of the banks operating in the Australianmarket, the scope of visits is tailored to the bank under review. The visitprogram has three main objectives:

• for supervisors to learn more about banks' risk management methodologies andtheir practices in relation to market risks;
• to help the Bank to determine the approach it will adopt on the proposed capitalstandards on market risks; and
• to ensure, as far as possible, that banks have in place systems and controls to addressthe market-related risks that they face in their derivatives and other activities.Where this is not the case, we will be seeking corrective action.

The program is still building up but, by the end of 1995, it is expected that around20 banks – including all the major participants in derivatives –will have been covered, with the remainder scheduled for 1996.

Some additional reassurance in this area comes from the examination of banks'trading areas by internal and external auditors. Under established arrangements,external auditors of banks are required, for example, to give an opinion tothe Reserve Bank on the adequacy of their internal management systems and controls;in particular, they advise on whether the banks' management systems tocontrol and limit credit, liquidity and foreign exchange risks are effectiveand are being observed. Consideration is currently being given to commissioningmore detailed reports from auditors on particular aspects of banks' systems.

Improvement of Operational Risk Controls

Despite the technical complexity of derivatives, the failure of basic operationalcontrols seems to have been the main cause of many losses in derivatives dealing,including by Barings. In the normal course of our supervisory work, the Bankreceives descriptions of the risk management systems in place at each bank.These, and the results of the survey conducted in April last year (see below),form the starting point for our discussions on operational risk issues duringan on-site visit. These discussions also draw on the guidelines for ‘bestpractice’ procedures in managing derivatives risk issued in July 1994by the Bank for International Settlements. While these guidelines are not applicablein their entirety to all banks – because of the different scope of theiroperations – they constitute a framework with which all banks shouldbroadly conform.

The proposed capital standards for market risk will provide an additional incentivefor banks to strengthen their operational risk controls. Only those banks ableto demonstrate that their market risk measurement procedures are of an adequatestandard will qualify to use their own models as a basis for calculating relevantcapital requirements; such banks will avoid the costs of parallel systems toreport their risk exposures.

Improved Information on Banks' Derivative Activities

Because derivatives markets have developed so rapidly and are not well covered bytraditional statistics, discussion internationally has emphasised the needfor improved data, both qualitative and quantitative, on such matters as theproducts used and offered by banks, the maturity profile of derivative instruments,types of counterparties engaged by banks in these activities, the extent ofproduct innovation taking place within the market, and the concentration ofderivatives risks in the banking system.

The Bank has collected some data from banks on their off-balance sheet activities(of which derivatives now form the bulk) since 1986. The Bank also conducteda survey of banks' derivative activities as at the end ofMarch 1994; the results were analysed and distributed to banks, anda summary of the main findings was published in the September 1994 issue ofthe Bulletin.

As well as adding to our knowledge about the size and structure of the derivativesmarket, that survey established that, broadly speaking, banks had reasonablecontrols in place to manage their derivative activities. There was, however,some unevenness in practice and one of the objectives of the program of visitsto banks is to follow up on such points.

The Bank co-operated with the Bank for International Settlements in the preparationof an international survey of derivative markets which was conducted in April1995. This sought detailed information on products used, the counterparty breakdownand maturity structure of banks' derivatives trading; it also covered non-bankfinancial institutions as well as banks. The results of this survey are expectedto be available later this year.

Improving Disclosure in Published Financial Accounts

In addition to the need of regulatory authorities for improved data on derivativesactivities, investors and others in the markets would be assisted by betterinformation when assessing the soundness of banks and other institutions. Undercurrent accounting conventions, derivatives do not appear on the balance sheetbut their presence ‘off-balance sheet’ can alter significantlythe overall risk profile of an institution. In the absence of improved accountingstandards, the current and potential exposures faced by an institution canbe difficult for investors to assess, especially for those relying solely onpublished financial statements. While levels of public disclosure by bankshave generally improved in recent times, there is still some way to go.

In October 1994, the Bank for International Settlements (BIS) issued apaper^[4]on disclosure with a series of proposals which was intended as a catalyst forfurther discussion. These proposals envisage information being provided byfinancial institutions on current exposures to derivatives, the potential forfurther exposure to risk should market prices fluctuate significantly, theextent to which revenues of an institution have been derived from derivativesactivities, and the volatility of derivatives-based revenues.

The Bank is keen to promote discussion on improved disclosure of derivatives in publishedfinancial accounts and, to that end, it has circulated the BIS discussion paperto banks. Several banks have provided feedback and others are likely to doso in the near future: these submissions will be analysed and discussed withthe industry, which is itself moving in the same direction. In time, the Bankcould use the BIS recommendations, together with the outcome of its discussionswith banks and accountants, to encourage more openness by Australian banksin their public disclosures about derivatives.

Financial System Issues

Efforts to ensure that the substantial potential benefits from derivatives are maintained,while the risks are contained, are not confined to the Reserve Bank's supervisionof the banking system. The use of derivatives is widespread in the financialsystem and a number of regulatory agencies and self-regulatory bodies are involved.These include the Australian Securities Commission, which has responsibilityfor promoting efficient and fair markets in financial products including derivatives,and the Insurance and Superannuation Commission, which supervises the use ofderivatives in its area of responsibility. Self-regulatory bodies include thefutures and stock exchanges which monitor the activities of brokers and seekto promote efficient and fair trading.

Many financial institutions use derivatives and the potential always exists for aparticular difficulty to be spread through exposures to other market participants.It is essential, therefore, that the responsible regulatory bodies co-ordinatetheir supervisory activities, both to try to head off problems, and to co-operateeffectively in the event of a problem occurring. The Council of Financial Supervisors,which was established in 1992 and plays a co-ordinating role generally in thefinancial system, is currently reviewing the adequacy of existing proceduresand lines of communication for dealing with a Barings-type situation in Australia.In the Bank's view, the Council is well placed to perform this role: itbrings together the main supervisors involved and its basic rationale is toachieve high-level co-ordination so that the whole financial system is supervisedefficiently and fairly.

The Council is also expected to participate in the review of law on derivatives beingconducted by theCompanies and Securities Advisory Committee (CASAC) for the Attorney-General.This Committee is charged with the task of recommending appropriate protectionfor participants in Australian derivatives markets while at the same time encouragingthe benefits of a free, innovative and competitive market. A particular issueis the appropriate degree of supervision and investor protection which shouldapply to derivatives trading where parties with different degrees of sophisticationare involved. In the interests of efficiency, scope also appears to exist torationalise the present array of distinctions made in the law between derivativesproducts and markets.

A sub-committee of CASAC has been established to investigate the legal support forcertain forms of bilateral netting of credit exposures. An important element in reducing therisks of counterparty failure in derivatives transactions is the existenceof appropriate documentation for derivatives contracts, as well as effectivebilateral netting arrangements. Netting allows offsetting transactions betweentwo counterparties to be set off, one against the other, so that the net obligationbetween the two can be expressed as a single figure. The significance is thatin the event of a default or failure by one of the parties, that net amount,not the gross obligations, becomes the amount due and payable. If netting arrangementscan be made effective under bankruptcy, then it could lead to significant reductionsin the risk arising from a given volume of derivative transactions. The Bankis participating in the CASAC sub-committee which is to examine the viabilityof netting in the Australian market and recommend specific legislative changeswhich are required to give iteffect.^[5]

The Bank is also promoting reforms to minimise the likelihood of financial disruptions,whether arising in derivatives markets or elsewhere, being communicated morebroadly through the payments system. It is, in particular, exploring a proposalfor interbank settlements to be conducted on a real time gross basis so thatunsettled exposures do not accumulate as under the present system.

Conclusions

Derivatives do not, of themselves, create any additional risks. Rather, properlyhandled they provide a means for managing risks which already exist and whichhave tended to increase as markets have become more volatile. Some recent experiencesdemonstrate, however, that they do need to be properly understood and carefullymanaged by all the parties involved.

Perhaps the main threat to systemic stability from derivatives is the threat to liquidityin the event of a serious problem occurring in one part of the system. Thisthreat can be addressed by ensuring that all participants adopt sound riskmanagement practices, and by modernising the infrastructure of financial markets(including the legal framework, and the payments and settlements arrangements).

The initiatives being undertaken by the Bank, and by bank supervisors in other countries,to address concerns about derivatives, has led to some significant changesin the structure of supervisory arrangements and practice. Internationally,the expansion of the capital adequacy framework will represent a major stepforward. The Reserve Bank's program of visits to banks is a further significantdevelopment in supervisory practice.

Improved supervisory arrangements can play a role in reducing the probability ofproblems arising, and in limiting the severity of any problems that do emerge.Notwithstanding such improvements, however, no amount of supervisory or regulatoryoversight can be expected to provide total protection against the possibilityof problems arising within banks or other financial institutions as a resultof derivative or any other activities.

The central tenet of the Bank's supervisory philosophy is that the prime responsibilityfor effective management of banks, and for the introduction of systems whicheffectively control or limit risk, rests with the bank itself, its managementand its board. In the light of Barings and other recent episodes involvingderivatives, it is not surprising that the boards and managements of bankshave been reviewing their current practices and, where necessary, taking stepsto upgrade those practices. It is the Bank's role to see that this processis on-going.