Large, Complex Financial Institutions: Investors Need Better OTC Derivative Disclosure

Categories: Derivatives, European Regulatory Reform, FASB, Financial Reporting, IASB, IFRS, US Regulatory Reform
Financial report

The lessons learnt from the financial crisis regarding counterparty risk of over-the-counter (OTC) derivatives contracts have helped inform a raft of regulatory proposals — from the EU European Market Infrastructure Regulation (EMIR) directive to the U.S. Dodd-Frank Act — requiring greater use of central counterparty clearing houses (CCPs). The question is this: Have these efforts enhanced risk transparency and risk management at the systemic level and within individual financial institutions?

CCPs are characterized by contracts that are more standardized and liquid than OTC contracts as well as by higher collateralization requirements. The problem of under-collateralized OTC trades was highlighted in an International Monetary Fund (IMF) working paper, which estimates the existence of $2 trillion of under-collateralized risk exposures across the financial system. For example, five large and complex financial institutions (LCFIs) in the U.S. (Goldman Sachs, Citigroup, JPMorgan, Bank of America, and Morgan Stanley) had net derivatives payable, with assigned collateral taken into account, of $500 billion as of the third quarter of 2009. Likewise, five of the largest European banks (Barclays, Royal Bank of Scotland, UBS, Deutsche, and Credit Suisse) had under-collateralized exposures (measured by residual derivatives payable) worth $600-700 billion as of December 2008. The under-collateralization was predicated on the questionable presumption of LCFIs being safe.

In tandem to EMIR and Dodd-Frank requirements, Basel III has strengthened the capital requirements for financial institutions related to counterparty credit risk (CCR) by imposing a surcharge on counterparty valuation adjustments (CVA). CVA is made for derivatives assets, and it is somewhat analogous to loan- loss provisions made for loans that are held as financial assets. Capital provisions are just one way of managing risks arising from OTC positions. That said, there have been several speed bumps in the quest for consistent adoption of Basel III, including varying adoption dates among countries and exemption of the EU from some of the capital requirements (the EU’s Capital Requirement Directive (CRD) IV proposes capital exemptions for pension funds, nonfinancial corporates, and sovereign exposures). And as highlighted in the July 2013 Risk Magazine, another wrinkle could arise due to differences in the presentation of net derivatives assets across jurisdictions (i.e., whether collateral is netted or not) if capital is determined based on the reported amounts. Under U.S. Generally Accepted Accounting Principles (GAAP), banks are able to report derivatives assets net of cash collateral received, but this is not allowed under International Financial Reporting Standards (IFRS).

Individual financial institutions tend to be quite opaque regarding the risk exposures associated with OTC contracts. The inadequacy of OTC-related disclosures at the firm level is highlighted in an excellent paper from Viral Acharya of the New York University Stern School of Business. Acharya’s paper shows that limited transparency at the firm level has an impact on the pricing of derivatives because instrument holders are unable to factor into their pricing models the effective risk exposure that related counterparties bear. This means that pricing inefficiencies arise when counterparties have limited knowledge about each other’s risk profile due to poor disclosures. A more accurate risk-adjusted pricing of derivatives instruments would enable the desired right-sizing and effective allocation of OTC and CCP derivatives positions.

Improving Disclosure for Derivatives Counterparty Credit Risk

CCR of derivatives arises whenever the derivatives position held by a company is ‘in the money’ and there is the risk of nonpayment from the associated counterparty; this risk usually pertains to OTC derivatives. There are opportunities to improve disclosure around CCR, as highlighted in a CFA Institute report on disclosures of derivatives and hedging activities under IFRS and an issue brief on the reporting of CCR. A 2009 European Central Bank report also highlighted the difficulties of discerning, based on financial reporting disclosures, whether banks are net sellers or net buyers of credit risk protection through credit derivatives, and whether there is concentration risk with associated counterparties. Acharya’s paper underscores the difficulties in getting information to properly judge the adequacy of collateral held. The paper proposes the disclosure of exposure profiles, concentration, uncollateralized net exposures, and information to assess adequacy of collateral or the margin coverage ratio (i.e., cash and liquid asset holdings as a proportion of contingent collateral or margin calls).

It is worth noting that both IFRS and U.S. GAAP requirements cover derivatives disclosures, including some that could address the desired disclosures for CCR. In addition, both the International Accounting Standards Board (IASB) and U.S. Financial Accounting Standards Board (FASB) recently augmented the financial instruments offsetting disclosures regarding the nature of counterparties and details of offsetting exposures and credit risk mitigants. That said, there is often inconsistent, incomparable, and incomplete compliance with the accounting requirements, and it remains to be seen whether there will be significant enhancement in the transparency related to CCR across so-called LCFIs.

Opportunity to Improve the Disclosure of Novated Derivatives

Another angle to derivatives transparency relates to how gains or losses are reported. Under IFRS and U.S. GAAP, derivatives used as hedges can be designated for hedge accounting treatment. This minimizes accounting volatility through the income statement to the extent that the hedge is effective. However, existing accounting guidance under IFRS was not so clear on whether “novated” derivatives (in which one party of the derivative contract has been replaced with a new one, such as a CCP — ones that also are considered hedges — would automatically be de-designated. De-designation occurs when hedging relationships cease to exist (e.g., hedging instruments are settled, terminated, or sold). The following questions arose in response to the underlying need to migrate to CCP:

  • Would increased volatility arise from novated derivatives that are currently recognized as accounting hedges? Increased volatility would still arise if active hedging relationships involving novated derivatives were de-designated and then subsequently considered to be still eligible for hedge accounting (i.e., re-designated).
  • Would IFRS reporting companies be disadvantaged relative to those that use U.S. GAAP?

To address these concerns, the IASB recently issued updates to its standards that allow the continuation of hedge accounting for novated derivatives, in so far as novation arises as a result of legal requirements, involves a CCP, and the usual effectiveness requirements are satisfied. However, the IASB ruled against enhancing the disclosures of novated contracts. Hence, there remains a window of opportunity for LCFIs to improve disclosures by clearly earmarking novated derivatives contracts as well as portraying the ‘before and after’ picture of CCR associated with these contracts.

The push for novation to CCPs, alongside the strengthened capital standards, is envisioned to increase the overall transparency of derivatives contracts, to bestow greater capacity to unwind these contracts if required, and therefore to reduce overall systemic risk. However, it is necessary to enhance transparency of CCR exposures and corresponding risk management at the individual firm level. The risk management reporting should cover the adequacy of collateralization (as well as how the hedging of these exposures occurs. In addition, disclosures should clearly portray how CCR exposure has changed for novated derivatives. The combination of these disclosures will contribute to greater market efficiency in pricing of derivatives instruments. They will also lead to greater understanding by investors and counterparties of the real risk profile of individual LCFIs.


Photo credit: @iStockphoto.com/spectrelabs

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