Risk Disclosure by Financial Institutions ^*1

*1The full text is on the February 1997 issue of the Quarterly Bulletin.

February 1997
Bank of Japan
Financial and Payment System Department

INTRODUCTION

Public disclosure by financial institutions has long provided information about business performance through the publication of financial statements. In recent years, however, a number of financial institutions have come to focus on disclosure of a wider range of information, including their management policies. This is partly attributable to the expansion of derivatives transactions, which has made risk management techniques increasingly important in the management of financial institutions, and which has thereby encouraged financial institutions to improve such techniques. Accordingly, individual financial institutions have been motivated to reveal voluntarily their risk exposures and risk management methods in order to win a favorable assessment from market participants. Disclosure thus brings into play a check mechanism inherent in financial markets (hereafter referred to as the market check mechanism) that disciplines management of financial institutions, and thereby helps to enhance the efficiency and transparency of the markets and to stabilize the financial system.

This report examines the disclosure of information on risks of financial institutions, with an overview of the current practices and future issues. It is intended to serve market participants, the beneficiaries of the information disclosed.

I. Functions of Public Disclosure

Public disclosure has developed as a system which legally requires institutions to disclose information that will enable investors to assess risks and returns. As a result of its development, disclosure performs an effective function, as part of the institutions' strategies, of providing information on management policies and risks to the parties concerned. This aspect of disclosure is also of great significance to the entire financial system.

Disclosure has the following three major functions with regard to the management of financial institutions and the financial system:

(1) Provision of information to facilitate the selection of counterparties
Disclosure provides information that enables market participants to evaluate not merely the amount of risks borne by counterparties but also how well the institution is managing the risks. Thus, market participants can more easily select counterparties based on their own evaluation.
(2) Enhancement of accurate pricing in financial markets
The information, disclosed to facilitate the selection of counterparties, enhances the accurate pricing of various financial instruments, including derivatives, and thereby improves the efficiency of financial markets.
(3) Strengthening of management discipline
The management of a financial institution will review its policies, improve its risk management techniques, and/or implement more rigorous risk management policies in order to gain a favorable assessment from market participants. Such strengthening of management discipline helps to maintain the soundness of financial markets.

These three functions are founded on the market check mechanism inherent in financial markets. Information about a financial institution's risk exposures and risk management skills conveys significant messages about business performance, and thus will be reflected in the stock price and funding costs of the institution. If the market judges that a financial institution has a high risk management ability and is performing well, the market check mechanism would work to raise the institution's stock price and to reduce its funding costs. Conversely, if an institution is judged to be taking risk exceeding its capacity and conducting inadequate risk management, the market check mechanism may function so as to lower the institution's stock price and raise its funding costs. Such a market check mechanism can motivate financial institutions to pursue disclosure that will win a favorable assessment from market participants. If an institution is not evaluated favorably, it will naturally be spurred to improve the particular line of business which gained a relatively low market evaluation, or to withdraw from the market if necessary. Hence, this process can promote a market participant's entry into or withdrawal from the financial markets, and may thus push up the overall quality of participants, thus enhancing the stability of the financial system.

II. Background of Risk Disclosure

Derivatives transactions in international financial markets have expanded rapidly in recent years, and this has achieved the favorable effects of creating new financial services, promoting financial innovations, and improving the efficiency of financial markets. On the other hand, however, it has been suggested that derivatives might also increase systemic risk. Faced with this possibility, market participants and financial authorities have strongly recognized the effectiveness of disclosure as a means to avert and contain systemic risk and to maintain the stability of the financial system.

A. Growth of Derivatives Transactions

1. Size of derivatives markets

Derivatives transactions, such as foreign exchange-related and interest rate-related derivatives, have expanded rapidly since the latter half of the 1980s. According to the Central Bank Survey of Derivatives Market Activity, conducted by the Bank for International Settlements (BIS) with the cooperation of 26 central banks on a notional and over-the-counter (OTC) basis, the global total for the notional amount outstanding of OTC derivatives contracts amounted to US$47.5 trillion as of the end of March 1995 (Table 1). Although this notional amount does not accurately represent the size of risks, since the principal of a derivatives contract is not always exchanged, taken merely as a yardstick, it is close to seven times the nominal GDP of the United States in 1995. On a market value basis, outstanding transactions amounted to only US$2.2 trillion, less than five percent of the notional amount. ¹

At some internationally active financial institutions, the notional amount outstanding of derivatives transactions exceeds the sum of on-balance-sheet assets, such as lending and securities. In particular, the notional amount of derivatives transactions at some major U.S. financial institutions has reached close to 20 times their on-balance-sheet assets. Accordingly, it is apparent that derivatives transactions account for an extremely large share of their banking business (Table 2). As for major Japanese financial institutions, this same ratio has reached two to five times.

2. Significance and risks of derivatives

Derivatives are extremely efficient tools used by market participants to control risks -- unbundling and reorganizing risks arising from daily financial transactions, and transferring them to those who have the will and capacity to assume them. Derivatives therefore enhance the efficiency of financial institutions and financial markets, and promote financial innovation.

However, various studies conducted on derivatives have made the central banks of the major industrialized countries aware of the possibility that the growth of derivatives transactions may increase systemic risk. ² The reasons for this are that (1) since derivatives transactions are actively used for risk-hedging and arbitrage, shocks could be easily transmitted through the linkages among financial markets; (2) since derivatives transactions tend to be concentrated in a handful of major financial institutions, the shock will be more serious if risks are mismanaged at these institutions; and (3) some derivatives instruments, such as options, can temporarily amplify the price volatility of a financial asset depending on the market conditions. While these aspects simply suggest the possibility that systemic risk might be increased due to derivatives, they do not lead to the conclusion that derivatives necessarily increase such risk.

B. Disclosure as a Means to Contain Systemic Risk

The central banks of the major industrialized countries have continuously examined the implications of rapidly expanding derivatives markets for their monetary policies and for the financial system. ³ At the same time, they have deliberated on how to avoid increases in risks. The deliberations so far have assumed that the following four factors, one of which is improvement of derivatives disclosure, will be effective in containing systemic risk.

1. Improvement of risk management of financial institutions

Improvement of risk management of individual financial institutions is most fundamental to containing systemic risk. As financial institutions have sought to improve their asset and liability management (ALM), risk management techniques have rapidly progressed. ⁴ Indeed, high-tech financial services can be offered only with adequate risk management. Thus, it can be said that competition in offering financial services is in fact competition in risk management.

Risk management includes quantitative measurement of risk as well as the establishment of an effective organizational structure. In this regard, value-at-risk (VaR) has become a widely adopted method of quantifying market risk at major financial institutions. At the same time, current exposure has become a common method of measuring credit risk resulting from derivatives transactions. ⁵ Financial institutions are also improving their organizational structure by establishing a specialized risk management section which comprehensively measures and controls the overall risk of the institution.

2. Improvement of the financial infrastructure

For the market check mechanism to work effectively, it is necessary to improve the financial infrastructure, such as the settlement systems and accounting principles. In this respect, recent legislation in Japan, the "Law to Implement Measures for Ensuring the Sound Management of Financial Institutions," has provided that mark-to-market accounting be applied to the trading accounts of financial institutions from fiscal 1997.

3. Improvement of disclosure practices

The Federation of Bankers Associations of Japan amended the uniform disclosure standards applied to financial institutions to include disclosure of derivatives (i.e., off-balance-sheet) activities starting in fiscal 1995. The new standards recommend disclosure of quantitative information such as the notional amount/contract value and the credit risk equivalent (for example, the current exposure) of derivatives transactions. They also recommend disclosure of qualitative information such as additional explanations of the quantitative information, the types of instruments banks offer, and their management strategies.

In July 1996, ministerial ordinances and circulars, such as the "Regulation concerning Terminology, Forms and Method of Preparation of Financial Statements, etc.," were revised to enhance derivatives disclosure by firms, including nonfinancial firms. The revisions expanded the types of transaction to be disclosed, improved the contents of quantitative information, and introduced disclosure of qualitative information.

The uniform disclosure standards of the federation are of great significance, as they set out the minimum disclosure requirements. However, from the viewpoint of reinforcing the market check mechanism, it is most desirable that banks voluntarily disclose information beyond the minimum level, as will be discussed in more detail below.

4. Role of financial authorities

Strengthening of the risk management of financial institutions and improvement of the financial infrastructure are likely to induce further disclosure. This in turn will promote efficient functioning of the market check mechanism, and thereby contribute to the stability of the financial system. With this virtuous circle, financial authorities will be able to make effective use of the market check mechanism.

In view of the above, the role of central banks will be to consider ways to ensure the stability of the financial system by drawing out the incentives inherent in financial institutions to improve their risk management ability -- in other words, by utilizing the risk management function inherent in the market.

III. Current Disclosure Practices by Financial Institutions

A. Recent Discussion on Public Disclosure

There is a growing awareness in Japan and abroad of the role of public disclosure. In the United States, where extensive disclosure has been made with the aim of providing precise business information to investors, the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) have proposed disclosure standards for quantitative information on market risk associated with derivatives. ⁶

In an internationally coordinated effort, the BIS Euro-currency Standing Committee (ECSC) of the G-10 central banks published "Discussion Paper on the Public Disclosure of Market and Credit Risk by Financial Intermediaries" in September 1994 (Table 3 on the following page).⁷ The report suggested that financial institutions disclose information derived from their internal risk management systems, and recommended disclosing not only the risk profile, but also quantitative and qualitative information about risk management performance. While the suggestions aimed at strengthening the market check mechanism, they were also expected to increase the transparency of markets, because disclosure can trigger a "dynamic competitive process," in which disclosure of information by a financial institution with a good risk management system invites other institutions to follow suit.

In November 1995, the Basle Committee on Banking Supervision (Basle Committee) and the Technical Committee of the International Organisation of Securities Commissions (IOSCO) jointly issued "Survey of Disclosures about Trading and Derivatives Activities of Banks and Securities Firms." The report, analyzing the disclosure in the annual reports of banks and securities firms, suggested further improving disclosure practices following the concepts developed in the Fisher Report. A survey on financial institution disclosure was subsequently conducted to follow up on the joint report.

In Japan, a working group organized under the Financial System Research Council, an advisory committee to the Minister of Finance, published a report in May 1995 on the improvement of derivatives disclosure of financial institutions. This report led to the aforementioned revision of the uniform disclosure standards of the Federation of Bankers Associations of Japan.

B. Developments at Individual Financial Institutions

Several leading U.S. financial institutions, which adopt the most advanced approaches to public disclosure, are aware of the benefits of disclosure, and accordingly are making innovative improvements in their disclosure regardless of the formal requirements. In response to the requirements and recommendations in Japan and abroad, some Japanese financial institutions disclosed information on their derivatives transactions and risk management in their fiscal 1994 annual reports. A larger number of major Japanese financial institutions disclosed such information in their fiscal 1995 annual reports.

An overview of the disclosure by Japanese and foreign financial institutions on derivatives and risk management in their 1994 and 1995 annual reports appears below. In it, a distinction is made between "trading transactions" and "banking transactions"; risk measurement and risk management performance are evaluated in terms of market and credit risks. ⁸ The illustrative examples of disclosure in the charts are simplified to make them easier to understand.

1. Disclosure of market risk

a. Overview of disclosure practices

Japanese, U.S., and European financial institutions disclose information on market risk in a variety of ways. The information disclosed can be classified into four levels: (1) actual profits and losses (changes in portfolio market value); (2) expected degree of risk (e.g., VaR); (3) risk management performance; and (4) other information on risk or risk management.

(1) Disclosure of actual profits and losses
As they conduct market transactions, financial institutions mark to market their trading portfolios on a daily basis, and disclose the changes (i.e., profits and losses) for a certain time span (e.g., the reporting period). The changes can be considered the realized market risk. The daily changes are often illustrated in graphs or histograms (Chart 1).

Such information is disclosed by several U.S. and European financial institutions, but not by Japanese financial institutions.

(2) Disclosure of expected degree of risk
Financial institutions disclose their expected degree of market risk in order to indicate how much risk they anticipate in carrying out transactions. The VaR method is widely used for measuring risk exposure, and disclosure of VaR figures has become common practice among leading U.S. financial institutions. As for Japanese financial institutions, more of them disclosed VaR estimates in their fiscal 1995 annual reports than in the preceding years.

Specifically, institutions use graphs to illustrate daily VaRs, or show the average, highest, and lowest VaRs for the reporting period (Chart 2). ⁹ Some Japanese financial institutions provide VaRs by market, by currency, and by risk factor on an end-of-period or period-average (e.g., quarterly average) basis.

(3) Disclosure of risk management performance
Changes in portfolio value and expected degree of risk provide information about the size of the anticipated and realized risk, but they do not convey any information about risk management performance. To disclose risk management performance, financial institutions show the reliability of their risk measurement models by comparing the estimated risk exposure with the realized profit or loss.

Specifically, institutions compare daily VaRs with the actual profit or loss (a process called "backtesting"), in order to indicate how frequently the decline in portfolio value exceeded the VaR figure (see Box 1).

A larger number of Japanese financial institutions included in their 1995 annual reports diagrams plotting VaRs against actual profits and losses (Chart 3). Some of the institutions created a histogram representing the ratio of the profit or loss on a portfolio to VaR (see Chart 4 and Box 2). This method is also aimed at conveying information on the profitability and stability of the portfolio.

(4) Disclosure of other information on risk or risk management
Some Japanese financial institutions disclosed in their fiscal 1995 annual reports information on estimated risk amounts using a method called "stress testing," although in a limited manner (see Box 3).

Stress testing is a method of estimating quantitatively how a portfolio is affected by stressful events -- such as an abrupt and violent fluctuation in the market prices of financial instruments, or default by a major market participant. Financial institutions make use of stress testing in order to prepare themselves for the worst contingencies. While VaR, in many estimates, assumes a normal distribution of and a stable correlation among risk factors, stress testing supposes the collapse of such assumptions. Stress testing can thus be considered complementary to the VaR method. Since it is still under study, however, there is no standard method, and few financial institutions disclose related information.

b. Efforts by Japanese financial institutions to improve public disclosure

As mentioned, Japanese financial institutions have made significant progress in market risk disclosure in their fiscal 1995 annual reports, and this suggests an increasing awareness in Japan of the importance of public disclosure. In particular, the fact that a significant number of institutions innovatively disclosed their risk management performance suggests that the "dynamic competitive process" has been set in motion in Japan. It is likely that more institutions will adopt such disclosure practices in the future. However, not a few challenges remain.

First, the evolution of disclosure practices must keep pace with the ongoing sophistication of risk management techniques. While the VaR method was employed by more financial institutions in fiscal 1995 disclosure than before, it should be noted that VaR is not the single best tool for measuring risks. Financial institutions will have to review their disclosure methods continuously in accordance with the expected improvements in risk management technology and their management strategies at the time. More effective disclosure will enable financial institutions to demonstrate their risk management skill, and will also allow the market check mechanism to function more effectively.

Second, from the viewpoint of conveying meaningful information to its recipients, actual disclosure does not always cover all the important business areas or financial instruments. In addition, the coverage is not always clearly stated. Such coverage inevitably depends on the management policies of the disclosing institution, as well as on the costs related to the generation of the information. However, it is desirable that financial institutions expand the scope of their disclosure as much as possible and mention it clearly. Moreover, once the coverage is determined, it should be kept consistent so long as it is possible in order to ensure the continuity of information.

2. Disclosure of credit risk

With regard to credit risk, it is difficult to manage the market value or loan assets, since no market price is publicly available. ¹⁰ It is also difficult to estimate the "default probability" of a counterparty and the "collectability" of an asset -- two necessary factors in evaluating credit risk -- due to insufficient data on defaults and creditworthiness of firms. The approaches used to measure market risk therefore cannot be applied to credit risk. ¹¹ This explains why the disclosure of the former is more advanced than that of the latter.

In the following, the information to be disclosed on credit risk is analyzed in three conceptual steps: the principal, credit exposure, and risk equivalent. Charts and tables illustrate examples of possible disclosure methods as a reference for future study. The current practices of credit risk disclosure by Japanese, U.S., and European financial institutions are also reviewed. Because the methods for the measurement and disclosure of credit risk remain under development, the following description might throw some light on what is expected of individual financial institutions.

a. Measurement of credit risk

Table 4 represents a conceptual analysis of the measurement of credit risk associated with on- and off-balance-sheet (i.e., derivatives) transactions. It shows the different degrees of accuracy with which the risk is measured. The measurement consists of three stages of increasing accuracy.

In the first stage, the risk is measured by "principal." The principal of an on-balance-sheet transaction refers to the amount outstanding of the asset, as is the case with loan portfolios. The principal of a derivatives transaction refers to the notional amount. Both are the basic and most easily available risk indicators, but neither directly reflects the amount of risk involved.

In the second stage, risk is measured by "credit exposure." The credit exposure represents the real amount of credit, obtained by marking the principal to market. In the case of on-balance-sheet transactions having no market price, the net present value of future cash flow (interest plus principal) could substitute for the exposure. ¹² For off-balance-sheet (derivatives) transactions, the exposure is equivalent to the current exposure. Some institutions also incorporate "potential future exposure," taking account of possible changes in the market value that might occur in the future in addition to the current replacement cost.

In the third stage, the measure is the "risk equivalent." The risk equivalent is the expected amount of loss or the maximum possible loss, based on the creditworthiness, and possible changes thereto, of the counterparty. Such "quantitative measurement of credit risk" is also being developed for practical use by Japanese financial institutions. ¹³Theoretically, the risk amount can be obtained by multiplying the credit exposure by the counterparty's default probability. However, considerable challenges remain in developing specific methods for such calculations and in determining the default probability, which is an indispensable factor in the calculation. Basically, there are two approaches to the calculation: a "static" approach reflecting solely the "current" default probability; and a "dynamic" approach which attempts to foresee the changes in risk amount resulting from changes in the default probability and market conditions. Still other issues must be dealt with in order to increase the accuracy of the measurement before any method is put into practical use -- among them, the incorporation of asset collectability into the measurement, with due consideration of collateral.

b. Conceptual examples of credit risk disclosure

Conceptual examples of credit risk disclosure -- disclosure of risk amounts and of information on risk management -- are given below as possible subjects for future study. ¹⁴

(1) Disclosure of risk amounts
Default probability, one factor of credit risk, can hardly be calculated on a daily basis, and for some transactions, it is unsuitable by nature to observe returns and losses on a daily basis. Therefore, disclosure of risk amounts would be based on end-of-period or period-average figures. Profitability in relation to risk might be disclosed by directly comparing the risks and returns in each period chronologically or by showing the risks and returns in the form of spreads (i.e., the theoretical risk premium and actual spread) against a base market rate (charts 5 and 6). ¹⁵

(2) Disclosure of information on risk management
Disclosure of information on risk management can be effected by showing the principals and credit exposures by type of transaction, geographic area, or by internal credit rating, thus revealing the dispersion or concentration of risk (Chart 7). More detailed information can be provided by disclosing net exposure, which is obtained by deducting the effects of netting arrangements and the portion covered by collateral from gross exposure. The example in Chart 8 indicates that the exposures are reduced significantly by netting arrangements and collateral enhancements, leaving fairly small amounts of risk in real terms.

To provide information on the appropriateness of credit screening, it would be useful to compare estimated default probabilities and actual default rates for each internal credit rating. The example in Table 5 indicates that actual default rates are close to what was estimated for highly rated credits, which means that the screening was reasonable, while significant negative deviations are observed for credits with lower ratings.

(3) Disclosure of other information
The concept of stress testing described earlier for market risk is also applicable to credit risk (Chart 9). While stress scenarios for market risk consist of abrupt changes in market conditions, those for credit risk could include, for example, materialization of country risk due to political instability (so-called "event risk"), or increased defaults in a specific industry due to deterioration of business conditions caused by violent changes in the economic environment.

c. Current practices of credit risk disclosure by Japanese, U.S., and European financial institutions

In fact, no financial institutions, not even the front-runners in the United States and Europe, disclose quantified credit risk incorporating default probability. However, not a few U.S. and European financial institutions disclose information about credit risk amount and risk management performance -- for example, credit exposures by type of transaction, geographical area, and internal credit rating. Several have taken further steps to disclose the effects of netting arrangements and collateral in reducing credit risk, or the potential future exposure calculated by internal simulation.

In Japan, on the other hand, several major institutions provide qualitative information referring, for example, to their ongoing efforts to develop a system for quantitative measurement of credit risk. However, quantitative disclosure remains limited to the outstanding amounts of on-balance-sheet lending by type of industry, or, for derivatives transactions, current exposure by type of instrument.

CONCLUSION

During the past several years, the most urgent task for Japan's financial system has been to overcome the nonperforming-loan problem. From now on, however, the pressing task for Japan will be to construct an efficient and stable financial system. The most important principle in seeking this objective is the maximum use of the market mechanism. The rapid development of new financial services such as derivatives has in fact been driven by the financial innovation induced by market competition. With respect to efficiency, what is required of the new financial system is the full functioning of the market mechanism, incorporating the latest innovation and other developments taking place in the markets. With respect to stability, if the market check mechanism functions effectively, it should urge prompt review of the management of a financial institution to correct problems at an early stage, thereby averting the possibility of risk being amplified. Disclosure is a means to stimulate such a market check mechanism, and to thereby ensure financial system stability.

While Japanese financial institutions are enhancing their disclosure practices, continued efforts are needed to improve disclosure methods in view of the incessant technological innovation in the financial markets and the sophistication of risk management systems spurred by such innovation. These efforts will strengthen individual institutions' competitiveness in the global financial markets, and will also benefit the financial system as a whole.

footnotes

The market value is the replacement cost of a contract, or the cost of re-implementing an identical transaction in case the counterparty defaults. The gross market value excludes the effects of netting arrangements.
Although there is no standard definition of systemic risk, it is most typically defined as the risk that the failure of a financial institution will trigger, through the network of credits and debts, the failure of other financial institutions, and ultimately, impair the stability of the entire economy. Defined more broadly, it is the risk that market functions will be jeopardized by large fluctuations in financial asset prices resulting from some kind of shock, as was the case with Black Monday in 1987. The market functions are considered jeopardized when no financial transactions are made, and such a situation, if not alleviated, may lead to the insolvency of financial institutions.
The Euro-currency Standing Committee (ECSC) of the BIS published "Recent Developments in International Interbank Relations" (the Promisel Report) in November 1992. This report analyzes the impact of the recent changes in financial markets due to the expansion of off-balance-sheet transactions, such as derivatives, on the global financial system. It also emphasizes the need for stronger international cooperation among central banks in order to improve the financial market infrastructures and contain systemic risk.
Following the discussions developed in the Promisel Report, the ECSC continued deliberations on the actual situation of derivatives transactions and on the impact of the growth of such trades. In December 1994, the ECSC published "Macroeconomic and Monetary Policy Issues Raised by the Growth of Derivatives Markets" (the Hannoun Report) and in February 1995 "Issues of Measurement Related to Market Size and Macroprudential Risks in Derivatives Markets" (the Brockmeijer Report). The two reports indicate that while derivatives may amplify volatility of financial asset prices, they function to redistribute risks and improve the overall stability of financial markets.
Developments to raise the sophistication of financial institutions' ALM systems are discussed in "Asset and Liability Management of Japanese Financial Institutions" in the November 1995 issue of the Bank of Japan Quarterly Bulletin.
VaR is the maximum potential loss a portfolio may incur due to adverse movements in market prices, given a certain holding period and confidence interval.
Current exposure is the replacement cost of a contract -- or the cost of re-implementing an identical transaction in the market -- should the counterparty default, and is equal to the market value of the transaction.
The FASB published a statement of financial accounting standards (SFAS 119) in October 1994 that requires firms to disclose the fair value, on an end-of-period and period-average basis, of their derivatives transactions conducted for trading purposes, and which encourages them to do the same for non-trading derivatives transactions. The statement also encourages disclosure of quantitative information about market risks associated with derivatives.
The SEC proposed amendments in December 1995 to the disclosure requirements of publicly traded companies. The proposal requires disclosure of information on market risks associated with all "market-risk-sensitive instruments," including derivatives and other financial instruments. Furthermore, it requires disclosure of quantitative information on market risks, which was merely a recommendation in SFAS 119, such as the results of a sensitivity analysis of the possible profit/loss arising from changes in the market conditions -- for example, a unit change in the interest rate (e.g., a 0.1 percentage point change) -- or the risk exposure measured by VaR.
The report was prepared by a working group on disclosure organized under the ECSC. It is referred to as the Fisher Report, after Peter R. Fisher, chairman of the working group and the present executive vice president of the Federal Reserve Bank of New York.
"Market risk" is the risk of loss on portfolio value which may be incurred as a result of changes in market prices (e.g., the interest rate or foreign exchange rate) of financial instruments. "Credit risk" is the risk of loss on the economic value of a contract which may be incurred due to changes in a counterparty's creditworthiness or the default of counterparties.
VaR estimates change depending on the assumptions, such as the holding period, confidence interval, and observation period. Therefore, information on those assumptions should also be disclosed.
In the U.S. and Euro markets, there are growing markets where large loan assets, such as internationally syndicated loans, are traded, and some U.S. and European financial institutions are functioning as market makers for specific loans. However, unlike interest rates or stock prices, market prices for these loan assets are not always quoted daily.
Studies are under way to apply an extended version of the VaR method to the quantitative measurement of credit risk.
The market value does not reflect the counterparty's creditworthiness or possible changes thereto.
To be more accurate, it is necessary to take into account the possibility of prepayment, as in the case of housing loans, and the price changes of collateral.
Quantitative measurement of credit risk has already been incorporated into the internal risk management of several major U.S. and European financial institutions. Japanese financial institutions have also come to recognize the importance of such measurement for various reasons: (1) faced with the nonperforming-loan problem, they have become increasingly concerned about credit risk when screening potential borrowers; (2) with larger firms having shifted toward financing in capital markets, financial institutions are focusing more on small and medium-sized firms, which may carry higher credit risk; (3) in this context, they are beginning to evaluate the profitability of lending in relation to the risk involved; and (4) some institutions are aware of the need to watch not only market risk, but also the overall risk profile of their portfolios in order to enhance risk management.
The examples presume that risk amounts can be known in some way, although no quantitative measure of credit risk, such as the VaR used for market risk, is actually available. All the examples are prepared for illustrative purposes, and individual financial institutions are expected to develop their own disclosure methods based on their management policies.
It would, however, be difficult to distinguish the return as a reward for credit risk from that as a reward for market risk -- i.e., risk origins of obtained profit cannot be clearly identified.

Box 1 Backtesting

One approach to backtesting is illustrated in Chart for Box 1, where the lapse of business days is represented on the horizontal axis, and the corresponding daily VaRs and actual profits and losses on the portfolio are represented on the vertical axis.

Another approach is shown in the example of Chart 3, which compares daily VaRs plotted on the horizontal axis with the absolute values of actual profits and losses during a certain period (one year in this example) on the vertical axis.

VaR is the maximum potential loss a portfolio may incur due to adverse movements in market prices, given a certain holding period and confidence interval. For example, assuming 250 business days and a confidence interval of 95 percent on both sides (97.5 percent one-sided), the actual profit or loss can be expected to exceed the VaR on fewer than 12 out of the 250 business days.¹ If this is the case, it indicates that the financial institution's risk management is good. The number of days exceeding VaR is indicated in Chart for Box 1, where the actual loss extends from the area lying within the VaR (referred to as the confidence band), and in Chart 3 by the dots plotted above the 45-degree line. The example in Chart 3 indicates that in only five days did the actual profit or loss exceed the VaR, and thus demonstrates that the VaR model would be accurate under a 95 percent confidence interval -- in other words, the institution's risk management is good. Conversely, if a significant number of dots were plotted above the 45-degree line, that might imply some problem with the risk measurement model.

It should be noted that there are limitations to the evaluation of risk management performance through backtesting. The actual profit or loss that is compared with the VaR is the change in the mark-to-market value of a portfolio from the previous day, including realized profit or loss. Therefore, one limitation of backtesting is that if a trading position happens to grow during a particular day, causing the day's profit or loss to expand temporarily, there is a possibility that this may result in the profit or loss exceeding the VaR. Other limitations include the effects of the assumption of market price volatility in measuring VaR as well as the statistical accuracy of backtesting.

1. 250 days - (250 days x 95 percent) = 12.5 days.

Box 2 Distribution of the Risk-Return Ratio

Some Japanese financial institutions used a histogram of the risk-return ratio -- the actual daily profit or loss arising from trading activity as a ratio to VaR -- in their fiscal 1995 annual reports. The histogram represents the results for one year, consisting of 250 business days, with a normal distribution curve superimposed. An illustrative example is given in Chart 4, which provides information on the following diagnosis of trading activity and risk management performance.

1. Profitability
The returns relative to risks on trading activity can be analyzed by means of the distribution of the risk-return ratio. In Chart 4, the distribution generally lies in an area where the risk-return ratio has a positive value, indicating that on average the trading activity generated profits. A ratio of more than 1.0 corresponds to dots plotted above the 45-degree line in the backtesting diagram (Chart 3), and is therefore considered undesirable from the viewpoint of risk management. In Chart 4, the distribution of positive ratios is mostly below the +1.0 level. The distribution of negative ratios lies almost entirely between -0.5 and 0, indicating that losses relative to risks have been contained. In general, if the distribution lies within the range of -1 to +1, it can be concluded that risk management performance is good.

2. Stability
Compared with the normal distribution, the distribution in Chart 4 is concentrated in the middle, near the mean. This indicates that the fluctuation in returns relative to risks was small, and that earnings were stable.

Box 3 Stress Testing

VaR usually assumes that the volatility of each risk factor is governed by normal distribution (Chart for Box 3 [1]). It is also assumed that there is a certain correlation among the risk factors. However, these assumptions do not always apply. For example, the volatility of risk factors might diverge from normal distribution. It happens with some frequency that losses climb way beyond the confidence interval assumed in the VaR, as seen in the case of the stock market crash on Black Monday in 1987. Stress testing is an undertaking to estimate the changes in the portfolio value that might be incurred due to such a rare but radical change in market conditions (an "abnormal" or "stressful" situation). Financial institutions establish contingency plans based on the results of the testing.

Although stress testing has been incorporated into the internal risk management of several financial institutions, no standardized method exists. This is an area where intensive research is being conducted by private financial institutions, academics, and financial authorities.¹ Methods now employed by financial institutions or studied by financial authorities include (1) assuming a longer holding period and a wider confidence interval for risk factors (Chart for Box 3 [1]); (2) setting a fluctuation range of risk factors with reference to past events (e.g., the maximum fluctuation that has been observed); (3) assuming a collapse of the correlation among risk factors; (4) assuming a distribution of risk factors other than a normal distribution, such as one with a "fat tail" (Chart for Box 3 [2]); and (5) combining these scenarios as appropriate.

1. Stress testing is of great interest to central banks from the viewpoint of averting systemic risk. In November 1995, the central banks of Japan, the United States, and the United Kingdom together with the Bank for International Settlements jointly held in the United States a research conference on "Risk Measurement and Systemic Risk." Participants included representatives of the central banks of the G-10 countries, staff from major financial institutions, and academic experts.

Table 3

Outline of "Discussion Paper on the Public Disclosure of Market and Credit Risk by Financial Intermediaries" (the Fisher Report) of September 1994

A. The Objective of the Report
Suggestion of principles for disclosure of risk management in order to stimulate further debate about the methods and purposes of public disclosure.

B. Rationale: Necessity of Disclosure
Financial institutions should move in the direction of disclosing meaningful information to improve the transparency and efficiency of financial markets.

C. The Recommended Framework of Disclosure
Utilization of information derived from the financial institutions' internal risk control systems in which risks are measured and expressed, for public disclosure purposes.

D. Recommended Principles
Each financial institution should provide periodic quantitative information in summary form on the following estimates on which its management relies in its internal risk management.

Estimates of the market risks in a portfolio and the firm's actual risk management performance
a. Measurement of the size and implied changes of risk (estimate)
b. Measurement of the size and changes in portfolio market value (actual result)
Estimates of the credit risks arising from the firm's trading and risk management activities and the firm's performance in managing the risks
a. Current credit exposure
b. Potential credit exposure
c. Measurement of the counterparty's default probability
d. Measurement of the incurred loss

Risk Disclosure by Financial Institutions *1