Chairman Gramm and Members of the Subcommittee:
I am pleased to appear today to testify on behalf of the Securities and Exchange Commission ("Commission" or "SEC") regarding rules, adopted by the Commission on January 28, 1997, that require certain disclosures about market risk sensitive instruments. These disclosures are an important step in improving investor understanding of the market risks facing public companies and how individual companies manage those risks.
The disclosures are designed to help investors answer questions such as: What types of market risk exposures from market risk sensitive instruments does the company face? How are those risks managed? What losses may occur if interest rates, foreign currency exchange rates, or commodity prices move by certain amounts? Answers to these questions and others like them should help to demystify these instruments and increase the ability of investors to analyze the market risks inherent in their investments.
This is a particularly significant rule making effort because it is the first time the Commission has asked registrants to quantify for investors the risks associated with changes in market rates and prices. Developing an appropriate and understandable disclosure framework for these risks was a significant and critically important task as risk management techniques become more complex and fundamental to the success of American businesses.
As explained more fully in the attached adopting release, the Commission amended its rules to expand existing disclosure requirements for market risk sensitive instruments in three ways:
As explained below, the Commission has studied how to improve disclosure about market risk since 1994. This process included discussions with representatives of investors and analysts, the business community, and the securities industry. In addition, the process encompassed an extensive review of disclosures by registrants and a thorough review of comment letters received over a one year period.
In many cases, comments from investor organizations conflicted with those from registrants. The Commission weighed the views of commenter's in light of perceived costs and benefits and the current state of technology and risk measurement methodologies, and made several changes before adopting the final rules to balance the various considerations.
Nonetheless, the Commission recognizes that the disclosures may not be the perfect solution; they are, however, responsive to the well-founded need to improve disclosures in this important area. In addition, the Commission expects to monitor the effectiveness of the new rules and to reevaluate them no later than a period of three years from their initial effective date.
The Commission understands that the Subcommittee has expressed interest in the Financial Accounting Standards Board's ("FASB" ) project on accounting for derivatives. As noted later, the Commission has encouraged FASB in its efforts. However, the FASB has not yet completed its deliberations, and therefore, the Commission's testimony relates only to the Commission's recently adopted market risk disclosure rules.
During the last several years, the use of market risk sensitive instruments increased substantially. Indeed, these instruments are more common now than ever before for companies in many different industries. Illustrative of this increased use is the growth of worldwide notional/contract amounts for derivatives from $7.1 trillion in 1989 to $69.9 trillion in 1995.
The Commission recognizes that derivatives often are used as effective tools for managing exposures to market risk. over the past several years, these instruments have been used to mitigate the potential losses to American businesses from significant changes in interest rates, foreign currency exchange rates, and commodity prices. Derivatives allow companies to change their market risk profile in an effective and efficient manner by shifting a specific risk from themselves to others who seek to accept and manage that risk.
Due to the growth in the use of derivatives, the Commission believes it has become more important to discern from current disclosures the risk profile of a registrant. Moreover, the last time there were major movements in interest rate and foreign currency markets, several headline stories about losses from derivatives and other market risk sensitive instruments by corporate end-users and dealers alike surprised investors and the markets. These stories include the losses incurred by Bankers Trust, Dell Computers, Gibson Greetings, and Proctor & Gamble, among others. The surprise accompanying such losses demonstrates the need for more public disclosure of what market risks are and how the registrants in which the public invests its money are managing those risks.
As discussed more fully in the adopting release, certain private sector organizations, such as the Association of Investment Management and Research ("AIMR") and the American Institute of Certified Public Accountants, expressed concerns that users of financial reports are dissatisfied with current disclosures about market risk sensitive instruments. A recent example of such concerns appears in a survey of year end 1994 derivative disclosures sponsored by Coopers & Lybrand L.L.P. Foundation ("C&L") which states:
In addition to expressing concerns similar to C&L's, some organizations's recommended improvements to market risk disclosures, which generally are consistent with the disclosure framework embodied in the Commission's rules.
In October 1994, the FASB, responding in part to calls for improved disclosure, issued Statement of Financial Accounting Standards No. 119, "Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments" (11FAS 11911)." FAS 119 was designed, in part, to help investors and others understand how derivative financial instruments are reported in the financial statements by requiring qualitative disclosures about those instruments. However, FAS 119 applies only to derivative financial instruments and does not apply to other derivative instruments with similar characteristics, such as derivative commodity instruments. In addition, FAS 119 does not require, but only encourages, disclosure of quantitative information about an entity's market risk exposures.
To understand better the issues relating to the disclosure of market risk, the SEC staff reviewed over 500 filings made by registrants both before and after FASB's adoption of FAS 119. The SEC staff noted that the 1995 disclosures were more informative than the 1994 disclosures, in part because of improved FASB disclosure guidance. However, apart from the lack of quantitative disclosures, the staff observed the following three significant disclosure deficiencies:
Overview of the Rules
The Commission adopted rules designed to address those disclosure deficiencies. In particular, the rules require registrants to provide three different types of disclosures regarding market risk sensitive instruments. First, registrants must provide enhanced descriptions of accounting policies for derivatives in the footnotes to the financial statements. Second, registrants must provide qualitative information outside the financial statements about their primary market risks, how those risks are managed, and changes in either the risk exposures or how they are managed. Third, registrants must provide quantitative information about market risk sensitive instruments outside the financial statements.
Under the rules, quantitative information may be provided using one of three alternatives. Specifically, registrants must provide: (i) tabular presentation of fair value information and contract terms relevant to determining future cash flows, categorized by expected maturity dates; (ii) sensitivity analysis expressing the potential loss in future earnings, fair values, or cash flows from selected hypothetical changes in market rates and prices; or (iii) value at risk disclosures expressing the potential loss in future earnings, fair values, or cash flows from market movements over a selected period of time and with a selected likelihood of occurrence. The quantitative information must be provided separately for instruments entered into for trading purposes and other than trading purposes for different market risk exposure categories (i.e., interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market risks,, such, as equity price risk), to the extent material.
In addition to disclosures about market risk sensitive instruments, the rules also encourage, but do not require, the market risk disclosures to include information about other instruments and transactions that are subject to market risk, such as commodity positions. The Commission considered expanding the required disclosures to include commodity positions and other similar instruments and transactions; however, many internal risk measurement systems currently do not incorporate many commodity positions and anticipated transactions. Thus, the Commission did not require the inclusion of these items at this time. To the extent such encouraged disclosures are not provided, registrants must discuss the absence of those items as a limitation of the disclosed market risk information.
Finally, the rules provide that forward looking disclosures made pursuant to the rules are within the statutory safe harbor under the Securities Act of 1933 and Securities Exchange Act of 1934 whether or not the registrant or the transaction would otherwise be disqualified from the statutory safe harbor.
The Commission believes that investors will benefit greatly from the disclosures about derivative accounting policies and market risk. It is expected that such disclosures will complement the Commission's existing disclosure framework and improve the usefulness of financial reporting.
Disclosure of accounting policies for derivatives currently is required by generally accepted accounting principles. However, those requirements do not indicate explicitly what information should be included in the disclosures of derivatives accounting policies. As a result, the accounting policies footnote for derivatives varies among registrants. often, such disclosures are overly broad and do not provide insight as to the quality of the accounting policies or the criteria needed to be met by the registrant to qualify for hedge accounting.
For example, a registrants accounting policy for derivatives currently might state: hedge accounting is used for derivatives that hedge the price of inventory.
Such a policy does not describe the type of instruments used to hedge inventory, the specific type of hedge accounting applied to each type of instrument used, the criteria that must be met to qualify for hedge accounting for each type of instrument used, the type of accounting that occurs if the criteria for hedge accounting are not met, or other key aspects to the accounting policies for derivatives. Without such information, investors are unable to understand when and under what circumstances any gains or losses from these contracts will be recorded in the financial statements. In addition, investors and analysts are unable to determine the quality of the accounting policies being applied to derivatives.
The rules require registrants to disclose specific details about the accounting policies used for derivatives. For example, the rules require disclosure of the accounting method applied to each type of derivative used, the criteria required to be met for each accounting method used, and other key aspects of the accounting policies for derivatives. All information that the registrant already has, but which currently is not disclosed. The Commission expects that such disclosure will facilitate an investor's understanding of the effects of derivatives on financial statements and improve the ability of investors and analysts to evaluate the quality of the accounting policies across registrants.
Quantitative disclosures about market risk currently are not required and usually are not included in filings with the commission. The Commission believes such quantitative information and related disclosures about the model, parameters, and key assumptions is helpful to investors; therefore the rules require such information. The Commission believes that these disclosures will provide critical information about the amount of risk inherent in market risk sensitive instruments and the key elements underlying how that risk was measured and quantified. Thus, the Commission expects that investors will be able to evaluate better a registrant's exposure to changes in interest rates, foreign currency exchange rates, and commodity prices. For example, using the sensitivity disclosure alternative provided in the Commission's rule, registrants might disclose that: at December 31, 19x7, a one percent gradual decline in interest rates would result in a $XXX decline in the Company's earnings.
Such disclosure provides forward looking information about the sensitivity or variability in earnings from a hypothetical, though possible, change in interest rates. This type of disclosure allows investors to assess the aggregate impact that changes in interest rates might have on earnings. The Commission believes investors will be able to use that information in understanding the risk associated with possible changes in interest rates. In addition, the Commission expects that investors will be able to determine better whether the risk inherent in one investment is increased or mitigated when combined with the risk inherent in other investments. Also, investors will be able to assess better whether the model and key assumptions are reasonable. If registrants such as Gibson Greetings, Dell Computer, or others that incurred significant losses from derivatives over the past few years had made such disclosure, the Commission believes that investors and the markets would have been less surprised when those losses actually occurred.
Lastly, many registrants currently disclose some qualitative information about market risk exposures and how those risks are managed because current rules require a general discussion of risks and uncertainties. However, the content of those disclosures is not consistent among registrants. The rules make clear the qualitative disclosure requirements for market risk sensitive instruments and make the quantitative disclosures about market risk more meaningful. In particular, the rules require disclosure of (i) a registrant's market risk exposures, (ii) how those exposures are managed, and (iii) changes in either the registrant's market risk exposures or in how those exposures are managed. Such disclosures should help investors understand a registrant's market risk management activities and strategies and help place those activities and strategies in the context of the business.
For example, assume a registrant discloses that it had been exposed to short-term changes in the Mexican peso, but as a matter of policy it enters into derivatives to convert that exposure into short-term US dollar exposure. In those circumstances, the qualitative disclosures about the registrant's derivatives strategy allows investors to conclude that changes in US interest rates will affect the registrant more than changes in Mexican peso/US dollar exchange rates; a conclusion that may not have been reached without the qualitative disclosures. In addition, the qualitative disclosures should enable investors to understand better a registrant's attitude toward taking risk and its ability to manage risk.
In sum, the Commission believes that disclosures about derivative accounting policies and market risk will benefit investors in many ways. Assessments about the impact of derivatives on the financial statements will be improved; judgments about potential losses from changes in market rates or prices will be more informed; and an understanding of the risks a registrant faces and how those risks are managed will be increased.
In developing these rules, the Commission received letters from 97 respondents. Several significant issues were raised in these letters, and the Commission considered such issues prior to adopting the final rules. The more prominent issues follow.
Competitive Concerns. Some commentators expressed concern that the proposed quantitative disclosure requirements, particularly the tabular disclosure, would result in the presentation of proprietary information and competitively disadvantage registrants. They expressed concern that the tabular information required by the rules was so detailed and disaggregated that competitors, suppliers, and market traders potentially may be able to use the informat registrants' positions in the market. other commentators maintained that, in certain limited circumstances, period-end reporting of sensitivity analysis and value at risk amounts also may reveal proprietary information.
As an initial matter, the Commission notes that registrants concerned that tabular disclosure may result in the disclosure of proprietary information may, instead, provide disclosure of quantitative information about market risk using the sensitivity analysis and value at risk alternatives. Those alternatives do not necessarily require disclosure of detailed information. Moreover, after careful consideration, the Commission modified the sensitivity and value at risk rules to address proprietary concerns. Specifically for those registrants with concerns about reporting fiscal year-end information, the rules were revised to permit registrants to report the average, high, and low sensitivity analysis or value at risk amounts for the reporting period, instead of requiring the reporting of potentially proprietary year-end information.
In addition, some have commented that requiring registrants to comply with such disclosure requirements puts them at a disadvantage when compared with companies that file in other markets around the world. Although the rules apply to domestic and foreign registrants that file with the Commission, the Commission is aware that the rules require market risk disclosures that are more comprehensive than those required by other countries. Historically, the Commission has determined to impose new disclosure requirements on registrants only when the benefits of the disclosures outweigh the costs. The U.S. markets have thrived under this comprehensive disclosure framework and are the most liquid and efficient markets, affording ready capital that attracts users of capital from around the world, precisely because of the transparency afforded to investors. The new rules are consistent with this framework, and the commission believes that the utility of the disclosures will outweigh the costs.
Concerns About Flexibility. Several commenters suggested that the proposing rules requiring
quantitative information about market risk could be more flexible. In response to those commenters,
the Commission made several changes in the requirements that should enhance registrants' flexibility
in preparing the quantitative disclosures, and thereby also reduce costs. In addition to changes relating
to reporting the average, high, and low value at risk and sensitivity amounts described above, the more
significant changes include:
Comparability Concerns. Some commenter's suggested that the flexibility allowed in the rules would make it difficult for investors to compare disclosures across registrants. In developing the quantitative disclosures about market risks, it became clear there was not a consensus among experts on how to best present information about market risk. For example, some commenters, such as AIMR and Robert Morris & Associates, wanted more standardized disclosures that easily could be compared from registrant to registrant, while other commenters, including many registrants, wanted the flexibility to present the information in accordance with the approach used internally to manage their market risks. However, no commenter seeking added flexibility specified another approach that they wanted to use that was not already permitted by one of the three quantitative disclosure alternatives allowed by the rules.
The Commission tried to strike a careful balance between comparability and cost, often making decisions that the Commission believes should result in lower costs and more flexibility in the preparation of the disclosures. These decisions were influenced by the relatively nascent stage of market risk management methodologies.
The disclosure options provided to registrants to use one or more of three methods, and to use different methods for different portfolios and categories within portfolios, admittedly will limit comparability across registrants. To help investors better understand and compare registrants' disclosures, however, the rules require registrants to provide insights into how the disclosures were prepared, including the assumptions and parameters of the model selected, and the limitations on those disclosures. Also, the disclosures are required for the two most recent fiscal years, therefore, information will be available to allow investors to make comparisons of a registrant's market risk exposures between years.
The Commission expects that, over time, market risk management methodologies will converge. This convergence should aid in the comparability of the disclosures. Also, the Commission expects to reevaluate these disclosures with the goal of increasing comparability once the Commission, investors, and registrants gain experience in this area.
As noted above, users have identified the lack of market risk disclosures as a significant deficiency in the current financial reporting framework. The expected benefit of these rules is to make information about market risk sensitive instruments more accessible and understandable to investors and others. Moreover, by improving investor understanding of market risk, the Commission expects the rules to improve the efficiency of the markets.
Although the Commission solicited comment on the costs, none of the comment letters provided empirical or statistical information about the costs to comply with the proposed quantitative disclosures of market risk. Because information relating to accounting policies and qualitative disclosures are known and readily available to management, the Commission believes that costs to prepare those disclosures should not be substantial.
As a preliminary matter, for cost/benefit reasons, the Commission excluded small business issuers from the quantitative and qualitative disclosure requirements. With respect to other registrants, an important aspect of the quantitative disclosures requirement, from a cost perspective, is that registrants will have the flexibility to choose one or more of three disclosure alternatives (tabular presentation, sensitivity analysis, or value at risk) for disclosing such quantitative information. Thus, the costs associated with complying with this requirement depend largely on which disclosure alternative is chosen and whether the alternative selected is used currently by the registrant for management or regulatory purposes.
Some registrants are required to prepare quantitative information for regulatory capital measurement purposes. In particular, thrift institutions are required to prepare fair value sensitivity analyses for risk-based capital purposes. Also, banks and bank holding companies with significant exposure to market risk are required to prepare a value at risk analysis for risk-based capital purposes. Consequently, these entities should not incur significant additional cost. Similarly, other companies that use one of these alternatives for either management or regulatory purposes should not incur significant additional cost. The Commission also recognizes that the more complex and difficult disclosures will be required of those entities that have a larger number of instruments and more complex instruments; however, these entities are likely to be knowledgeable about market risk management methods and have risk management systems in place. Thus, many times the incremental costs are not expected to be significant for these entities.
A significant number of registrants, because of the size or nature of their businesses, do not have a significant number of derivative instruments or do not have complex instruments. For these companies, a simple tabular presentation may suffice. The time and cost to prepare such disclosures should not be significant. Admittedly, for larger commercial corporations currently not using one of the three alternatives, the costs for preparing and presenting the required information may be higher due to greater overall start-up costs.
In an effort to mitigate the costs of complying with the rules, the portion of the rules relating to quantitative and qualitative disclosures about market risk will be phased in. Registrants with market capitalizations over $2.5 billion or which have control over banks or thrifts are required to comply in filings that include financial statements for fiscal years ending after June 15, 1997, the phase-in date is June 15, 1998 for other registrants. Therefore, for registrants with fiscal years coinciding with calendar years, the first filings that require the new disclosure will be due in March 1998 or 1999. it is expected that about 600 registrants, plus banks and thrifts, will be included in the first phase.
The Commission believes that costs to comply with the rules will vary from registrant to registrant. Costs are expected to be highest for registrants with significant market risk exposures that do not currently manage those exposures in a centralized manner. Costs are expected to be lowest, however, for registrants that already use one of the three disclosure alternatives for internal risk management purposes. After considering the comments, the Commission estimated the average hours and cost per registrant to comply with the rules to be 80 hours at $100 per hour. Accordingly, the overall cost estimate was revised to be approximately $40 million for the approximate 5,000 registrants that, once the disclosure requirements are fully phased-in, will comply with the required disclosures.
In the near term, the Commission expects that the development of software will facilitate the preparation of the quantitative disclosures and reduce the associated costs materially. For example, the Commission understands that some of the data and the systems needed to develop these analyses recently have been made available at a relatively moderate cost.
In recent years, constituents of the financial reporting system increasingly have concluded that the current accounting model for derivatives has failed to provide adequate and timely disclosure to investors of important exposures facing public companies. Those concerns, and the growing use of derivatives as basic risk management tools, led the Commission to encourage the FASB to address the accounting for derivatives.
After substantial research and open debate, the FASB exposed a draft standard for public comment (the "exposure draft"). Since that time, as part of its deliberative process, the FASB has considered a number of alternative approaches, met with many interested parties, held public hearings, and reviewed the significant number of comment letters on its exposure draft. The FASB is now reviewing the comments received and re-deliberating its proposal.
Practically since its inception, the Commission has looked to the private sector for leadership in setting accounting standards, a role now being performed by the FASB. The Commission's role in this process generally has been one of oversight. Nevertheless, the Commission has the authority, and the responsibility, to see that accounting principles followed by registrants serve the interests of investors. Accordingly, we oversee all FASB standard-setting projects to assure that the FASB is operating in the public interest and that the results of its work are credible and are the product of an independent and unbiased process. The FASB's existing procedures, with public participation and commission oversight, ensure that there are opportunities for all interested parties to express their views, and that the views expressed are evaluated carefully.
The Commission's oversight includes consulting with the FASB and its staff, reviewing comment letters, and observing selected open meetings and public hearings. Although we rarely express definitive positions on the provisions of proposed standards, we consistently have encouraged the FASB to develop standards that provide high levels of transparency to underlying events and transactions, that eliminate needless accounting alternatives, and that are protective of the interests of investors. The Commission has provided such encouragement with respect to the FASB's project on accounting for derivatives and indicated that, after more than four years of debate, it is time for the FASB to finish its project and provide the much-needed new accounting standards for derivatives and hedging instruments.
Despite encouraged disclosures recommended by the FASB, the Basle Committee, an FEI task force, and other organizations, current disclosures with respect to market risk are not as helpful to investors as they should be. This concern has been stressed by many organizations including the GAO, AIMR, AICPA, Federal Reserve Board, and the report published by the Coopers & Lybrand Foundation.
In acknowledgment of the evolving nature of risk management, the Commission developed a disclosure framework that provides more useful information about market risk while allowing flexibility for change. The rules reflect careful balancing of numerous considerations. They require qualitative disclosures about accounting policies and market risk and, importantly, allow registrants to select from three disclosure alternatives when presenting quantitative information about market risk. Over the long term, these disclosures should ensure a better understanding by investors, by policy makers, and by regulators, of how derivatives and other financial instruments are used, what they do, what risks are inherent in their use, and how they play an important role in the management of market risks. The Commission expects to reevaluate the effectiveness of the disclosures after three years from the date the rules initially become effective.
The Commission shares this Subcommittee's commitment to ensure that the U.S. securities
markets remain the most vibrant and healthy markets in the world. If we are to maintain that status,
however, investors need to better understand the potential impact of derivatives and other market
sensitive instruments on the issuers of securities. The market risk disclosures adopted by the
Commission are an important and innovative development in ensuring that better understanding. The
Commission looks forward to the Subcommittee's ongoing oversight as we continue our consideration
of these issues.
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