A clearer view of risk

IFRS 7, Financial Instruments Disclosures, effective for annual periods beginning on or after 1 January 2007, introduces new requirements to improve the information on financial instruments that is given in entities’ financial statements. The standard is a move towards greater transparency around risk management, as disclosures are required to be based on an entity’s internal management reporting systems. This would mean that the risk management processes would be subject to a higher level of scrutiny - e.g. by the auditors who have to understand the systems that generate information reported in the financial statements - and the market would have a better knowledge of how companies are managing the risks.

In respect of credit risk, the standard introduces various additional requirements that include disclosure of changes attributable to credit risk in the value of a loan designated at fair value through profit or loss, qualitative and quantitative disclosure of exposure to credit risk, maximum exposure to credit risk, description of collateral and credit enhancements, information on credit quality and certain information on restructured or past due assets. However, the standard does not fully address the complexities introduced by increasingly popular instruments for gaining credit exposure - credit derivatives.

A credit derivative contract allows one party to get credit risk exposure of a third party, or parties that are not a party to the instrument. However, the standard defines credit risk as “the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation”. A strict interpretation of this definition would not recognise the underlying exposure in a credit derivative as credit risk. This would lead to inconsistent disclosure of otherwise similar cash and synthetic credit risk positions as funded positions would be included in credit risk disclosure, while synthetic positions would be excluded and would most likely be disclosed as market risk exposure.

Furthermore, the definition restricts the credit risk to “failure to pay”. Most credit derivatives require pay offs on events such as restructuring and bankruptcy in addition to “failure to pay”. However, it is not uncommon to find credit risk defined as a combination of “default risk” - which is risk of failure to pay - and “downgrade risk” - which arises from changes in market perception of the credit quality. The definition might be interpreted to exclude downgrade risk from credit risk disclosures and consider it as market risk. This difference of interpretation would have implications for quantification of credit risk for disclosure and hedging purposes.

The standard requires disclosure of “credit quality”; however, it has not specified a method to provide this information. Credit quality may be represented by credit ratings if the counterparties are rated, or by credit spreads or any other indicator. However, in the absence of a single suggested method, comparability of the disclosures across entities would be reduced. Credit derivatives also pose a challenge here. The ratings and spreads of structured transactions take into account the correlations of the underlying exposures - therefore, the credit rating of a portfolio of individual exposures would not be directly comparable to a similar exposure obtained through a structured transaction.

In respect of unrated exposures, the same words might be used by different entities to describe different levels of credit risk. For example, loans described as “doubtful” in one set of financial statements may represent 75% default probability while, in another, “doubtful” may represent 50% default probability. The standard encourages, but does not require, companies disclosing credit quality based on internal ratings to explain their internal rating process. It would be difficult to link a ratings methodology to the actual underlying risk without analysing the history of defaults or changes in the rating of individual exposures. In order to provide a better understanding of the effectiveness of the ratings process, it might be useful to include a history of actual and estimated losses over a period of time - this is comparable to loss development tables required under IFRS 4, Insurance Contracts.

Choice

Some entities may use regulatory definitions for disclosure in the financial statements while others may use economic risk capital to provide quantified information of the credit quality. As the standard has left the choice of method to disclose credit quality to the market, it would be interesting to see how the practice evolves.

The standard also requires summary quantitative data about the “exposure” to each type of risk, including credit risk, and further goes on to require quantitative disclosure of “maximum exposure” in respect of credit risk. As the standard does not define exposure, the participants with similar risks may describe these differently. For example, two banks presenting concentration analysis may allocate complex exposure into various categories on different bases, some entities may not adjust the exposures for correlations and entities with sophisticated systems may use correlations that reflect their own views.

Finally, the application guidance in appendix B to the standard, also supported by the discussion in basis for conclusion on the standard, specifies that the maximum exposure to credit risk for derivative contracts including credit derivative carried at fair value is its fair value. Interestingly, for a financial guarantee, it requires the disclosure of notional amount as maximum exposure.

From a risk management perspective, for a protection seller the fair value of a credit derivative represents the expected loss rather than the maximum loss. Maximum loss, consistent with the concept of maximum loss on loans, is the par value of the referenced obligation underlying the derivative. The standard applies this concept to financial guarantees but does not define the maximum risk of a credit derivative in similar terms.

In its current form, the guidance may lead to under reporting of maximum credit risk for credit derivatives as part of it might be disclosed as other market risk or omitted completely. For example, in the issuer’s books a single tranche Collateralised Debt Obligation has a fair value based on the tranches sold, but the credit risk is on the total of unsold tranches.

IFRS 7 is a significant improvement on the previous guidance; however, further guidance should be provided to address the complexities introduced by the rapidly developing credit derivatives market.

Due to the severity of loss that can arise from credit risk, developments in the trading of credit risk and recent default events, the credit risk disclosures are expected to be an important area of the financial statements. It might not be too early for various market forums to start discussing the guidance and to explore ways to ensure overall consistency in its application in order to provide a clearer view of the risk across the market.

Danish A Siddiqui is employed in the global capital markets group of PricewaterhouseCoopers.