Market transparency is a simple concept that brings huge private and public rewards. Adoption of good disclosure practices makes the financial markets fair and thus encourages people to invest their savings. What is also important is the transparency of not just markets but transparency of companies. Transparency, which applies to self-dealing and share trading by management as well as company revenues and profits also gives substance to shareholder rights by providing the information essential to their decisions.

Also, good disclosure forces Supervisory Councils and Management Boards of banks to manage better and thus benefits employees, investors and the country as a whole. When speaking about corporate governance the first thoughts that come to mind are the legal requirements and structures of the Supervisory Councils and Management boards. However, the very positive effect on corporate governance itself is the financial reporting system, and in particular, full transparency and disclosures.

The absence of a large, long term shareholder (e.g. “the main bank” system that dominate in the German industry) can be compensated by vast mass of shareholders and investors (e.g. US and UK capital markets) thanks to the system of full transparency and good disclosure.

Transparency seems simple but is highly complex

Transparency is easy to define but in the reality is complex and difficult to maintain. It has many dependent parts. The financial markets depend on good disclosures. The entire history of financial markets demonstrates the need for government laws, rules, oversight and discipline to ensure that investors receive the information they need.

Also, financial reporting rests on the variety of difficult judgments, such as provisions, contingent liabilities, revenue recognition and other factors. The goal to make financial reporting consistent from year to year and comparable across banks is not an easy task. Even with government regulation, market abuse and excesses are possible, and without it, they are inevitable.

Apart from demands of the financial markets, transparency is effected by other groups of participants, such as:

accounting standard setting groups, that operate under the oversight of the security exchange commissions (e.g. in the US, the Financial Accounting Standards Board is privately run but operate under the oversight of SEC) or other government bodies (e.g. in Ukraine, the accounting standards are set by the Ministry of Finance);

security analysts who prepare economic and industry analyses for investors on the basis of company-specific reports;

credit rating agencies which do similar work (as security analysts) for banks and other lenders and often have preferred access to data;

investment banks which market new issues of shares to investors;

major law firms which structure complex transactions that can be used to enhance or defeat transparency; and

audit firms: if disclosure begins with management it surely ends with accountants.

Comprehensive, accurate, relevant and timely public disclosure benefits:

bank – it enables the bank to access capital markets more efficiently and strengthens their market discipline;

shareholders -it enhances the wider set of shareholders to participate in the governance of the bank and makes the corporate governance process more transparent;

market participants – because they can use the information as a basis for making various types of business decisions;

bank supervision – it enables them to control systemic risks and take early corrective measures.

There are inherent difficulties in making a bank transparent:

financial strength and performance may be heavily dependent on accounting estimates (such as loan impairment and various provisions) and therefore, is a subject to certain degree of uncertainty;

important elements of banks’ risk strategy and internal controls may be difficult to communicate meaningfully and as a result, difficult to make transparent sometimes;

banks, due to the need to preserve a degree of confidentiality, can not publicly disclose all data that may be relevant to assessment of its activities and risk exposures.

Privacy laws may restrict a bank’s ability to disclose information on individual customers; sometimes costs involved in preparing public disclosures (e.g. publication costs; costs in developing, implementing and maintaining the system to generate the required disclosures etc) can be very significant. banks are not motivated to promote full transparency when:

disclosure standards are not reinforced by government and regulators and shareholders, creditors and market participants tend to rely on secondary information (credit ratings, media and rumors);

bank heavily rely on retail deposit customers that may lack skills to monitor a bank’s condition via its public disclosures;

a bank is on the brink of bankruptcy, its share capital eroded – shareholders may have an economic interest to tolerate or promote risky strategies, since they have little to lose.

In many countries, comprehensive accounting and reporting guidance is available on the presentation and disclosure of main categories of information, each of which should be addressed in clear terms and appropriate detail to help achieve a satisfactory level of bank transparency.

Great volume of authoritative guidance has been issued by legislators, regulators, national and international accounting standard-setters. This can be used as a reference source to identify appropriate disclosures and to gain an understanding of why they are useful.

Example

In 2001, Trema Group (the premier provider of strategic software solutions for the financial industry) issued the annual survey on financial risk management disclosure. The survey covered the 2000 annual reports of 45 large European banks from 14 countries. The main focus of the survey was the level and quality of disclosures in the following areas:

strategic risk and shareholder value information;

credit risk;

market risk;

operational risk;

assets and liability management;

These areas included about 70 items, including description of definitions, risk management methods and tools, description of policies, strategies and objectives, quality and extent of quantitative data, organization and reporting issues. Each items was graded on a scale of0to5: 5 -excellent/best practice, 3 – satisfactory, 1 – inadequate, 0 – no information.

There were considerable differences in the level of risk disclosure among surveyed banks. These differences were largely due to cultural differences between geographic areas and especially due to differences in the size of the banks. In general, Nordic, German and Swiss banks tend to present the best disclosures on risks, although British and Spanish banks are also among the top performers. Usually, larger banks tend to disclose more information than smaller ones. However, the difference in the level of disclosure between the worst and best performers were alarming.

The Basel Committee considers bank transparency to be of the utmost importance. Financial market players can reinforce the efforts of bank supervision if they have access to timely and reliable information which enables them to assess a bank’s activities and the risks inherent in those activities. Toward this end, banks and bank supervisors need to ensure that appropriate disclosures are being made.

To achieve transparency a bank, in its financial reports and other disclosures to the public, should provide timely information on key factors affecting market participants’ assessment of banks. Basel Committee sets forth the following six broad categories of information, each of which should be addressed in clear terms and appropriate detail to help achieve a satisfactory level of bank transparency:

basic business, management and corporate governance information;

risk management strategies and practices;

risk exposures (including credit risk, market risk, liquidity risk, and operational, legal and other risks);

financial performance;

financial position (including capital, solvency and liquidity); and

accounting policies.

To accurately evaluate a bank’s disclosures about its financial position and financial performance and its risks and risk management strategies, market participants and bank supervision need fundamental information about the bank’s business, management and corporate governance.

Such information can help provide the appropriate perspective and context to understand a bank’s activities. For example, management’s discussion about the bank’s position in the markets in which it competes, its strategy and its progress towards achieving its strategic objectives is important for assessing the bank’s future prospects.

Banks should consider providing general information that would help market participants and supervisors gain a broad understanding of the bank’s corporate culture. Banks should be innovative in identifying the types of information they provide and the methods by which they present such data.

Bank’s organizational structure, in terms of both its legal and management structure, provides information about an institution’s key activities and its ability to respond to changes. Accordingly, it is appropriate to disclose information about the Supervisory Council structure (e.g., the size of the Council, committees, and membership), senior management structure (responsibilities, reporting

Disclosure of basic business, management and corporate governance information lines), and the basic organizational structure (line of business structure, legal entity structure).

In addition, information should be provided about the qualifications and experience of the Council and Management Board senior executives. This information may be helpful in assessing how an institution may perform in times of stress or how it may react to changes in the economic or competitive environment.

Information about the incentive structure within a bank, including its remuneration policies, such as the amount of executive compensation and the use of performance bonuses and share options, helps evaluate the incentives management and staff have to take excessive risks. Useful information may include a summary discussion of the philosophy and policy for executive and staff compensation, the role of the Council in setting compensation, and compensation amounts.

In addition, banks should provide information on the nature and extent of transactions with affiliates and related parties. Such information is useful in identifying relationships that may have a positive or negative impact on a bank’s financial position and performance.

Management Discussion and Analysis (MD&A) disclosure provides a context within which the financial results and financial position portrayed in the financial statements can be interpreted. It also provides material historical and prospective disclosure in the text of a document that enables shareholders and other users of information to assess the financial condition, changes in financial condition and results of operations of a public company, especially the prospects for the future.

The main requirement to this voluntary information is to be in conformity with facts and conclusions contained in the audited set of financial statements.

Example

Below is provided the extract from the MD&A section of the 2002 annual report of the National City Corporation (top 10 bank in the United States), as an example of MD&A disclosure as relates to the discussion of non interest expenses.

Non-interest expense

Details of noninterest expense follow:

Noninterest expense was $3.7 billion in 2002, compared to $3.3 billion in 2001 and $3.2 billion in 2000. In general, the increases in noninterest expense over the past two years reflected higher personnel, processing, and operational costs associated with increased business volumes and various brand development, technology, and service quality initiatives.

Salaries, benefits, and other personnel expense increased in both 2002 and 2001 primarily due to a higher level of commissions and contract labor costs associated with mortgage loan origination and sales activity. Employee benefit-related expenses rose in both years due to higher costs associated with medical benefits, an increase in contributions to 401 (k) plan participants and, in 2002, a reduction in the net periodic benefit earned related to the Corporation’s defined benefit pension plan. The Corporation expects the net periodic pension benefit to decrease to approximately $15.7 million in 2003 due to a decline in the fair value of plan assets related primarily to the decline in the equity markets. Further discussion of the Corporation’s benefit plans is included in Note 22 to the consolidated financial statements. The Corporation also plans to begin expensing stock options in 2003, as discussed in Note 2 to the consolidated financial statements, and estimates the associated pretax cost will be approximately $18 million. National City’s staffing level on a full-time equivalent basis was slightly higher than at the end of 2001 as increases in staff to support the record level of mortgage banking activity were mostly offset by personnel reductions resulting from efficiencies achieved across the Corporation and operational changes at National Processing. The decline in staff from 2000 to 2001 was associated with divestitures at National Processing.

Equipment and net occupancy expenses increased in both 2002 and 2001 in conjunction with investments made to improve processing and communications equipment within the branches and back office of the retail banking network.

Third-party services expense rose in both 2002 and 2001 primarily due to an increase in activities outsourced related to the significant increase in mortgage banking volumes and, to a lesser extent, increases in regulatory examination fees, payment processing referral fees, and professional service fees.

The increases in card processing expense in 2002 and 2001 were driven mainly by volume increases in payment processing activity at National Processing and increases in credit and debit card usage by retail banking customers.

Amortization expense associated with intangible assets declined in 2002 due to the adoption of Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets. Upon adoption on January 1, 2002, the Corporation ceased ratably amortizing its goodwill into the income statement. Further discussion of the adoption of SFAS 142 and detail of goodwill and other intangible assets is included in Note 9 to the consolidated financial statements.

Marketing and public relations expense in 2002 included a $52.8 million charge related to the donation of appreciated investment securities to the Corporation’s charitable foundation. Excluding this charge, marketing and public relations expense increased due to costs associated with a brand awareness campaign, which included targeted television and print advertising across the National City footprint.

State and local tax expense increased in 2002 due primarily to an increase in franchise taxes paid by the Corporation’s subsidiary banks as a result of higher capital levels. State and local tax expense was reduced in 2000 by the receipt of several tax refunds.

Other real estate owned expense is comprised of costs associated with maintaining and selling properties held for sale which were either obtained in satisfaction of nonperforming loans or were formerly used as bank premises. Also included in expense are any disposition gains and losses resulting from the sale of these assets, as well as any write-downs in the estimated fair values of such properties while they are held for sale. Other real estate owned expense has increased over the past two years as a result of an increase in the amount of other real estate owned, principally resulting from residential mortgage foreclosures.

Other noninterest expense in 2002 increased due primarily to losses related to the revaluation of community development and civic partnership investments, which totaled $67.6 million in 2002, compared to $7.1 million in 2001, a $15.9 million loss incurred in 2002 upon the consolidation of an asset-backed commercial paper conduit, higher expenses associated with mortgage banking activities, and increases in minority interest expense and fraud losses. Somewhat offsetting the increase in other expense in 2002 was a decline in write-downs taken on automobile lease residual values, which totaled $50.9 million in 2002 compared to $67.4 million in 2001. Noninterest expense in 2000 included $41.0 million of automobile lease residual value write-downs and an $18.0 million charge related to closing certain nonconforming retail and wholesale loan origination units and ceasing the origination of automobile leases.

The efficiency ratio, which expresses noninterest expense as a percentage of tax-equivalent net interest income and total fees and other income, was 55.1% for 2002, down from 55.7% in 2001 and 58.8% in 2000. Over the past two years, the Corporation’s efficiency ratio has improved due to revenue growth and cost management across all business lines.

Under all of the approaches this disclosure is viewed as fulfilling several important objectives:

First, MD&A-type disclosure enables shareholders and investors to see the bank “through the eyes of management.”

Second, MD&A-type disclosure improves financial disclosure overall and provides the context within which financial statements should be analyzed. Third, MD&A-type disclosure provides information about the different components of earnings and cash flow and the extent to which they are recurring elements, thereby enabling shareholders and investors to make a better prediction about the sustainability of earnings and cash flow in the future.

Fourth, MD&A-type disclosure provides information about the risks to a bank’s earnings and cash flow.

The following principles are the useful guidance for banks in preparing MD&A-type disclosure and for regulators in reviewing such disclosure:

MD&A-type disclosure should highlight the most relevant information.

MD&A-type disclosure should be clear, concise and meaningful, and in plain language.

MD&A-type disclosure should be presented in a format that will enhance the comprehensibility of the financial statements to shareholders, as well as to other users of this information, such as investment advisors and rating agencies.

Irrespective of whether it is provided as a separate report or included as part of a periodic report, MD&A-type disclosure should be provided at the same time as the presentation of the relevant financial statements.

Precautions when preparing MD&A-type disclosure in order to satisfy these objectives:

Care should be taken to avoid the use of complicated language that appears to be in technical compliance with disclosure requirements, but that nonetheless fails to provide shareholders/investors with appropriate information they need to make valuation and investment decisions.

MD&A-type disclosure should be properly crafted to address a bank’s specific situation. This will increase the overall quality of financial reporting, and assure material correctness and completeness of financial reporting regardless of the detailed accounting and financial requirements applied.

MD&A-type disclosure should provide an objective analysis that may require the disclosure of information that could reflect negatively on the company’s financial condition, changes in financial condition and results of operations.

Example

Strategic Finance Magazine, the official magazine of the Institute of Management Accountants, has surveyed 140 sell-side star analysts to find out what analysts really want in doing their work.

The financial analysts came from a group honored as All-Star Analysts by The Wall Street Journal or as members of the All-America Team by Institutional Investor magazine.

Half the star analysts believe that the current disclosures by corporations are inadequate to facilitate an increased role of investors in corporate governance.

An overwhelming majority of the analysts, 91%, believe they are getting the information they need to forecast future financial performance, but only 41% believe that they receive the information necessary to diagnose the source of any company problems if the strategy is ineffective

Most analysts do find annual reports an important source of information. The management discussion and analysis (MD&A) section and most other parts are well read and used. One notable exception is the balance sheet that analysts often perceive as irrelevant because of its reliance on historical costs and arbitrary write-offs of intangible assets.

More than 85% of the analysts said they would like more information on key business risks and uncertainties, financial liquidity and flexibility, the competitive strategy of the significant business units, and an identification of the corporate strategy. Another item that star analysts want is a budgeted income statement for the coming year with an earnings forecast included in the MD&A section. This result is also consistent with other results related to the importance of MD&A.

Thirty-five percent of the analysts have difficulty understanding the footnotes, and 55% would like further explanation of the footnotes. 18% of the analysts had trouble understanding the statement of cash flows, and 34% would like further explanation of this financial report. Some 49% would like further explanation of the MD&A.

The bottom line is that financial analysts want companies to be more forthcoming with their financial information and provide more voluntary disclosures that “tell the corporate story” to external users.

Disclosures may include discussions of overall risk management philosophy, overall policy and methodologies, how risks arise, how risks are managed and controlled, and whether and how derivatives are used to manage risks. It may also be useful to discuss the risk management structure and risk measurement and monitoring (e.g., models, value-at-risk, simulation, credit scoring, capital allocation, etc.), monitoring process, model validation process, stress testing, back testing, the use of risk-mitigating tools (collateral/guarantees, netting agreements, managing concentrations), limits (e.g., credit limits, market risk limits), and periodic review of exposures.

Disclosure of risk exposures

Market participants and bank supervision need qualitative and quantitative information about bank’s risk exposures, including its strategies for managing risk and the effectiveness of those strategies. Understanding of the nature and extent of an institution’s risk exposures helps assess stability of an institution’s financial position and the sensitivity of its earnings potential to changes in market conditions.

Traditionally, banks have focused on disclosing information about credit risk and market risk, including interest rate and foreign exchange risk, and, to a lesser extent, liquidity risk.

In discussing each of these risk areas, a bank should present sufficient qualitative (e.g., management strategies) and quantitative information (e.g., position data) to help readers understand the nature and magnitude of these risk exposures. Further, comparative information of previous years’ data should be provided to give the financial statement user a perspective on trends in the underlying exposures.

Other risk exposures such as operational, legal and strategic risk are less easy to quantify, but may be highly relevant. Qualitative information should be given about the nature of the risks and how they are managed.

For many banks, credit risk is the most significant exposure. Although typically it arises primarily from the loan portfolio, credit risk also arises in the investment and trading portfolios and in other banking activities (e.g. asset securitization, interbank lending, overnight deposits).

Credit risk

To achieve transparency, a bank should provide descriptive information about the business activities that create credit risk, its strategies regarding those business lines, and the nature and composition of the exposures that arise. Useful disclosures include a discussion about business strategies, risk management processes and internal controls relating to activities that generate credit risk.

Example of required credit risk disclosures:

- gross position on loan exposure;

- industry/sector concentrations;

- individual credit exposures;

- amounts of problem/impaired loans;

- details and movements in provision for impaired loans;

- policies and details about use of collateral and guarantees;

- use of credit assessment methods;

- portfolio risk measurement tools;

- organization of credit risk function; and

- other relevant discussions about activities on managing credit risk exposure

Market risk

As with credit risk, an institution should provide both quantitative and qualitative information regarding its market risk exposures. Market risk arises from the potential for changes in market rates and prices, including interest rates, foreign exchange rates, and equity and commodity prices. A bank’s disclosures about each of these types of risk should be comparable with the degree of exposure.

Since interest rate risk is especially relevant to banks, disclosure should provide detailed quantitative information about the nature and extent of interest rate-sensitive assets and liabilities and off-balance sheet exposures. Examples of useful disclosures for this information include breakdowns of fixed and floating rate items and the net interest margin earned.

Other useful disclosures include the duration and effective interest rates of assets and liabilities.

Disclosures should also provide information about the interest rate sensitivity of a bank’s assets and liabilities.

For example, disclosures about the effect on the value of assets and liabilities given a specific range of changes (increase or decrease) in interest rates can provide a useful summary measure of the bank’s risk exposure.

To facilitate understanding of foreign exchange risk exposures, banks should provide summarized data for significant concentrations of foreign exchange exposure by currency, broken down by hedged and unhedged exposures. It is also helpful to disclose information about investments in foreign subsidiaries (foreign currency translation risk). This quantitative information should be supplemented with discussion about the nature of the currency exposure, how that exposure has changed from year to year, foreign exchange translation effects, the earnings impact of foreign exchange transactions and the effectiveness of risk management (hedging) strategies.

Example:

The extract from the 2002 UBS Group’s annual report is provided below for the best practice example for market risk disclosure (page 131 of annual report):

Market Risk

Overview

Market risk is the risk of loss arising from movements in observable market variables such as interest rates, exchange rates and equity markets. In addition to these and other general market risk factors, the risk of price movements specific to an individual issuer of securities is considered market risk.

Market risk is incurred in UBS primarily through trading activities which are centered in the Corporate and Institutional Clients business of UBS Warburg. It arises primarily from market making, client facilitation and proprietary positions in equities, fixed income and interest rate products, foreign exchange and, to a lesser extent, precious metals and energy. Such activities are mainly in OECD markets, with some business in emerging markets.

Group Treasury assumes non-trading risk positions that arise from its balance sheet management activities. Further market risks arise, but to a much lesser extent, in other businesses primarily from the facilitation of customer business. Market risk measures are applied to all foreign exchange, precious metal and energy positions, to the trading books of UBS Warburg, to interest rate risk in the Group Treasury book and the private banks, and to any other material market risk arising. The principal risk measures and controls on market risk are Value at Risk (VaR) and stress loss. VaR expresses the potential loss on the current portfolio assuming a specified time horizon before positions can be adjusted (holding period),and measured to a specified level of confidence, based on historical market movements.

Stress loss is assessed against a set of forward-looking scenarios, approved by the Board of Directors, using stress moves in market variables. Complementary controls are also applied where appropriate, to prevent undue concentrations, including limits on exposure to individual market risk variables, such as individual interest or exchange rates, and limits on positions in the securities of individual issuers. These controls are set at levels which reflect variations in price volatility and market depth and liquidity.

It should be noted that, in management’s view, any representation of interest rate risk at a specific date offers only a snapshot of the risks taken by the Group, since both trading and non-trading positions can vary significantly on a daily basis, because they are actively managed. As such, it may not be representative of the level of risk at other times, either in general or in specific currencies or tenors. Furthermore, the presence in the portfolio of option products means that only limited inferences can be drawn about exposure to larger movements in interest rates. The table sets out the extent to which the Group was exposed to interest rate risk at 31 December 2001 and 2002. It shows the net impact of a one basis point (0.01%) increase in market interest rates across all time bands on the fair values of interest rate sensitive positions, including balance sheet assets and liabilities and derivatives.

The impact of such an increase in interest rates depends on the net asset or net liability position of the Group in each category, currency and time band in the table. A negative amount in the table reflects a potential reduction in fair value as a result of an increase in interest rates, while a positive amount reflects a potential increase in fair value.

Interest rate sensitivity position

Liquidity risk

Liquidity is the ability to have funds available to meet the commitments of the bank. To enable market participants to understand a bank’s liquidity risk exposure, a bank should provide information about its available liquid assets, as well as its sources and uses of funds.

For example, disclosures about short-term assets (e.g., cash and cash equivalents, repurchase agreements and interbank loans) and short-term liabilities (e.g., reverse repurchase agreements) provide basic information about an bank’s liquidity profile.

A cash flow statement shows the sources and uses of funds and provides an indication of an bank’s ability to generate liquid assets internally. Information about concentrations of depositors and other fund providers, maturity information about deposits and other liabilities, and the amount of securitized assets, are useful in assessing an bank’s liquidity.

Descriptive discussion about the diversity of funding options and contingency plans provides additional perspective on the potential impact of liquidity risk to the bank.

Example

As the example of the liquidity risk disclosure below are provided extracts from the 2001 annual report of Deutsche Bank.

As our balance sheet has grown significantly in the recent years, our liquidity management function has become more important. With our finalizing of the funding matrix and the stress testing capabilities we describe below, we have concluded the last steps to establish a fully integrated liquidity risk management framework.

The Funding Matrix shows the excess or shortfall of assets over liabilities in each time bucket and thus allows us to identify and manage open liquidity exposures. We have also developed a cumulative mismatch vector, which enables us to predict whether any excess or shortfall will grow, decline or switch over time. The Funding

Matrix forms the basis for our annual securities issuance plan which upon approval of our Group Asset and Liability Committee establishes issuing targets for securities by tenor, volume and instrument. On the basis of this model we have not identified any material funding mismatches.

Short-term Liquidity

We have established a system to track net cash outflows over an eight-week horizon. This system allows management to assess our short-term liquidity position in any location, region and globally on a by-currency and by-product basis. The system captures all of our cash flows, thereby including liquidity risks resulting from off-balance sheet transactions as well as from transactions on our balance sheet. We model transactions which have no specific contractual maturities using statistical analysis to capture the actual behavior of these transactions. Our Group Board, upon the recommendations of our Group Asset and Liability Committee, has set global and regional limits for the liquidity exposures which we monitor on a daily basis.

Funding Diversification and Asset Liquidity

Diversification of our funding profile in terms of investor types, regions, products and instruments is an important part of our liquidity policy. Our core funding resources, such as retail and fiduciary deposits and long-term capital markets funding, form the cornerstone of our liability profile. Customer deposits, funds from institutional investors and interbank funding are additional sources of funding. We use interbank deposits primarily to fund liquid assets.

In 2001, we completed the development of stress testing and scenario analysis to evaluate the impact of sudden, unforeseen events with an unfavorable impact on the bank’s liquidity. The scenarios are either based on historic events (such as the stock market crash of 1987, the U.S. liquidity crunch of 1990 and the terrorist attack of September 11, 2001) or modeled using hypothetical events. They include internal scenarios (such as operational risk, merger or acquisition, credit rating downgrade by 2 and 4 notches) as well as external scenarios (such as market risk, emerging markets, systemic shock and prolonged global recession).

Under each of these scenarios we assume that all maturing assets will need to be rolled over and require funding whereas rollover of liabilities will be partially impaired. We then model the steps we would take to counterbalance the resulting net shortfall in funding needs such as selling assets and adjusting the price we would pay for liabilities. This analysis is fully integrated within the existing liquidity framework. We take our contractual cash flows as a starting point, which enables us to track the cash flows per currency and product over an eight-week horizon (the most critical time span in a liquidity crisis) and apply the relevant stress case to each product. Asset saleability as described in the paragraph above complements the analysis. Our stress testing analysis provides guidance as to our ability to survive critical scenarios and would, if deficiencies were detected, cause us to make changes to our asset and liability structure. The analysis is performed monthly.

To assess the financial performance of a bank it is essential to have a breakdown of income and expenses. It typically includes an income statement that groups income and expenses by nature or function within the bank. For example, business and geographical segment information aids in the analysis of past performance and assists in assessing future prospects.

Information about the accounting policies that have been employed in the preparation of financial reports should also be disclosed. Accounting policies, practices and procedures differ not only between countries, but also between banks in the same country. Accordingly, users of accounting information need to understand how items are being measured to properly interpret the information.

Disclosure of significant accounting policies on which financial reporting is based enables users to make reliable assessments of the bank’s reported position and performance.

Disclosure of accounting policies may include a general accounting principles, changes in accounting policies/practices, principles of consolidation, policies and methods for determining when assets are impaired, recognizing losses on impaired assets and losses on non-performing credits, policies to establish specific and general loan loss allowances, income recognition, valuation policies (trading securities, investment securities, loans, tangible fixed assets, intangible fixed assets, liabilities, etc.), recognition/derecognition policies, securitizations, foreign currency translations, loan fees, premiums and discounts, repurchase agreements, securities lending, premises/fixed assets, income taxes, and derivatives (hedging, non-hedging, losses on derivatives).

Example

Below is the example of the accounting policy for determining the provision for loan losses as described in 2002 annual report of HSBC Bank.

It is HSBC’s policy that each operating company will make provisions for bad and doubtful debts promptly where required and on a prudent and consistent basis. Loans are designated as non-performing as soon as management has doubts as to the ultimate collectability of principal or interest or when contractual payments of principal or interest are 90 days overdue. When a loan is designated as non-performing, interest will be suspended and a specific provision made if required. However, the suspension of interest may be deferred for up to 12 months past due in the following situations:

where cash collateral is held covering the total of principal and interest due and the right of set-off is legally sound; or

where the value of net realisable tangible security is considered more than sufficient to cover the full repayment of all principal and interest due and credit approval has been given to the rolling-up or capitalisation of interest payments.

There are two basic types of provision, specific and general, each of which is considered in terms of the charge and the amount outstanding. Specific provisions

Specific provisions represent the quantification of actual and expected losses from identified accounts and are deducted from loans and advances in the balance sheet.

Other than where provisions on smaller balance homogenous loans are assessed on a portfolio basis, the amount of specific provision made is assessed on a case by case basis. The amount of specific provision raised is HSBC’s conservative estimate of the amount needed to reduce the carrying value of the asset to the expected ultimate net realisable value, and in reaching a decision consideration is given, among other things, to the following factors:

the financial standing of the customer, including a realistic assessment of the likelihood of repayment of the loan within an acceptable period and the extent of HSBC’s other commitments to the same customer;

the realisable value of any security for the loan;

the costs associated with obtaining repayment and realisation of the security; and

if loans are not in local currency, the ability of the borrower to obtain the relevant foreign currency.

Where specific provisions are raised on a portfolio basis, the level of provisioning takes into account management’s assessment of the portfolio’s structure, past and expected credit losses, business and economic conditions, and any other relevant factors. The principal portfolios evaluated on this basis are credit cards and other consumer lending products.

International Accounting Standard No. 30 “Disclosures in the financial statements for banks and similar financial institutions” and NBU instruction No. 545 dated 26.12.2001 “On preparation of annual financial statements” provide detailed guidance on the format and content of the components of the financial statements of a bank.

Disclosure is the principal mechanism for achieving transparency. But disclosure has its limitations. Disclosure does not equal transparency. Transparency depends upon the existence of a rigorous and comprehensive disclosure framework and upon a committed response by the private sector to these requirements.

Furthermore, the market demands more than disclosure and looks for some form of independent verification of the disclosed information. Investors must be able to feel confident about the numbers. Financial statements have to represent a true and fair statement of the health and wealth of companies. Accounting and audit firms have a key role in ensuring that this happens.

Regulation of the audit profession is important to ensure accounting standards are properly adhered to. In many countries regulations on auditor independence were revised, targeting potential conflicts of interest by requiring that audit firms should not provide non-audit services where this would compromise the auditor’s ability to take an independent view.

Particularly, after Enron scandal, the auditors’ independence has been heavily criticized. Until recently, in some countries like USA, audit fees comprised only about 25% of large audit firms. More money, more interesting work and more growth lay in the consulting area that accounting firms can gain once they receive the audit work from the client. As a result, the audit was blamed to become an industry rather than a profession because auditors’ ability to say ‘no’ to the client was diminished.

Example

In the United States, the Sarbanes-Oxley Act, which became law in July 2002 contains a number of provisions to improve accounting, audit independence and disclosure rules. To bolster independence of external auditors, it prohibited external audit firms from providing certain internal audit and other consulting services to their clients. As a result, large audit firms had to dispose of their consulting divisions (PricewaterhouseCoopers Consulting was sold to IBM, Andersen Consulting became known as Accenture, BearingPoint was formerly KPMG-Consulting etc).

The explosive growth of investing and raising capital in the       global markets has put new emphasis on the development of international accounting, auditing, and ethical standards. The worldwide accountancy profession, together with issuers of financial statements, users, regulators, and other bodies, have been putting a great effort in the development of high-quality standards that can be implemented in the global as well as the domestic capital markets. The harmonization of these standards is receiving greater and greater attention by the participants in these markets.

International standards on auditing are promulgated by the International Auditing Practices Committee (IAPC) of the International Federation of Accountants. A codified core set of international standards on auditing were completed and released in 1994. The release of the core set has led to a growing acceptance of the standards by national standards setters and auditors involved in global reporting and cross-border financing transactions.

The benefits for the use of common global accounting standards by preparers of financial statements and common auditing standards by auditors of those statements have been debated for a number of years. Although the debate continues, there is strong support for the creation of a common set of standards for use in capital markets around the world, particularly for cross-border financing transactions.

Two important sets of standards have emerged as candidates for widespread adoption: the accounting standards being developed by the International Accounting Standards Committee (IASC) and the auditing standards being developed by the International Auditing Practices Committee (IAPC) of the International Federation of Accountants (IFAC).

Since their release, there has been a growing acceptance of International Standards on Auditing (ISAs), particularly adoption and use of the standards by:

a number of the large international accounting firms as the basis for their worldwide auditing standards;

global public companies reporting outside their national borders;

companies involved in issuing securities in cross-border financing transactions;

companies issuing securities in domestic financing transactions;

regulatory bodies accepting financial statements audited using the ISAs for regulatory filings in their countries, or requiring the use of ISAs by including them in company law;

global organizations, such as the Organization for Economic Cooperation and Development, that have endorsed ISAs for use in auditing financial statements in their jurisdictions; and

national accountancy bodies that have used ISAs as the basis for their national auditing standards.

A 1998 survey of IFAC member bodies revealed some interesting information. First of all, of the 65 countries responding, the survey showed that eighteen (18) countries have completely adopted the ISAs as their national auditing standards. Of the remaining 47 countries, the survey showed that:

28 countries had no significant differences between the national standards and the ISAs;

9 countries had some significant differences, usually relating to reporting; and

10 countries had not identified whether there were any differences.

The Cabinet of Ministers of Ukraine and National Bank of Ukraine have declared the objective to adopt the ISA in Ukraine by 2004.

In May 2003, the Chamber of Auditors of Ukraine has made the decision to introduce the ISA as the national audit standards in Ukraine.

International Standards on Auditing comprise about 40 separate standards. In general, these standards cover the broad range of issues such as planning the audit, execution procedures, audit completion and reporting.

For example, the standards listed below have a particular relevance to the audit of banks and financial institutions:

“Communications of audit matters with those charged with governance”

“Audit of accounting estimates”;

“Auditing fair value measurements and disclosures”;

“Related parties”;

“Considering the work of internal auditing”.

The exact role of external auditors varies from country to country. One constant, however, is the independent auditors’ requirement to provide an opinion on the truth and fairness of financial statements. It is also widely expected that external auditors will gain an understanding of a bank’s internal control system to the extent that it relates to the accuracy of the bank’s financial statements.

It is also generally expected that material weaknesses identified by the auditors would be reported to Supervisory Council and Management Board and, in many countries, to the bank supervision authority. In countries where external auditors have a close relationship with the supervision authority, they are often requested to give an opinion on the functioning and the quality of the internal audit department of a bank. Supervisory Council and the Management Board should ensure the implementation of remedial actions related to internal control weaknesses outlined in the reports of the external auditors.

The bank’s Supervisory Council has the ultimate responsibility for ensuring that Management board establishes and maintains an adequate and effective system of internal controls, a measurement system for assessing the various risks of the bank’s activities and appropriate methods for monitoring compliance with laws, regulations and internal policies.

Chapter summary

Transparency is the main element of sound corporate governance

To achieve full transparency a bank should provide detailed disclosures in the following areas:

basic business, management and corporate governance information

risk management strategies and practices;

risk exposures (credit risk, market risk, liquidity risk, operational and other risks);

financial performance;

financial position;

accounting policies;

Effectiveness of disclosures depends on existence of independent verification of disclosed information.