234 PA R T I I I Financial Institutions the guidelines to examiners on trading and derivatives activities Now bank examiners focus on four elements of sound risk management: (1) the quality of oversight provided by the board of directors and senior management, (2) the adequacy of policies and limits for all activities that present significant risks, (3) the quality of the risk measurement and monitoring systems, and (4) the adequacy of internal controls to prevent fraud or unauthorized activities on the part of employees This shift toward focusing on management processes is also reflected in recent guidelines adopted by the Canadian bank regulatory authorities to deal with interestrate risk These guidelines require the bank s board of directors to establish interestrate risk limits, appoint officials of the bank to manage this risk, and monitor the bank s risk exposure The guidelines also require that senior management of a bank develop formal risk-management policies and procedures to ensure that the board of directors risk limits are not violated and to implement internal controls to monitor interest-rate risk and compliance with the board s directives Particularly important is the implementation of stress testing, which calculates losses under dire scenarios, or value-at-risk (VaR) calculations, which measure the size of the loss on a trading portfolio that might happen 1% of the time say over a two-week period In addition to these guidelines, bank examiners will continue to consider interest-rate risk in deciding a bank s capital requirements Disclosure Requirements The free-rider problem described in Chapter indicates that individual depositors and creditors will not have enough incentive to produce private information about the quality of a financial institution s assets To ensure that there is better information in the marketplace, regulators can require that financial institutions adhere to certain standard accounting principles and disclose a wide range of information that helps the market assess the quality of an institution s portfolio and the amount of its exposure to risk More public information about the risks incurred by financial institutions and the quality of their portfolios can better enable stockholders, creditors, and depositors to evaluate and monitor financial institutions and so act as a deterrent to excessive risk taking Disclosure requirements are a key element of financial regulation Basel puts a particular emphasis on disclosure requirements with one of its three pillars focusing on increasing market discipline by mandating increased disclosure of credit exposure, amount of reserves, and capital Provincial securities commissions, the most significant being the Ontario Securities Commission (OSC), also impose disclosure requirements on all corporations, including financial institutions, that issue publicly traded securities In addition, it has required financial institutions to provide additional disclosure regarding their off-balance-sheet positions and more information about how they value their portfolios Regulation to increase disclosure is needed to limit incentives to take on excessive risk, and it also improves the quality of information in the marketplace so that investors can make informed decisions, thereby improving the ability of financial markets to allocate capital to its most productive uses The efficiency of markets is assisted by the OSC s disclosure requirements mentioned above, as well as its regulation of brokerage firms, mutual funds, exchanges, and credit-rating agencies to ensure that they produce reliable information and protect investors Bill 198, introduced by the Ontario government in October 2002 in response to the Sarbanes-Oxley Act in the United States, took disclosure of information even further by increasing the incentives to produce accurate audits of corporate income statements and balance sheets, and put in place regulations to limit conflicts of interest in the financial services industry