Financial instruments – Hedge accounting
The hedge accounting exposure draft carried forward the existing hedge accounting guidance from IAS 39 related to designation of portions of items that are larger than the cash flows of the hedged item (commonly referred to as the 'sub-LIBOR issue'). While the issue is not limited only to hedging of interest rate risk, this is where the issue primarily arises; specifically because certain instruments are priced sub-LIBOR and therefore have cash flows less than the benchmark interest rate.
During the comment letter process and Board's outreach activities, the staff recognised there was some level of confusion around the guidance included in the exposure draft. Some respondents requested that the Board differentiate between sub-LIBOR instruments with a floor at zero per cent and instruments without a floor as the original agenda paper prepared by the staff noted the issue only arises when the interest-bearing instrument has a floor. Additionally, respondents requested the Board reconsider the restriction with respect to 1) hedging a net exposure where the aim is to lock in a fixed interest margin, 2) hedging a non-financial item priced below the benchmark, and 3) hedging of core deposits and macro hedge accounting.
For the discussions today, the staff asked the Board to focus solely on the issue of using a hedging instrument based on a benchmark risk to hedge an item with total cash flows less than those associated with that benchmark, and the purpose is to hedge a fixed margin between an interest-bearing financial asset and an interest-bearing financial liability.
The staff proposed retaining the restriction from the exposure draft for portions of items larger than the cash flows of the hedged item when an interest rate floor is in place. Their belief that doing so avoids counter-intuitive results such as paying interest on an asset and deferral of hedge ineffectiveness while illustrating that a fixed' margin does in fact become variable when LIBOR drops below a critical range (i.e., the range of the negative spread to LIBOR).
The discussion began with one Board member asking a question that since the guidance from IAS 39 was carried in to the exposure draft, whether it was possible to get hedge accounting today for these issues. The staff responded that hedge accounting was possible, but because of the 80-125% effectiveness threshold, entities may have experienced issues with failing hedge accounting, particularly in today's current low interest rate environment. One Board member suggested that taking a second look at the wording in the exposure draft may help to resolve a lot of the questions around the issue. The Board tentatively decided to retain the restriction in the exposure draft when an interest rate floor is in place but to consider ways to further clarify the guidance.
Cash instruments as eligible hedging instruments
The hedge accounting exposure draft proposed that financial instruments carried at fair value through profit or loss be eligible hedging instruments. Comment letter respondents raised certain issues related to this part of the proposals.
Eligibility of Cash Instruments Not Measured at Fair Value through Profit or Loss
Some of the respondents requested that cash instruments not designated at fair value through profit or loss (i.e., amortised cost) also be eligible hedging instruments as they asserted conceptually there was no basis for differentiation.
The Board had little interest in expanding the proposal beyond its original scope and tentatively decided to limit cash instruments as eligible hedging instrument to those cash instruments measured at fair value through profit or loss.
However, the discussion turned to a broader discussion of the proposals around eligibility of cash instruments. One of the Board members raised the concern over the possibility of creation of synthetic' available-for-sale classification where one equity instrument is used to hedge the purchase of another equity instrument in a cash flow hedge. He believed that the use of cash instruments should be limited only to fair value hedges because of this reason. The IASB Chair requested the staff develop an example for future consideration by the Board.
Eligibility of Cash Instruments Designated under the Fair Value Option
Some of the respondents thought the Board was not restrictive enough in their proposals related to the eligibility of cash instruments as hedging instruments. In particular, it was noted that assets carried at fair value through profit or loss from election of the fair value option' would have been done so to eliminate an accounting mismatch. Therefore, application of hedge accounting would undermine the rational for initial election of the fair value option. Additionally, it was noted that for liabilities designated under the fair value option, the credit component is recognised in profit or loss while other changes in fair value are recognised in OCI.
In considering these comments, the staff felt that a blanket prohibition of items designated under the fair value option may be overly restrictive. This is because items may have been initially designated to reduce an accounting mismatch, however because of the irrevocable nature of the fair value option the accounting mismatch may no longer exist and the entity may now wish to designate the item as a hedging instrument in a hedge relationship. However, the staff recognised the need to clarify the issue around financial liabilities designated under the fair value option and their mixed recognition approach (between profit or loss and OCI).
The Board tentatively agreed not to restrict financial instruments designated under the fair value option as eligible hedging instruments but to clarify that financial liabilities designated under the fair value option where part of the change in fair value is recognised in OCI should not be eligible.
Macro hedge accounting
The Board held an education session on the forthcoming macro hedge accounting project. No decisions were made during this session.
Based on the research performed to date, the initial observations communicated to the Board included that the risk profile of a portfolio is different from the risk profile of the various individual items. This is due in part to the law of large numbers', from a statistical standpoint, the greater the number of items will reduce the actual deviation between actual and expected cash flows. Another key observation was that various approaches may be utilised in managing the risk associated with the portfolio. In the example of managing a portfolio of prepayable interest rate assets, potential risk management alternatives include using interest rate options, hedging the portfolio on the basis of tranches (layers based on probability of prepayment), and using dynamic strategies with open portfolios (considering future events and interdependencies between scenarios). One other observation is that hedging strategies for portfolios may focus on cash flows, fair value, income or some combination of some or all of those. Therefore, the existing cash flow and fair value hedge accounting models may not perfectly fit a macro hedge accounting model.
One of the IASB members noted the example used in the agenda paper focused on a bank's portfolio of interest rate assets. He mentioned that during outreach on hedge accounting, several energy companies had enquired on the macro hedge accounting project and wanted to understand what the scope of the project would include. The staff clarified that the same challenges banks may face in applying hedge accounting to their portfolios, energy, utility and other companies may face in dealing with portfolios of commodities. As such, this project is not intended to address any specific industry or risk but a broad coverage of the use of portfolios to manage risk.
Another IASB member asked a question on the comment made about portfolios may manage risks somewhere between managing fair values and managing cash flows, specifically would the current hedge accounting models not work for portfolios. The staff responded that it may work, but there may need to be adjustments in order to fit portfolio hedging strategies.
Another IASB member encouraged the staff to hold education sessions with financial and non-financial risk managers to provide the Board with insights on the techniques utilised by companies for portfolio level hedging strategies.