Financial instruments — Macro hedge accounting
The Board continued its discussions on development of a macro hedge accounting model. At the November 2011 Board meeting, the staff introduced eleven steps that will be considered for alternatives in the valuation of the risk position in a macro hedge accounting model.
The January discussion focused on the following steps:
- Step 4: Portfolio as unit of account
- Step 5: Open portfolios to be included
- Step 6: Applying repricing risk for periods rather than days.
The staff presented the Board with agenda papers using the example of hedging interest rate risk. These papers focused on risk management approaches based on expected behaviour of a portfolio using 1) portfolios as units of account for hedge accounting purposes and 2) bottom layer approaches. One of the papers walked through these approaches using a closed portfolio as an example with the second paper overlaying application to an open portfolio and the additional considerations introduced with a constantly shifting portfolio. The staff did not ask the Board to make any decisions during this meeting.
The papers laid out three potential alternatives and the implications for each. The first alternative is the portfolio fair value hedge of interest rate risk under IAS 39. The second alternative is a portfolio valuation approach attributable to the hedged risk on the basis of the net position with a constant hedged proportion. This approach would allow designation of the portfolio as the unit of account and therefor the ongoing valuation of the portfolio for purposes of hedge accounting. The third alternative is a bottom layer approach to reflect the net risk position (e.g., a layer of a gross position that represents the net risk).
The staff analysis for the alternative of applying existing IAS 39 highlighted the problems and limitations that currently exist. Over hedging the net risk position (from a risk management perspective) is not visible to the extent the hedging instruments are covered by the gross position designated for hedge accounting purposes. Similarly, under hedging the net risk position is also not visible. Prepayment risk of the net position is only partly visible in that a release of the hedge adjustment is dependent on the hedge proportion and the designated hedged items out of the net risk position. The ineffectiveness of the hedging relationship is also only partly visible based on the hedged proportion and the designated hedged items out of the net risk position. Perhaps most importantly, application of the IAS 39 approach is operationally complex requiring tracking of the hedge adjustment based on changes in hedged proportions, frequent re-designations and 'late hedges'.
The staff analysis for the portfolio valuation approach highlighted that this approach provides visibility in to both over and under hedging the net risk position as the entire hedged portfolio (both assets and liabilities) would be remeasured and therefore increases or decreases in the net position would give rise to ineffectiveness. Additionally, it provides visibility of prepayment risk as each prepayment triggers a release of the related hedge adjustment. This approach also provides visibility to the hedge ineffectiveness. The staff also highlighted that the portfolio valuation approach does not require tracking of hedge adjustments due to a uniform hedged proportion for all items (rather than a proportion) and immediate consideration of changes to the portfolio resulting in no late hedges. They noted that the complexity will depend on the level of synergies with the valuation approaches applied by risk management.
The staff analysis for the bottom layer approach highlighted that it does not provide visibility in to over or under hedging. It also does not provide visibility of prepayment risk if the risk does not lead to a decrease or breach of the designated layer. Visibility of hedge ineffectiveness would be dependent on the flexibility regarding the definition of layers. The staff noted this approach would be the most simple approach so long as the layer does not change, but changes to the designated layer leads to similar tracking issues as hedge accounting but at a portfolio level.
Most of the Board members expressed general support for the portfolio valuation approach based on the staff analysis as it provides the most transparency. One Board member felt the papers did not adequately address the interdependence between interest rate risk and behavioural factors (such as prepayments). Another Board member highlighted the importance of appropriate disclosure for these hedging relationships. One Board member asked the staff if the portfolio valuation approach was consistent with how risk managers currently managing risk citing concerns the accounting approach could instead drive risk management. The staff responded that this approach is the most common approach used by risk managers; however one Board member questioned this noting that some financial institutions focus on the matching of cash flows and are not fair valuing demand deposits and suggested the staff conduct outreach to ensure this approach was operational before proceeding too far down this path.
The Board made no tentative decisions during this session. The staff noted the Board's initial preference towards a portfolio valuation approach and will continue to proceed through the remaining five steps using that approach as a basis for further development.