Financial instruments — Macro hedge accounting
Setting transfer prices
This session focused on the revaluation of the hedged risk in the net valuation approach macro hedge accounting model. In the context of the current discussions around interest rate risk, the revaluation of the hedged risk requires establishing a benchmark interest rate. However, financial institutions don’t use consistent benchmark interest rates; rather, they are typically adjusted in order to reflect the specific attributes of the entity and the financial products. Those entity specific adjustments can include optionality risks, liquidity risks and counterparty risks.
A transfer price is an internal rate used within financial institutions to price the transfer or risk between business units. A transfer price determines both the cash flows transferred between the business units and the discount rate used to calculate the present value of those cash flows. The transfer price is calculated using an interest rate curve (or multiple curves) from the inter-banking market and then adjusted for the entity specific factors.
The staff asserted that as part of consideration of the macro hedge accounting model, the Board will need to consider the relationship between the valuation parameters for the hedged risk and for the pricing of the hedging instrument and what minimum requirements should be established for setting transfer pricing and the benchmark interest rates.
With respect to the relationship between the valuation parameters for the hedged risk and the hedging instruments, one alternative raised by the staff was that using transfer prices for valuing the risk position would only be permitted if the parameters for the transfer price are highly correlated to the pricing of the hedging instrument. Another alternative would be that the hedged risk position is valued based on transfer prices and the related benchmark rates used risk management purposes.
Similarly, with respect to the minimum requirements for setting transfer prices and benchmark rates, the staff presented the Board with two possible approaches:
- The first approach would be to allow an entity to choose transfer prices and yield curves in valuing the hedged risk and hedging instruments based on risk management decisions. While this approach is aligned with how management measures interest rate risk, it also has the risk of decreasing comparability because of the diversity that various institutions will have
- The second approach would be to stipulate what transfer prices and yield curves should be used in valuations or require a standardised, minimum composition of risk that can be hedged. This would improve comparability between entities but would no longer reflect how management measures the hedged risk and also may have additional operational considerations.
One Board member reference a mention in the agenda paper regarding entities already disclosing information about transfer pricing today. The staff responded that in particular a large US and Japanese bank provide information on this subject. Another Board member also noted that most banks’ segmental disclosures include a transfer rate in order to determine profitability of each segment and that information about the transfer rate is usually disclosed.
One Board member expressed that he was having difficulty with this notion. If this were not in the context of hedge accounting then the transfer pricing would be eliminated in consolidation, but here you can define the risk being transferred in to exactly match the derivative which would result in no hedge ineffectiveness. He felt that if the Board doesn’t put some rigour around it then it could end up with some bad results.
Other Board members raised similar concerns. One noted that transfer pricing may include bias for a variety of reasons such as preferable tax results or to artificially prop a certain business segment and had concern over this being carried over for financial reporting purposes. Another Board member mentioned caution as the Board has never permitted commercial entities to utilise internal transfer pricing for external financial reporting.
The Board made no decisions during this session.