Macro hedge accounting
The IASB continued its discussion on development of an accounting model for macro hedging activities on the basis of the ‘11 steps’ that the Board initially discussed at its November 2011 meeting. Similar to previous meetings, this session was an educational session where no decisions were made.
At this meeting, the Board discussed two topics:
- Should internal derivatives play a role in external accounting (step 10 of the 11 step overview presented at the November 2011 meeting)?
- What are the implications of risk limits in the determination of ineffectiveness of hedging activities (step 11 of the 11 step overview presented at the November 2011 meeting)?
The IASB first discussed whether ‘internal derivatives’ could play a role in accounting for macro hedging. Internal derivatives are derivatives that are entered into between different business units within a consolidated group.
The discussion focused on a bank with a business model in which banking book interest rate risk is managed (partly or wholly) through the use of the internal derivatives with the trading book. The debate considered two aspects:
- whether the existence of internal derivatives is a relevant aspect when deciding the financial assets and liabilities to which a revaluation model for interest risk could be applied; and
- whether internal derivatives should also have a role in income statement presentation.
Although there was no specific suggestion in the staff paper that profit or loss should be recognised from an internal derivative, the staff outlined many considerations which could support the application of a revaluation model for a portfolio of financial assets or liabilities that is hedged wholly or partly with internal derivatives. Specifically, the staff noted that such an accounting treatment would be consistent with the risk management activities of those managing the banking book. However, the staff noted that whether it would best represent the financial performance and position of a consolidated group depends on how an open interest rate risk position is characterised and what role the internal organisation and business models play.
Multiple Board members highlighted the usefulness of internal derivative information. However, they questioned how the information could be displayed usefully, especially in situations in which there is no linkage between internal and external derivatives. For example, these Board members saw difficulties in displaying the appropriate impact on net interest income and any remaining volatility in non-trading profit or loss from interest rate risk in consolidated financial statements without reference to internal derivatives. If it is determined that internal derivatives should have a role in income statement presentation, the Boards would have to consider if it is appropriate to ‘gross up’ the impact of internal derivatives within the consolidated financial statements in situations in which revaluation adjustments from internal derivatives offsets volatility from derivatives used for risk management, or perhaps consider separate disclosure at a segmental reporting level (if appropriate).
Another Board member expressed a more broad concern with application of the macro hedging model; that being, comparability. He believed that entities should be required to make a policy election on applying the macro hedging accounting model. Otherwise, he feared that entities may elect to apply the general hedging model to one portfolio of assets and the macro hedging model to another portfolio of assets in order to reduce financial statement variability. The IASB Chair noted that this concern would be considered at a later date.
The IASB then discussed the implications of a risk limit concept for accounting purposes. An entity establishes risk limits to set thresholds for risk levels that it can accept without seeking mitigation. As long as a risk position remains within the risk limit, the entity does not have to take any steps to maintain a position that is acceptable to it.
With this in mind, and considering the practical difficulties in assessing ineffectiveness on a macro model, the staff raised the issue of using risk limits as a possible way to link an entity’s objective to hedge only a part of the risk position with the accounting model for macro hedging that is based on a revaluation approach (i.e., as long as the amount of risk is within the risk limit set by management, a hedge is regarded as perfectly or automatically effective).
Multiple Board members noted strong disadvantages in applying risk limits. These disadvantages, as described more fully in the staff paper, included:
- Applying an accounting model that accommodates the risk limit concept may require departures from IFRS principles (e.g., in some cases, all ineffectiveness would not be recognised).
- Applying the risk limit concept would raise the question of how to account for breaches of the risk limits. This is because such an accounting model would not recognise in profit or loss the mismatches in value changes as long as the risk limits are not breached. Therefore, the model would not be based on a revaluation approach, but instead, would require deferral of certain fair value changes.
- Applying the risk limit concept could create a moral hazard whereby entities set wider risk limits seeking more stable profit or loss. To this end, one Board member believed that it should be left to regulators to set limits. However, others noted that allowing regulators to set limits would reduce comparability.
Although these disadvantages were discussed, the Board made no tentative decisions on this topic.