Accounting for Dynamic Risk Management

Date recorded:

Agenda Paper 4: Comment letter analysis

The Visiting Fellow informed the Board that whilst in February they had only considered comments on certain issues, this session would cover the responses on the remaining issues, i.e. revaluing the managed portfolio, presentation and disclosure and application of the portfolio revaluation approach (PRA) to other risks.

Section 4 of the Discussion Paper (DP) had considered practical aspects of revaluing the managed portfolio, including revaluation with respect to a funding index. Banks usually focused on the funding cost of assets when they dynamically managed interest rate risk with a view to managing net interest income (NII). However, revaluation with respect to a funding index could be a departure from IFRS 9. IFRS 9 required that every hedged risk component was separately identifiable and reliably measurable. Not many respondents had shared this concern.

Another practical aspect discussed in Section 4 had been the use of transfer pricing transactions as a practical expedient. Many respondents had favoured this approach, however they would only find it appropriate if the transfer pricing transactions represented the risk in the managed exposures. A market funding index that excluded other transfer pricing spreads should therefore be used in the application.

Section 6 of the DP had asked constituents which presentation alternative would be preferred in the statement of financial position. The DP had suggested line-by-line gross up, separate lines for aggregated adjustments to assets and liabilities or a single net line item. The last alternative had been preferred by most respondents as it would be consistent with dynamic risk management (DRM) that was based on the net open risk exposures and operationally less burdensome. Furthermore, the statement of financial position would be smaller than it would be with other presentation alternatives.

The DP had also asked for the preferred presentation alternative in the statement of comprehensive income. The DP had suggested actual NII presentation or stable NII presentation. The former had been supported by most respondents. A line item titled ‘net interest from DRM’ would depict clearly how DRM activities affected NII. Also, the presentation of the revaluation effect from DRM would be a good indicator of future NII.

The third question of section 6 of the DP had concerned the gross presentation of internal derivatives. It had been asked whether this would enhance the usefulness of information and operational feasibility. Respondents had expressed mixed views on this issue. Those who did not agree had found that a gross presentation was against the principle of eliminating internal transactions in the consolidated financial statements. Also, as internal derivatives were used differently, comparability would be reduced and IFRS 9 did not allow gross presentation. Furthermore, even if the effect was nil in profit or loss, line items would be affected. Supporters of gross presentation had argued that it served as a practical expedient as it would be operationally challenging to match external with internal derivatives. Gross presentation also better represented DRM activities within asset liability management (ALM) and trading activities within trading sections.

The final question in section 6 of the DP asked whether the disclosure themes provided useful information and whether the scope of disclosures should be the same as the scope of the application of the PRA. Many respondents had supported the disclosure themes. They had suggested adding a sensitivity analysis of NII before and after DRM, mismatch in maturity or duration in assets and liabilities and further decomposition of NII. Some respondents had suggested a comprehensive review of IFRS 7. Many respondents had supported the same scope for disclosures as for application of PRA. Other respondents had supported a more holistic approach to disclosures.

In Section 8 of the DP, the IASB had considered the application of the PRA to other risks. The DP had asked whether the PRA should be available for non-interest rate risks in non-financial industries. The views had been mixed. Some had supported the availability of the PRA to other risks because other risks were similar and risk management in some non-financial industries were similar to DRM in a bank. Many however had not supported the application of PRA to non-interest rate risks in non-financial institutes.

One Board member wondered whether the respondents who had supported the gross presentation of internal derivatives were closer to the details and the DP and had already considered the operational side. The Visiting Fellow replied that it had been continental European banks which had supported this. The Board member asked whether those who had been in favour of the PRA being applied to DRM for non-interest rate risks in non-financial industries were actually hedging those risks. The Visiting Fellow replied that respondents had viewed it from a more conceptual perspective.

Another Board member asked whether the survey that corporate treasurers had conducted on gross presentation of internal derivatives was inclusive with regard to geography and industry. The Visiting Fellow replied that participants in the survey had been mainly European but from diverse industries. The Board member agreed with the responses that the broader application of hedge accounting under IFRS 9 might solve issues of the non-financial industry in this aspect. The Technical Director supported this.

One Board member disagreed with the comment that dynamic interest rate management should only be available to banks. He said that it should be available for other industries as well. He also said that grossing up of internal transactions had so far only been allowed in segment reporting. He would therefore like to see strong arguments to extend this approach to the statement of financial position.

Another Board member said that with regard to the gross presentation of internal derivatives, constituents could be either completely opposed or simply not satisfied with the IASB proposal.

With regard to transfer pricing being used as a practical expedient, one Board member asked what respondents had meant by saying that the PRA should accommodate the fact that different actions taken by a business unit would give rise to different accounting results. The Visiting Fellow replied that as the purpose of the model was to have better alignment between DRM and financial reporting, the PRA should accept different treatments in transfer pricing transactions.

One Board member said that the project proposed many artificial accounting constructs that depicted DRM. He therefore expressed concerns about the continuation of performing research on the issues of this session. Examples were using a proxy for the identification of the managed risk and the gross presentation of internal derivatives. He asked whether a solution for the revaluation effect on profit or loss could be isolated. He said that this issue was so complex that only specialised users could understand the information. The Chairman replied that this was the reason why extensive research was needed. The Technical Director said that for the next meeting they would prepare a staff paper that would lay out the strategy in proceeding with the project.

A Board member said that she did not understand why it would be operationally challenging to match external derivatives with internal ones that were being used for the purposes of DRM in a dynamic environment. The Technical Director replied that ALM would not necessarily match an external derivative. It would accumulate a number of transactions and then perform a single trade. Matching would almost be impossible.

One Board member said that transfer pricing was negotiated internally and therefore transfer prices were subject to judgement and management decisions. The Technical Director said that the DP wanted to explore whether using transfer prices was operationally feasible. This would only be the case if transfer pricing was a proxy for the risk that was tried to be hedged. Another Board member added that users had liked the outcome, i.e. to see the sources of interest income and distinguish between internal derivatives.

No further comments were made.

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