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Dynamic risk management

Date recorded:

Dynamic Risk Management - Background and Proposed Approach - Agenda paper 4

Background

This was an educational session that provided the Board with the project history and discussed the Staff’s approach to developing the dynamic risk management model.

Dynamic risk management (DRM) refers to a situation where the risk position being hedged experiences frequent changes. In April 2014, the Board published the Discussion Paper Accounting for Dynamic Risk Management: A Portfolio Revaluation Approach to Macro Hedging. Overall, the respondents agreed that the DP captured the critical elements of DRM; however, they objected to the proposed solutions, mainly on grounds that revaluing residual risk does not necessarily reflect DRM and will lead to profit or loss volatility, and that some of the proposals may be inconsistent with the Conceptual Framework.

The Staff plans to develop the DRM model in the following stages:

  1. Develop the foundational knowledge of what is DRM, including an understanding of how DRM activities are currently reflected in the financial statements.
  2. Develop guiding principles to account for DRM. This includes an understanding of what the users’ needs are and whether the proposed model would faithfully reflect risk management, as well as the cost of implementation.
  3. Evaluate the merits and shortcomings of each proposed model and select the preferred approach for further development and discussion.

The Staff plans to complete these three stages by October 2017, before developing the preferred model further.

Discussion

The Board reconfirmed the following as previously discussed:

  • The IAS 39 hedge accounting will be grandfathered until the completion of the DRM project;
  • The Board will focus on developing an accounting model for net interest rate exposures and will consider extending that model to other sectors that are also subject to dynamic risks, e.g. the energy and commodities sector, at the end;
  • The Board will consider the feedback received on the DP in modifying the portfolio revaluation approach (PRA) which may end up being a new model given the shortcomings of the PRA as noted by the respondents. In other words, the Board will not start with a clean sheet of paper in developing the proposed model.

The Board also raised the following points:

  • What is the objective of this project? What is the scope of what the Board is trying to solve? Is there a gap in the hedge accounting requirements in IFRS 9 and if so, what is it? This will necessitate an understanding of what IFRS 9 allows entities to do and what the revised IFRS 7 requires entities to disclose regarding risk management. In order to start with a full picture when developing the proposed DRM model, the Board asked the Staff to review the detailed discussions relating to the grandfathering of IAS 39 and the related proxy hedging issue, which the Board consider to be compatible with IFRS 9. Those discussions contain a lot of information as to what IFRS 9 allows entities to do. The Board also asked the Staff to review the Board’s intention as regards the requirements of IFRS 7 and IFRS 9. All these matters are unlikely to be apparent from current financial statements, not only because IFRS 9 and the revised IFRS 7 are not yet effective, but also because entities are allowed to continue using the IAS 39 hedge accounting guidance. One Board member noted that Brazil is considering whether to prohibit the grandfathering of IAS 39 as they believed that the hedge accounting requirements of IFRS 9 alone are sufficient.
  • The potential to split the project into two parts: one part dealing with interest rate risks relating to core demand deposits (which mainly affects financial institutions), and another dealing with dynamic open portfolios (which is also applicable to energy companies).
  • To work with the Primary Financial Statements project team to see whether and how the presentation of alternative performance measures could satisfy some of the users’ needs for information regarding an entity’s profile of interest rate risk exposure, how the entity has managed that risk and whether it is working well.
  • Whether and how the current low interest rate environment affects the effectiveness of disclosures on risk exposure.
  • How will the proposed model help users understand how a bank stabilises its net interest margin over a period of time? Put very simply, how does a bank manage the variability of the net interest margin between fixed-rate demand deposits and the variable-rate assets that are funded by those deposits?
  • Whether application of the DRM model should be mandatory or voluntary. Feedback received indicated that preparers prefer voluntary application on a sub-portfolio basis. One Board member, however, favoured mandatory application as the Board is creating a specialised model to deal with a very specific risk. She also believes that mandatory application would elicit more involvement from the relevant stakeholder groups.

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