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Dynamic risk management

Date recorded:

For the project background and a summary of the Board’s discussions to date, see the September meeting summary.

Minimum performance requirements (Agenda Paper 4)

Background

The qualifying criterion for applying the dynamic risk management (DRM) model is the assessment of alignment between the target profile, the asset profile and the derivatives designated within the model. The objective of such an assessment is to set up a minimum level of alignment to apply the DRM accounting model.

During the September meeting, the Board tentatively decided that the assessment should be in the form of qualitative thresholds supported by a quantitative analysis and that no ‘bright line test’ will be introduced to the DRM model. No single method of assessment was specified but an entity may compare the actual derivatives used with the benchmark derivatives. The Board instructed the staff to explore a further combination of IFRS 9 Financial Instruments hedge effectiveness requirements and how they can be applied in the context of the DRM model in order to reflect the concept of asset transformation rather than the concept of offsetting that is in IFRS 9.  

Application of minimum performance requirements

  • Economic relationship—the staff proposes that the assessment of whether an economic relationship exists is based on an analysis of the possible behaviour of the asset profile and the designated derivatives and whether they can achieve the target profile. Furthermore, the staff proposes that sensitivity analyses with multiple scenarios of potential changes in market rates could be used to demonstrate the existence of such an economic relationship by comparing the resulting changes in fair value of the benchmark and designated derivatives. Chart 3 in the agenda paper illustrates this. The staff proposes that an entity’s management should define both the appropriate shocks in market interest rates used during testing and the appropriate range of alignment supporting existence of economic relationship.
  • Hedge ratio—in order to prevent the abuse of the ‘lower of’ test and intentionally designating less derivatives than required to achieve a perfect alignment, the staff proposes to carry forward the requirements from IFRS 9 which state that an entity should not introduce imbalance between the weightings of hedged item(s) and hedging instrument(s). Therefore, the designation of financial assets, financial liabilities and derivatives (which may be done either on a portfolio basis or as the percentage of the portfolios):
    • should be consistent with an entity’s risk management policies and procedures; and
    • should not reflect an imbalance that would create misalignment (irrespective of whether recognised or not) that could result in an accounting outcome inconsistent with the purpose of the DRM accounting model.
  • Rebalancing—under IFRS 9 an entity is required to adjust the quantities of either the hedged item or the hedging instrument in response to changes in circumstances that affect the hedge ratio. In the case of the DRM model, changes to designated portfolios of financial assets and liabilities result in updates to the asset and target profiles. Upon changes in inputs, an entity should prospectively assess the DRM model. Because the updates to the inputs do not represent a designation or a de-designation event but instead a continuation of the existing relationship, the staff thinks that a rebalancing requirement is not needed under the DRM model.

 Staff recommendations

The staff recommended that that an entity can apply the DRM accounting model if all of the following requirements are met:

  • there is an economic relationship between the target profile, the asset profile and the derivatives designated within the DRM model; and
  • any designation does not reflect an imbalance that would create misalignment (irrespective of whether recognised or not) that could result in an accounting outcome inconsistent with the purpose of the DRM accounting model.

Discussion

One of the Board members asked for more clarification in respect of paragraph 17 of the agenda paper, which states that the assessment of whether economic relationships exist may be performed by comparing the changes in fair value of the benchmark and the designated derivatives. According to the Board member that is confusing because the DRM model is a cash flow hedge model and not a fair value hedge model and hence it should be explained as to why fair values are used. The Vice-Chair strongly disagreed with the cash-flow based testing because there may be a big economic difference. It was indicated that a similar discussion was held during the work on IFRS 9 and then it was agreed that the cash flows may differ due to liquidity and credit risk and that is why testing should be based on present values of the cash flows. The staff agreed that the words about offsetting cash flows may confuse people and it was agreed that more explanation will be provided.

In respect of management judgement (paragraph 22 of the agenda paper), the Board member commented that even if it should not be spelled out (“thou shalt test in the following way…”) it is not enough to leave it at this high level. More commentary should be provided as to what the expectation of stress testing is and what reasonably possible movements for the target profile direction are. More should also be said about the objective of the DRM model but without saying directly how the economic relationship should be tested and without introducing any thresholds.  Similarly, another Board member stated that letting management determine what the appropriate range and shocks in the market interest rates are gives the entity too much discretion when assessing whether the economic relationship exists.  Again, it was suggested to provide some qualitative thresholds and more guidance on the judgements.

Another Board member agreed with the direction where the staff is going in respect of the assessment of economic relationships but indicated that there is lack of specifity. The challenges with the qualitative assessment are: (i) what should be assessed; and (ii) what is ‘good enough’ in order to qualify for the DRM model.  In the absence of any quantitative thresholds (which should not be introduced), it should be very clear what the economic relationship is that the entity will have to test. It was indicated that currently there are two risks:

  • constituents will say that whenever there is any sort of direction in the movements towards the target profile this is good enough and this qualifies for the DRM model because there is an economic relationship; or
  • constituents may ask themselves whether they think that they will achieve the target profile, i.e. the people may read that a 100% effectiveness is required to apply DRM model.

Those are two extreme scenarios and the DRM model should not be applied when there is just a slight movement in the right direction but at the same time there is no need for the DRM model to be 100% perfect. However, currently it is not described how close this movement needs to be to the target profile in order to qualify for the DRM model and that that still needs to be done.  Another Board member concurred with the view that there needs to be enough specifity to allow identification as to whether the expected modification of asset versus the target profile was achieved and it has to be ‘substantial’ achievement.

The staff commented that it is not easy to establish the qualitative degree of aligning, i.e. it is much easier to use numbers, but that would imply quantitative thresholds. One Board member indicated that the basic challenge in the qualitative test is the description of what the economic relationship is and, if it is not possible to articulate what an economic relationship is, then how that can be assessed. The staff asked whether including the wording of ‘substantially achieved’ or ‘faithfully represent’ would be sufficient to get comfortable with the link between the asset profile and the target profile. The Board members agreed with such a change, if it is explained and presented with examples as to what this means.

Other Board members mentioned the importance of the disclosures, specifically disclosures that describe what the risk management strategy is, how it was executed and what the outcome was as this would help with the understanding of the financial position of an entity.

One Board member suggested asking ‘the others’ [the entities] how they would describe what the economic relationship is in order to qualify for the DRM model indicating that it has to be “more than a little but less than a 100%”.

Decision

The Board unanimously supported part (b) of the staff recommendation above. As regards part (a) the Board unanimously voted on the principle of economic relationship and a qualitative testing, but the words are subject to further articulation with regard to how strong/good the economic relationship should be in order to qualify for the DRM model.

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