Dynamic Risk Management – Cover note - Agenda paper 4

The Board continued to discuss the development of an accounting model for dynamic risk management (DRM). The Staff discussed the asset profile in this session (AP 4B).

AP 4A contained the project background and a summary of the Board’s discussions to date.

Recap

The aim of the proposed DRM model is for financial statements to represent faithfully the impact of dynamic risk management activities undertaken by an entity. It aims to help users assess management’s performance by focusing on how well management was able to align the asset profile with the target profile using derivatives. Each of the elements that contributes to performance assessment, viz. (1) the asset profile, (2) the target profile and (3) the derivatives will be analysed by the Staff before they move onto performance assessment. This constitutes the first phase of the project. In the second phase, the Board will consider other peripheral issues relating to DRM.

The Board has tentatively decided that the DRM model should be developed based on the mechanics of cash flow hedge accounting.

Asset profile – Agenda Paper 4B

Background

The asset profile defines (in other words, it sets the parameters of) which items are managed for interest rate risk and are therefore subject to performance assessment under the DRM model.

In this paper, the Staff set out the qualifying criteria for designating an item into the asset profile. They also discuss some technicalities about designation and situations requiring de-designation, as well as documentation requirements.

Staff analysis and recommendation

1. Qualifying criteria for items to be included in the asset profile
   
   The Staff recommended that an item must meet all six criteria below in order to qualify for inclusion in the asset profile.
   
   
   • (i) Financial assets must be measured at amortised cost
     
     DRM is about managing interest income and expense. As interest income is calculated by applying the effective interest method to financial assets, the Staff believe that the asset profile should comprise financial assets that are measured at amortised cost. These assets also make up the bulk of the population that is subject to DRM activities. The Staff will consider financial assets measured at FVTOCI in the second phase of the project.
     
     
   • (ii) The effect of credit risk does not dominate the changes in expected future cash flows
     
     In some situations, the effect of credit risk can be of such a magnitude that it dominates the changes in the financial asset’s expected cash flows. In such cases, although there is an economic relationship between a derivative and the financial asset, the level of alignment with the target profile might become erratic due to the effect of credit risk. Consequently, the Staff believe that these items should not qualify for inclusion in the asset profile.
     
     
   • (iii) Future transactions must be highly probable
     
     In practice, in addition to exposures already recognised in the statement of financial position, entities often manage exposures associated with future transactions that are expected to affect future interest income and expense, e.g. expected growth of a portfolio or reinvestment of proceeds from maturing financial assets.
     
     The Staff believed that these future transactions should qualify for designation within the asset profile in order for the financial statements to represent faithfully an entity’s DRM activities. Consistent with IFRS 9’s guidance on qualifying hedged items, the Staff believed that only firm commitments and highly probable forecast transactions should qualify for designation because there is sufficient certainty regarding the timing and amount of cash flows from these transactions. Allowing other expected but not highly probable transactions for designation might negatively influence the alignment of the asset profile to the target profile which in turn affects management’s performance. This is because management’s ability to predict the occurrence, timing and amount of such transactions is more limited.
     
     
   • (iv) Future transactions must result in financial assets that are measured at amortised cost
     
     This is for the same reason as explained in (i) above.
     
     
   • (v) Items already designated in a hedge accounting relationship are not eligible under the DRM accounting model
     
     Designation of such items under the DRM model would result in deferring gains or losses in OCI. As these items are already subject to hedge accounting, this could result in double counting.
     
     
   • (vi) Items within the asset profile must be managed on a portfolio basis for interest rate risk management purpose
     
     See point (2) below.
     
     
2. Designation of items on a portfolio basis
   
   The Staff considered whether items should be designated as part of the asset profile on an individual basis or on a portfolio basis.
   
   The staff recommended that items be designated on a portfolio basis as this will simplify the designation process. This is because financial assets and future transactions that meet the asset profile qualifying criteria are allocated to a designated portfolio and will be considered as part of the asset profile without the need for frequent designation and de-designation on an individual basis. This is consistent with one of the goals of the DRM model which is to reduce operational complexities associated with the application of the current hedge accounting guidance to dynamic portfolios.
   
   Furthermore, this approach would align the designation mechanics with the way management considers interest rate risk. This is critical to achieving the objective of the DRM model.
   
   Each portfolio should consist of assets that share similar risk characteristics. For example, financial assets with prepayment features should be separated from those without such features and assets denominated in different currencies should be allocated to different portfolios.
   
   
3. Interaction between designation and the dynamic nature of portfolios
   
   Portfolios are constantly changing as new assets are added and existing assets mature. As such, an entity’s risk management objectives do not focus solely on existing assets, but also on what will happen to interest income when new assets are originated and when assets mature and the proceeds are reinvested.
   
   Whether or not future transactions arising from reinvestment can be designated as part of the asset profile (assuming they meet the qualifying criteria) depends in part on the time horizon set by the entity in its risk management objective.
   
   For example, assume an entity’s target is to reprice after five years. It has a portfolio of loans that will mature in five years which will be reinvested at that time. Since reinvestment will take place at a time that is consistent with the entity’s risk management objective, these reinvestments would not form part of the designated portfolios because they will affect interest income in a time horizon that is beyond the timeframe of the entity’s risk management objective.
   
   In contrast, assume another entity has a target repricing date in ten years’ time. It has a portfolio of loans that will mature in five years which will be reinvested at that time. In this case, the future transactions arising from the reinvestment may be designated as part of the asset profile (if they meet the qualifying criteria) because they will occur before management’s target repricing date and thus will affect interest income within the time horizon set by the entity’s risk management objective.
   
   In light of the above, the Staff recommended that an entity be allowed a choice to designate future transactions (i.e. growth and reinvestments) to be part of the asset profile but only at initial designation, provided designation is consistent with the entity’s risk management strategy.
   
   In addition, the Staff were of the view that changes to a portfolio resulting from updates to the asset profile are not a designation or a de-designation event but instead a continuation of the existing relationship. This is consistent with the rebalancing concept in IFRS 9 where the hedge ratio is updated in order to comply with hedge effectiveness requirements.
   
   
4. Designation of a percentage of a portfolio
   
   The Staff recommended that the DRM model allows for designation of a percentage of a portfolio, provided that:
   
   
   • (a) The designated percentage is consistently applied to all expected cash flows within the portfolio;
   • (b) The same percentage is applied to a related portfolio of future transactions; and
   • (c) Designation of a percentage of a portfolio is consistent with an entity’s risk management strategy.
   
   The Staff believed that there are valid reasons when an entity would manage only a portion of a portfolio for interest rate risks. The requirement to apply the same percentage to all future cash flows from the portfolio is consistent with managing these risks on a collective basis. An exception is made for future transactions arising from growth. See 5 below.
   
   
5. Growth of the asset portfolio
   
   Growth of an asset portfolio means an increase in the notional amount of the portfolio. For this to happen, an entity would require additional funding (i.e. to incur additional liabilities). Because both the asset and liability will be priced at future market rates, the entity is not exposed to interest rate risk. However, if the funding is expected to come in the form of zero-rate deposits, a mismatch in re-pricing does exist and entities may actively manage this risk.
   
   Given that growth of a portfolio is different from reinvestments, the Staff recommended that an entity be permitted to designate a percentage for future transactions related to growth that is different from the percentage designated for the associated portfolio of financial assets (i.e. existing ones or to arise from reinvestments), provided this is consistent with the entity’s risk management policies. The Staff further thought that allocating growth and other future transactions into separate portfolios may assist with tracking and performance assessment.
   
   
6. De-designation of a portfolio
   
   The Staff recommended that items be de-designated from the asset profile when one of the following occurs:
   
   
   • (a) Financial assets are derecognised;
   • (b) The effect of credit risk dominates the changes in expected future cash flows; or
   • (c) Future transactions are no longer highly probable.
   
   The last two points are consistent with the qualifying criteria discussed above.
   
   In addition, the Staff recommended that the Board prohibit voluntary de-designation for the same reasons given in IFRS 9 for prohibiting voluntary discontinuation of a hedging relationship.
   
   
7. Documentation requirements
   
   The Staff also listed several documentation requirements about designating items within the asset profile.

Next steps

The Staff plan to discuss the target profile at the next Board meeting.

Discussion

1. Qualifying criteria for items to be included in the asset profile
   
   The Board generally agreed with the qualifying criteria. Even though most of these criteria are existing concepts in IAS 39 and IFRS 9, the Board asked the Staff to understand how these terms are being applied in practice to see whether they would be operational under the DRM model. The Staff also acknowledged that applying these criteria to one-on-one hedging relationships under IAS 39 or IFRS 9 would be very different from applying them on a portfolio basis under DRM, so they will develop and test the model with that in mind.
   
   Several Board members also observed that the criterion that future transactions must result in financial assets that are measured at amortised cost may not be operational because entities generally do not predict what the accounting classification would be for a future transaction.
   
   Given the biggest criticism of the portfolio revaluation approach was that the accounting does not reflect an entity’s risk management activities, the Vice-Chair asked the Staff to consider whether various aspects of the qualifying criteria would fall foul of that criticism, especially when items are measured at fair value because they fail the SPPI condition. Risk managers could manage cash flows on these assets yet they would not qualify for designation under the Staff’s proposals. The Staff acknowledged her concern and observed that further distinction would need to be drawn between failing SPPI for ‘interest-related’ reasons, e.g. prepayment or extension options, or for other reasons such as the asset containing a commodity- or equity-linked feature.
2. Designation of items on a portfolio basis
   
   There was hardly any comment on this because designating items on a portfolio basis is essentially a prerequisite given the nature of the risk being managed.
   
   
3. (discussed together with 4. and 5., see below)
4. (discussed together with 3. and 5., see below)
5. Interaction between designation and the dynamic nature of portfolios, designation of a percentage of a portfolio and growth
   
   There was a lot of discussion on what constraints should be put around the percentage of the  portfolio that is designated as part of the asset profile, whether that percentage could be a range, how expectation of changes in that percentage could be incorporated, how it interacts with the qualifying criteria, the target profile and the resulting performance assessment.
   
   The Vice-Chair also questioned whether it is operational to split the management of cash flows between existing assets, future transactions and growth. There were also discussions about what the initial point of designation would be for future transactions and about the maintenance of a portfolio in general, e.g. does it have an infinite life especially in light of no voluntary de-designation? How much growth does it capture? When does it close down? These questions are all linked with decisions on the target profile and will affect the resulting performance assessment. The Board observed that it is important to clarify these aspects to achieve discipline and comparability across entities.
   
   The Staff were already aware of these issues and plan to address them as part of the target profile and performance assessment discussions.
   
   
6. De-designation of a portfolio
   
   Board members asked the Staff to clarify the following:
   • de-designation of a portfolio versus de-designation of the assets within the portfolio. The Staff agreed to a suggestion that an asset be de-designated from a portfolio as soon as it fails any of the qualifying criteria (e.g. a change in business model causes an asset to fail amortised cost measurement);
   • the boundaries of a portfolio, i.e. how granular it could get in order to avoid people dicing up a portfolio to circumvent de-designating the whole portfolio;
   • whether an entity could apply general hedge accounting to an asset that has previously been accounted for under the DRM model and vice versa; and
   • the consequences of de-designation.
     
     
7. Documentation requirements
   
   There was no discussion on this topic.