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Dynamic risk management

Date recorded:

Cover note (Agenda Paper 4)

Agenda Paper 4A provides a summary of the objectives of Agenda Paper 4B.

Agenda Paper 4B contains a presentation that summarises the key decisions of the Dynamic Risk Management (DRM) Model and demonstrates how the model captures and communicates the impact of risk management through transformation.

Agenda Paper 4C explores possible approaches for operational simplifications to the DRM accounting model.

Agenda Paper 4D contains discussion on whether application of the DRM accounting model should be optional or mandatory and what areas of focus should be for the model’s disclosure requirements.

DRM model demonstration cover note (Agenda Paper 4A)

The paper summarises the purpose of the presentation in Agenda Paper 4B. The purpose of the presentation is:

  • To summarise the key decisions concerning the DRM model;
  • To demonstrate the mechanics of the DRM model and show how it achieves the objectives of the project;
  • To explain what information the model provides and how the model captures and communicates the impact of risk management through transformation in the financial statements.

Staff recommendations

This paper does not contain any technical questions to the Board. The staff are seeking the Board’s feedback on the presentation.

DRM model demonstation (Agenda Paper 4B)

Not summarised. See the presentation on the IASB website.

Board’s feedback on Agenda Paper 4B

A question was raised on slide 12 Objective and outline of the model whether the objective is not too narrow. It was compared with IFRS 7:21A. It was indicated that the DRM model should not only improve the information about the risk management strategy of an entity but it should also explain the effects on entity’s financial position, performance, future cash flows and economic resources i.e. present the link between the risk management strategy and financial statements.  Similarly, other Board members commented on the wording within the same slide. It was indicated that even if the calculation shows throughout how an entity will take the total calculation of the fair value of the derivatives and identify a component as an ‘accrual’. It is not interest income even if that accrual will subsequently be reclassified and treated as net interest income. It is attribution of the change in  fair value to an interest element.

Another point was raised on the wording that the derivatives are transforming the loans but in fact, they do not transform the loans because the counterparty does not accept that change i.e. it is not part of the same instrument.

Another comment was raised in the case of wording used in respect of eligible hedged items on slide 13 Challenges the model tries to address. The Board member indicated that it should not be implied that no hedge accounting can be done now. It certainly cannot be applied directly to demand deposits but it can be applied to proxy hedging.

One Board member raised a question in respect of phase 1 and phase 2 of the DRM model (slide 15 Core Model) and whether the model will work for non-linear hedging relationships. The staff confirmed that it will add complexity. Another question was raised in respect of slide 30 Construction of a Target Profile, where the expression that ‘an entity should be confident’ seems to introduce a new definition of certainty. That Board member asked the staff to consider what existing definition of certainty could be used (rather than introducing a new definition).

Another Board member asked whether there are plans to test the model with investors and adapt the deck accordingly because they will be looking at this from a different perspective to preparers of financial statements. The staff replied that it is up to the Board to decide  how the outreach will be done. However, from information has always been tailored to the audience in outreach performed in the past.

Operational simplifications (Agenda Paper 4C)

In this paper, the staff explore the possible approaches for the operational simplifications to the DRM model. The staff is of the opinion that in the DRM model the operational challenges will arise with tracking benchmark derivatives used for measuring alignment and reclassifying accumulated gains and losses recognised in other comprehensive income to profit or loss. This is because the DRM model allows for designation of open portfolios (i.e. portfolios where new exposures are continuously added and other exposures are removed over time), hence the portfolio of derivatives required for alignment will also change. As a result, the benchmark derivative will become a portfolio of derivatives over time due to the dynamic nature of open portfolios.

The staff considered the following two approaches that could ease the potential operational burden related to tracking of multiple benchmark derivatives for the purpose of both measuring alignment and reclassifying accumulated gains or losses recognised in other comprehensive income to profit or loss.

  • Amortising swap; and
  • Aggregation by shared contractual terms.

Amortising swap

Under this method, the numerous benchmark derivatives will be combined into a single aggregated derivative that will replicate the risk profile. Such aggregated derivative will have:

  • an amortising notional (i.e. notional of the aggregated derivative will be changing at the same time when the individual benchmark derivatives matures); and
  • one blended fixed rate (i.e. the rate will be calculated as weighted average of fixed rates on the individual benchmark derivatives).

However, the staff have the following concerns with this approach:

  • The cash flow pattern of the aggregated derivative (amortising swap) is not the same as that of the portfolio of the individual derivatives, i.e. the accruals arising from the amortising swap and the individual benchmark derivatives would differ. This would distort the performance because the amount reclassified each period would be the accrual on the amortising swap rather than the combined accruals from the individual benchmark derivatives.
  • The change in fair value of the amortising swap will be different from the change in fair values of the portfolio of the defined benchmark derivatives for the same given change in interest rates. As a result, the sum of changes in fair value of the individual benchmark derivatives will not be equal to the change in the fair value of the amortising swap. Because of that, the staff is concerned that this simplification approach may be only possible when the fair value sensitivity of the amortising swap is not materially different from the benchmark derivatives, i.e. in certain market conditions.
  • Combining the individual benchmark derivatives into an amortising swap would not simplify the rolling nature of a laddering strategy because the amortising swap would not automatically capture the reinvestment.

For the reasons provided above, the staff is of the opinion that this approach will not be successful in providing a practical operational simplification to the DRM model.

Aggregation by shared contractual terms

Under this approach, for the purposes of tracking and measurement, the individual benchmark derivatives would be aggregated into a single derivative based on similar contractual terms, i.e. maturity date, payment date and floating rate basis. The fixed rate on the aggregated derivative would be calculated by taking the weighted average of the coupons on the individual benchmark derivatives with the same maturity dates. In this way the accruals from the aggregated derivative will be the same as from the individual benchmark derivatives. Furthermore, because the maturity of the aggregated swap will be the same as the individual benchmark derivatives, the change in the fair value of the aggregated swap will be equal to the sum of changes in the fair value of the individual benchmark derivatives (i.e. no measurement differences will arise). Finally, in the case of re-investment, the ‘new’ benchmark derivatives could be added to the existing aggregated swap (based on their critical terms) and the entity could recalculate the new weighted average rate for the revised aggregated swap.

This method could be used for forward starting interest swaps; however, it may be necessary to consider additional contractual terms.

Finally, the staff stated that the similar methods are used by industry participants to aggregate positions for various purposes, including collateral management.

Given the aggregation proposed in this approach does not alter the expected cash flows or the maturity dates between the individual benchmark derivatives and aggregated derivatives, the staff believe this method should significantly reduce the volume of data required for tracking and therefore bring significant operational simplicity.

Staff recommendations

The staff recommend aggregation based on similar contractual terms (i.e. maturity dates and floating rate basis) as a method to reduce the number of benchmark derivatives that require tracking.

Discussion

The Board member indicated that some of the wording need clarification i.e. what can be and what cannot be aggregated e.g. the use of the word ‘similar’ when intended to convey the meaning ‘the same’ in respect of maturity dates, interest rate basis (e.g. LIBOR) and payment dates. All three are important and all three should be the same. The staff agreed and the wording will be amended accordingly.  

Another Board member indicated that the proposed aggregation is only in respect of benchmark derivatives and not designated derivatives  thisshould be clarified. The same Board member raised questions about standardisation of repricing dates i.e. whether this will stop the entities from the using the intended simplification as well as whether this aggregation needs to be determined in advance or be part of the on-going decisions in  respect of  portfolio hedging. The Board member used the following example: if an entity has an additional CU500, will this be added to the existing ladder, which will be running for another 4.5 years, or should the  entity start a new 5 year ladder (because it runs 5year ladder policy)? The staff said that in a case such as this, the hedging documentation should specify this clearly. In respect of the standardisation, the staff said that an entity can always execute the tailored swap if that is needed. The simplification is to help manage the DRM model and it does not mean that if an entity cannot apply simplification then it cannot apply the DRM model.

One Board member has an observation on paragraph 6 that states “where operational challenges will arise and therefore, the simplification is required”. In his view, the wording is not appropriate as the simplification is not required to apply the DRM model. . Furthermore, the staff were asked to confirm that only the end dates matter and not the different start dates (chart 7, page 17). The staff confirmed and reiterated that end dates, payment dates and the interest basis matter but not the start dates. In other words, an entity would never be able group the benchmark derivatives together due to dynamics of the portfolio. It is duration that drives the interest rate sensitivity.  

A question was raised about the market of amortising swaps and the impact of that simplification. The staff answered that this will be just a speculation. The paper states that amortising swaps are ‘okay’ but not perfect and there always be an ineffectiveness , the size of which will depend on the market,that should be recognised.

Another Board member stated that the simplification is to make the DRM model easier, less costly to operate and not because of any weaknesses in the existing model. 

Decision

All Board members tentatively agreed with the preliminary staff recommendations.

Optional application and areas of focus for disclosure (Agenda Paper 4D)

In this paper, the staff discuss whether the DRM model should be mandatory or optional. Furthermore, the staff discuss the areas of focus for the disclosure requirements arising from DRM model.

Optional or mandatory

The staff highlight th following reasons for not making the DRM model mandatory:

  • The DRM accounting model is an exception from the normal accounting for derivatives, similarly like a general hedge accounting model.
  • The DRM model would require discipline (i.e. in order to apply the DRM model the entity will have to meet numerous qualifying criteria).
  • The DRM model would require a certain degree of sophistication in modelling and risk management systems that would cause undue cost or effort on entities that do not have the necessary facilities.
  • If an entity failed to demonstrate the existence of an economic relationship, such relationship still would not qualify for the DRM model and hence the mandatory application will be impractical.
  • Certain items may be included in the scope of risk management activities that could not provide useful information or even conflict with existing IFRS Standards.

The staff have only one argument against making the DRM model optional—it would reduce the comparability as different entities could opt for different accounting alternatives. However, this argument was quickly rebutted by stating that dynamic risk management would need to be defined precisely in order to provide comparability between entities. Because there is a diversity in dynamic risk management approaches, even among entities within the same industry, this may be difficult.

Therefore, the staff are of the preliminary view that the application of the model should be optional.

Disclosure

The objective of the DRM model is to improve information provided regarding risk management and how the risk management activities affect a financial institution’s current and future economic resources. The staff recognised that the current focus on the information presented in the statement of profit or loss or in the statement of financial position is not enough because not everything can be communicated through measurement e.g. impact of misalignment on future economic resources. Therefore, an entity should provide additional information within notes. The staff proposed that the following should be disclosed:

  • information that would enable users to clearly understand and evaluate the risk management strategy, i.e. information should be provided as the combination of qualitative and quantitative disclosures about the target profile;
  • information about whether a management has the historical ability to align the asset and target profiles throughout the period in question, not just as at the reporting date (quantitative disclosure); and
  • comparison of the designated derivatives with the benchmark derivative throughout the period (quantitative disclosure).

The staff think that before finalising the DRM model, a more detailed set of disclosures will be necessary. However, it may be more efficient and effective to develop the detailed requirements in a later stage of the project.

Staff recommendations

The staff recommend that:

  • a) the application of the model should be optional; and
  • b) the aim of disclosures should be to enhance or supplement the information provided in the statement of financial position and the statement of profit or loss. Disclosures should help users to:
    • i) understand and evaluate the merits of the entity’s risk management strategy;
    • ii) evaluate the entity’s ability to achieve the stated risk management strategy; and
    • iii) understand the impact of an entity’s risk management actions on current and future economic resources.

Discussion

A. Optional or Mandatory

Board members agreed that the model should be voluntary and not mandatory, however several Board members expressed that they did so reluctantly. Those Board members said that this optionality will impair comparability of the results of different financial institutions -something that is important for investors.. Board members said that it should be made as clear as possible which model a particular entity applied. The staff reiterated that the DRM model is not trying to replicate risk management strategy in the accounts, the DRM model works as an exception to the accounting for derivatives and that cannot be make compulsory.

One Board Member indicated that the optionality is not ideal, but due to cost considerations,  entities should have an option. The same Board member raised two questions i.e. whether the optionality will be at the level of an entity or at the level of the specific portfolio and whether the designation is irrecoverable. The staff clarified that the model cannot be revoked, it has to be change in the risk management strategy or derivatives expired. In the case of designations, the optionality is on the portfolio basis i.e. an entity can choose which portfolios to hedge.

Another Board member indicated that if the model is optional, then there are three consequences that would need to be considered: (1) education of investors to make them aware that there is another option in place; (2) clarity around who is using the DRM model and where the DRM model was used; and (3) disclosures around net interest income and margin.

One Board member asked whether the staff had thought about any mandatory disclosures for the entities that do not apply the DRM model. The DRM model provides useful information about the risk management strategy of an entity and even if the entity would not apply the model to recognition and measurement of the effectiveness, the information about the strategy, activity and the choices will be useful for the investors. The staff replied that mandatory disclosures for all entities may be considered but the staff currently did not think about that. Another Board member mentioned that a similar question was discussed during the general hedge accounting model (IFRS 9) where it was concluded that  entities not applying hedge accounting do not have to make those disclosures, however, she did not remember what the arguments were used and suggested that the staff look into this.

B. Areas of Focus

One Board member indicated that time should not be on the development of disclosures before the outreach has been conducted. Another Board member stated that disclosures should be developed because this will help to understand the implication of the DRM model on the financial statements. The same Board member stated that per her understanding during the outreach, the following stakeholder groupswill be addressed: (1) preparers in order to understand whether the DRM model is operational and whether they think it replicates their performance;  and (2) investors in order to talk about the information that they will obtain from DRM model. Based on the IFRS 9 experience, getting investors engaged in any talks about  hedging is difficult because they are not interested in the mechanics (i.e. they are too complicated). Disclosures are something that most of the investors will be interested in and should be the focus of the discussions with this user group. 

Some Board members saidthat the DRM model needs to be tested firstly with preparers and subsequently with investors..

One Board member stated that it is important to understand user needs and identify the specific  disclosures to be developed (i.e. taking into account their purpose and how they will be used). Furthermore, staff were asked to clarify the statement of ‘disclosures over time’ and how this should be applied. . The staff confirmed that the disclosures should provide information not just at the end of reporting period but whether during the period an entity was outside the thresholds.

Another Board member stated that the topic of disclosures should be discussed with both preparers and investors; however, the disclosures do not need to be developed prior to any consultation. Another Board member stated that prepares will expect that the DRM model would require detailed disclosures (based on their experience with IFRS 9, IFRS 13 etc.), even if they are not developed currently. Another Board member agreed that the general areas of disclosures should ultimately be provided as that will be the ‘whole’ package of the DRM model and not just recognition and measurement. 

One Board members expressed strong view that if the disclosures are not developed then the outreach should not proceed with investors as that will be a waste of their time. This would indicate doing the project in two phases as it was said earlier. Another Board member indicated that the phases do not need to be discrete and once some comments are gathered from prepares, investors can be consulted.

The Board voted on the original questions in paragraph 12 of Agenda Paper 4D plus an additional objective i.e. understanding the effects of the DRM model on the financial statements.

The staff confirmed that they have enough direction from the Board and  will develop objectives. This approach will reconcile with the question that the Board will be asked in the future about the structure of the outreach and how the outreach will be done.

Decision

The Board tentatively agreed with both preliminary staff’s recommendations unanimously.

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