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Dynamic risk management

Date recorded:

Refinements to the Dynamic Risk Management (DRM) model—Risk Limits (Agenda Paper 4A)

During the September 2021 meeting the Board discussed potential refinements to the DRM model in order to address the challenges identified during outreach and to align the DRM model more closely to entities’ risk management practices by incorporating the concept of risk limits into the target profile. In this paper, the staff is proposing further refinements to address the comments and questions received from the Board during the meeting in September and is also explaining the benefits of these refinements.  

Proposed refinements to the DRM model

  • Revising the definition of the target profile—the target profile will be defined as “the range (risk limits) within which the current net open risk position can vary while still being consistent with the entity’s risk management strategy”. The target profile will have to be linked to the entity’s risk management strategy and documented at initial designation of the hedge. Any changes to the target profile would result in the discontinuation of the hedge. The staff believe that the revised definition is more closely aligned with entities’ risk management strategies and also better aligned with the general hedge accounting model in IFRS 9 which will help with understandability and operability of the DRM model.
  • Introducing the risk mitigation intention—the risk mitigation intention will be described as “the extent to which an entity intends to mitigate the current net open risk position through the use of derivatives”. This will be a single-outcome element determined on the entity’s preferred risk metrics. The risk mitigation intention cannot create new risks, it has to transform the current net open risk position to a residual risk position that is within the target profile. It is a fixed amount of risk to be mitigated through derivatives and is set for a specific period of time. The maximum amount of risk mitigation intention is capped to the current open risk position and is not affected by the entity’s target profile determined at the inception of the hedge. On the other hand, the target profile determines the minimum amount that an entity needs to designate as the risk mitigation intention must be consistent with the entity’s risk management strategy. Once the risk mitigation intention is determined, it is documented via construction of benchmark derivatives. Changes to the risk mitigation intention can occur without affecting the continuation of the DRM model but any changes can be made only prospectively (i.e. entities are not allowed to amend the risk mitigation intention retrospectively). Any unexpected changes for the period under review will be captured through retrospective assessment and may affect the measurement of misalignment in the financial statements. The risk mitigation intention will have a similar role to that of the risk management objective in the general hedge accounting model of IFRS 9.
  • Revising the construction of benchmark derivatives—benchmark derivatives must be based on the risk mitigation intention because the risk mitigation intention is a ‘fixed amount of risk’ while the target profile represents acceptable open risk positions that do not specify the extent to which an entity decides to mitigate the risk. These benchmark derivatives will be used to measure the performance (similarly to hypothetical derivatives in the general hedge accounting model of IFRS 9).
  • Introducing prospective and two retrospective assessments—these assessments would ensure that the DRM model is used to mitigate the interest rate risk, that the target profile is achieved and that any misalignment that is driven by the effect of unexpected changes is captured in the financial statements. However, as the recognition of the misalignment will be determined based on the ‘lower of’ test, it may not always lead to the recognition of a gain or loss in the P&L (i.e. the entity only recognises gains and losses in the P&L on the over-hedged position similarly to the general hedge accounting model in IFRS 9).

Benefits of the refinements to the DRM model

The staff indicated that the introduction of the risk mitigation intention provides a clear link between the application of the DRM model and an entity’s risk management strategy. With this approach, entities can explain better the DRM results in their financial statements and the users of financial statements can have a better visibility of the alignment between the actual results achieved and the target profile (or the entity’s risk mitigation intention). Furthermore, this will reduce the need for ‘proxy hedging’. The introduction of the risk mitigation intention will result in an operational simplification, and reduced cost and/or errors because the retrospective assessment will be based on a ‘period-to-period’ comparison and hence entities will not be required to track the changes in the expected cash flows across several periods.  

Question for the Board

The staff ask whether the Board agrees with the proposed refinements to the DRM model.

Designation of a portion of prepayable assets in the DRM model (Agenda Paper 4B)

In this paper, the staff is addressing the second of the challenges identified during the outreach, namely the designation of a portion of prepayable assets in the DRM model. The participants of the outreach recommended that the Board allow the designation of the bottom layer of a portfolio of prepayable assets in the DRM model instead of the percentage approach.

The staff indicated that the proposed refinements to the DRM model (as described in Agenda Paper 4A) would also resolve the need to designate a bottom layer for risk management purposes. This is because the risk mitigation intention would allow an entity to decide the extent of the current net open risk position to mitigate by using derivatives. Specifically, when deciding how much of the open risk position to hedge, the entity would have to take into consideration that the prepayment levels need to be consistent with its risk management strategy. As such, an entity applying the DRM model would not need to use a bottom layer approach.

In the light of the above, the staff is not recommending any further refinements with regard to this issue.

Question for the Board

The staff asks whether the Board agrees with the staff view that no further refinements to the DRM model are needed in respect of the designation of a portion of prepayable assets.

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