(Macro Hedging)

The Board discussed the following issues:

What should be included in the final Standard about hedging a portion of a financial asset or financial liability?

Earlier in the meeting the Board discussed whether a designated portion need have some relationship to the instrument being hedged. The Board decided that it should not give any guidance on portions beyond that already contained in IAS 39 and the macro hedging exposure draft.

The staff proposed retaining the proposed new paragraph AG99A but removing the rest of the proposed new guidance on portions.

AG99A would state:

"If a portion of the cash flows of a financial asset or financial liability is designated as the hedged item, that designated portion must be less than the total cash flows of the asset or liability. For example, in the case of a liability whose effective interest rate is below LIBOR, an entity cannot designate (a) a portion of the liability equal to the principal amount plus interest at LIBOR and (b) a negative residual portion. However, the entity may designate as the hedged item the change in fair value or cash flows of the entire liability that is attributable to the hedged risk (eg that is attributable to changes in LIBOR). In addition, if a…"

The Board agreed.

What are the implications of the decision made at the last meeting that an entity cannot designate, as a hedged item, a portion of a financial asset or financial liability that is bigger than the total exposure on the asset or liability?

The staff proposed clarifying this issue by amending AG99A as follows:

"If a portion of the exposure on cash flows of a financial asset or financial liability is designated as the hedged item, that designated exposure portion must be less than the total exposure inherent in cash flows of the asset or liability. For example, in the case of a liability whose effective interest rate is below LIBOR, an entity cannot designate (a) a portion of the liability equal to the principal amount plus interest at LIBOR portion and (b) a negative residual portion. However, the entity may designate as the hedged item the change in fair value or cash flows of the entire liability that is attributable to the hedged risk (eg that is attributable to changes in LIBOR). In addition, if a…"

The Board agreed.

Whether to give implementation guidance on how cash flow hedges may be presented in the balance sheet.

The Board discussed three possible presentation formats and agreed to include these within an appendix as guidance. It was noted that further wording should be added to clarify what would not be permitted and that there may be other possible presentation formats.

Proposals put forward by the European Banking Federation (FBE) for a new kind of hedge accounting for hedges of interest rate margin.

In summary, the proposal is that:

• a. There would be a new kind of hedge accounting inserted into IAS 39 (in addition to fair value hedge accounting and cash flow hedge accounting) for hedges of interest rate margin.
• b. In a hedge of interest rate margin, the entity would designate as the hedged item a portfolio of assets and liabilities, accounted for at amortised cost. The hedging objective would be to reduce the potential variability of recognised (ie accrual accounted) interest margin that arises when interest rates change if the fixed (or floating) rate assets in the portfolio do not match the fixed (or floating) rate liabilities.
• c. The entity would also designate one or more derivatives (eg interest rate swaps) as the hedging instrument.
• d. To the extent that the designated derivative(s), when accrual accounted, have the effect of reducing variability of recognised interest rate margin, the hedge is effective.
• e. An effective hedge is accounted for as follows: In the income statement, both the hedging instrument (for instance, the interest rate swaps used to hedge) and the hedged item (that is, the portfolio of assets and liabilities) are accounted for using the effective interest method. In addition, the hedging instrument is measured at fair value in the balance sheet and an equal and opposite liability (or asset) is reported in the balance sheet in an account called 'interest rate margin hedge'. For example, if the designated hedging instrument is a swap and its fair value increases from zero to CU100 (hence the swap is an asset), the entity would recognise both an asset of CU100 for the fair value of the swap and a liability of CU100 for 'interest rate margin hedge'.

The staff noted that the approach has the following features:

• a. It results in amounts being recognised as assets and liabilities that do not meet the Framework's definitions. In the above example in which the entity recognises a liability of CU100 for 'interest rate margin hedge', there is no liability as defined in the Framework. That is, there is no present obligation that is expected to result in an outflow of economic benefits.
• b. The hedged exposure is an accounting exposure (ie the potential variability in accrual accounted interest margin). Under the fair value hedge accounting and cash flow hedge accounting models in IAS 39, the hedged exposure is an economic exposure (to changes in fair values or cash flows).
• c. It follows from (b) that the proposed effectiveness test is rather different from the effectiveness tests in IAS 39. The tests in IAS 39 compare the change in fair value of the hedging instrument with the change in fair value or cash flows of the hedged item. The test proposed for this new kind of hedge would compare how the recognised (accrual accounted) interest rate margin varies with movements in interest rates before and after the hedge.
• d. The hedge would be judged to be effective to the extent it reduces the variability of recognised (accrual accounted) interest margin. Thus no ineffectiveness arises if changes in the hedged portfolio result in the entity becoming under-hedged.
• e The hedged portfolio may include (i) core deposits that are assumed to be fixed rate liabilities up to the date that, on a portfolio basis, they are expected to be withdrawn, and (ii) held-to-maturity assets. IAS 39 would not permit fair value hedge accounting for the former and would not permit either fair value hedge accounting or cash flow hedge accounting for the latter. Hence the proposed approach would permit hedge accounting to be applied in cases when IAS 39 would not.

The Board noted that the FBE did not see this as an alternative to macro hedging, and wanted those proposals to continue, but rather as a proposal to assist in accounting for demand deposits.

The Board noted that work needed to be done to determine how effectiveness testing would be done.

The Board expressed concern as to the inclusion of items that would not meet the framework definitions on the balance sheet. The Board agreed that further work would continue in this area.

Concerns raised earlier at the Board meeting about entities 'ability to game' the macro hedging requirements.

The Board discussed an example that demonstrated how this could be done and acknowledged that it was possible.

The staff recommended that the final Standard retain the proposals in the Exposure Draft that prepayment dates should be re-estimated when interest rates change and that those re-estimates should be in accordance with the entity's risk management procedures and objectives.

The Board agreed with the staff's proposals.