Financial instruments - Hedge accounting

Date recorded:

Macro hedge accounting

Continuing from its preliminary discussions from the September 2010 meeting, the IASB discussed portfolio hedge accounting (also referred to as macro hedge accounting) at today's meeting. It provided the Board with an overview to their approach in developing a fair value hedge accounting model for a portfolio of prepayable fixed rate assets/liabilities.

The staff first provided a brief overview of common bank strategies for economically hedging interest rate risk. The staff then provided a summary of the current hedge accounting alternatives available under IAS 39 and discussed whether the alternatives effectively portray the economic objective of a bank that hedges interest rate risk on prepayable fixed rate assets/liabilities on a portfolio basis. The staff discussed the requirement to use a proportional approach to identify the hedged item under the current accounting model before outlining a basis to consider the use of an alternative bottom layer approach when identifying the hedged item.

For purposes of its deliberations, the staff encouraged the Board to consider the following points:

  • When hedging interest rate risk, a key objective of a bank is to stabilise net interest margin over a given period
  • A bank would typically under-hedge its interest rate exposure
  • A bank hedging interest rate risk will consider both fixed rate and floating rate assets and liabilities together and not focus only on one type of instrument (e.g., fixed or floating) on one side of the balance sheet (e.g., asset or liability)
  • Matching interest cash flows on both sides of the balance sheet not only reduces cash flow variability but also reduces fair value variability due to changes in interest rates. However, the risk management objective is not to fully offset the fair value change of pre-payable items due to changes in interest rates. It is to stabilise net interest margin.

The staff noted that while many banks apply a fair value hedge accounting model, the model's objective is not fully consistent with a bank's risk management policy. Accordingly, the staff outlined two alternative approaches to address the inconsistency:

  • Develop an entirely new hedge accounting model with different objectives to the current cash flow or fair value hedge alternatives that is consistent with the risk management objective (i.e., what is currently in IAS 39), or
  • Make certain changes to the objective and workings of the current model under IAS 39 to make it more operational and consistent with the risk management objective.

The staff stated their preference for the second alternative. Accordingly, the staff presented the Board with three proposed changes to the current portfolio fair value hedge accounting for interest rate risk model:

  • Proposal #1: Permit the hedge designation to include both benchmark interest rate risk and full prepayment risk (i.e. not just the interest rate risk part of the prepayment risk)
  • Proposal #2: Allow an entity to partial term hedge some of the cash flows of a portfolio of prepayable items. As a consequence this allows an entity to only hedge the prepayment risk associated with the hedge cash flows and not all cash flows
  • Proposal #3: Allow an entity to view its portfolio of prepayable items as a single unit that behaves in a more predictable manner. With this view an entity can characterise the prepayable nature of the bottom layer cash flows differently to the top layer. In other words, the cash flows in the bottom layer are viewed to be far less exposed to prepayment risk than the cash flows in the top layer.

After providing a summary of their reasoning for each of the proposed changes, the staff asked the Board if it supported its suggested overall approach to address this issue, as well as its proposals to change the current model to consider a bottom layer approach for defining the hedged item.

The Board's discussion focused on the differences between the use of a proportional approach and a bottom layer approach, with some Board members noting that a proportional approach is more effective when looking at an individual transaction, and not a portfolio.

One Board member expressed concern with the use of a bottom layer approach, noting that a part of a bank's business model is prepayment risk which is in turn interdependent with interest rate risk. The Board member questioned whether it was possible to separate prepayment risk and interest rate risk, and expressed concern that a bottom layer approach might not provide a full depiction of an entity's risk.

Multiple Board members expressed the need for the Board to obtain an understanding of the views of financial statement users, including what types of disclosures would provide relevant and useful information about an entity's risk management and hedging strategies. Another Board member suggested that the Board ask financial statement users about the level of importance that is placed on understanding the changes in fair value of an entity's instruments being hedged in such a portfolio.

By a vote of 10 — 5, the Board tentatively supported the staff's suggested overall approach to address the issue, as well as the proposed changes to the hedge accounting objective to further consider the use of a bottom layer approach in defining the hedged item.

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