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Dynamic risk management

Date recorded:

Dynamic Risk Management [Macro-hedging] – Agenda Paper 4

Background

When the IASB issued IFRS 9, it did not replace the requirements in IAS 39 for portfolio fair value hedge accounting for interest rate risk (often referred to as the ‘macro hedge accounting’ requirements). The Board has been assessing how to replace those requirements. A Discussion Paper was issued in April 2014. In the light of the comments received, the IASB decided to develop a second discussion paper, which it expects to publish in the first half of 2019.

Summary of discussions to date – AP4A

This paper provides details of the Board’s discussions to date and is for information only. See the March IAS Plus meeting summary.

Target Profile: Designation and Qualifying Criteria– AP4B

This paper sets out qualifying criteria for the financial liabilities used to determine an entity’s target profile. It also discusses designation and de-designation of financial liabilities within the Dynamic Risk Management (DRM) model and corresponding documentation requirements.

Staff preliminary views

The staff set out their preliminary views:

(a) Financial liabilities designated at fair value through profit or loss should not be eligible for the purpose of determining an entity’s target profile.

(b) An entity’s risk management policies and procedures will ultimately define when fixed rate financial liabilities with a demand feature are treated as core demand deposits within the DRM accounting model. However, core demand deposits must be financial liabilities with a demand feature and must not re-price with changes in market interest rates over time. Additionally, qualifying criteria focused on the estimation of the core portion of a demand deposit portfolio could be arbitrary and potentially inconsistent with the objective of the DRM model to not govern, but reflect the impact of risk management activities in financial reporting. Since the aim of the model is to faithfully represent, in the financial statements, the effect of DRM activities undertaken by an entity, the effects of when an entity inappropriately treats deposits as core demand deposits should be captured in performance assessment.

(c) Designation of financial liabilities and future transactions should occur on a portfolio basis. This is consistent with the asset profile designation mechanics agreed at the February 2018 Board meeting, which in turn is consistent with one of the goals of the DRM accounting model to reduce operational complexities associated with the application of the current hedge accounting guidance to dynamic portfolios. Designation of financial liabilities on a portfolio basis would allow for a faithful representation of DRM in the financial statements. In particular, this would align the designation mechanics with the way risk management considers interest rate risk.

(d) The DRM accounting model should allow for designation of a percentage of a portfolio of existing financial liabilities and future refinancing, provided that:

(i) the designated percentage is consistently applied to all expected cash flows within the portfolio;

(ii) the same percentage of a portfolio of financial liabilities is applied to a related portfolio of future refinancing; and

(iii) designation of a percentage of a portfolio is consistent with an entity’s risk management strategy.

Additionally, an entity can designate a proportion of growth in the target profile provided the designated percentage is consistent with the risk management strategy, and the designated amount is the same as the amount of growth designated as part of the asset profile.

(e) Financial liabilities and future transactions should be de-designated from the target profile if the financial liabilities are derecognised in accordance with IFRS 9 or the qualifying criteria are no longer met. In addition, the DRM model should not allow voluntary de-designation of portfolios within the target profile when the risk management objective for a particular portfolio of financial liabilities remains the same and all other qualifying criteria are still met.

(f) Formal documentation of items designated within the target profile should be required. In particular, an entity should document the following upon designation:

(i) The portfolio(s) of financial liabilities and amounts designated under the DRM accounting model. The level of detail of the documentation should provide sufficient specificity such that when new financial liabilities are originated it is clear to which portfolio they should be allocated;

(ii) A description of the methodology and key assumptions used by the entity to estimate the core and non-core portions of its demand deposit portfolio;

(iii) The methodology used by the entity to determine the amount of future transactions and how designation as part of the target profile is consistent with risk management policies and procedures. For example, if the entity designates future transactions related to refinancing and growth, the entity should document the methodology used to forecast the amount considered highly probable and how the designated level of future transactions is consistent with the entity’s risk management strategy; and

(iv) Evidence supporting the high probability of future transactions occurring. This is consistent with the documentation requirement applicable to the asset profile when an entity would prepare a cash flow maturity schedule, including the effects of the resetting of interest rates for financial assets and liabilities, showing that there are sufficient levels of expected cash flows to establish that the future transactions are highly probable to occur. This schedule can be supported by past practice of reinvesting cash inflows and refinancing cash outflows as well as observable data used to estimate the expected growth of a designated portfolio. In addition, the time period during which the portfolio of future transactions is expected to occur should be documented within a reasonably specific and generally narrow range of time from a most probable date, as a basis for assessing performance.

The documentation should be supported by an entity’s risk management procedures and objectives. Changes in documentation should be infrequent and consistent with the entity’s risk management practices.

Board discussion

Preliminary View (a)

The Board members agreed that there must be qualifying criteria. One member found the terms ‘forecast transactions’ and ‘firm commitment’ confusing as one was based on probability and one not.

One Board member noted that a hedge cannot be eligible if already designated for interest rate risk, however, it could be if designated for foreign currency risk and this should be considered more. Furthermore, when a liability in the past has been designated as FVTPL, on transition this can be amended to amortised cost so the liability can fall under these criteria but own credit risk cannot be recycled under IFRS 9. This should be considered further by Staff.

The Vice-Chair and other Board members questioned whether liabilities that have a variable rate and an interest swap to fix the interest could be included. Staff commented that they did not think so given that the risk should not be managed on both an individual and portfolio basis although the issue was more practical than conceptual. The Vice-Chair asked Staff to confirm this approach.

Preliminary View (b)

One Board member agreed with the proposal and agreed that if an entity treats a deposit as core it should be captured in the performance assessment. Additionally, there is a definition of a demand deposit but it would be helpful to also have principle based qualifying criteria to determine what is ‘core’. Another Board member and the Vice Chair agreed that it is important to consider what is core from management’s perspective based on future economics and that this should be based on available and supportable information and this should be included in the proposal.

The Chair added that ordinarily what is core is based on contractual rights and it would need to be explicit that this is based on future risk management.

Some Board members said that in their jurisdictions there were demand deposits available that are repriced that would not currently fall within the definition but are considered a core component. Staff agreed to consider how to address this issue.

Preliminary View (c)

One Board member commented that they could not see any alternatives to the portfolio basis. Another added that financial liabilities and future transactions, as at paragraph 37, should have similar risk characteristics if in the same portfolio.

One Board member reflected that they are happy with the proposals but find it hard to understand, prior to the performance discussion at a future meeting, the extent to which a target profile is a meaningful benchmark of the extent to which you achieve a goal. Additionally, there should be a further discussion on whether these proposals will be mandatory or elective, however, once there are designations and qualifying criteria they are effectively elective as an entity will be able to deliberately fail a test in practice.

The Vice Chair added that the comments on rebalancing in the paper do not appear to reflect how this is intended to work under IFRS 9 which is a very narrow concept rather than for a change in size of the overall group.

Preliminary View (d)

One Board member clarified that where in the example the liabilities had been split in to 2 parts, banking and equity, the words ‘designating 50% of liabilities’ meant designating 100% of the in scope liabilities.

Other Board members clarified that the risk management strategy is a high level concept that encompasses the wider risk management policies and procedures.

Board decisions

The Board supported all of the preliminary views unanimously except for (b) which had one dissenting vote.

The Dynamic Nature of Portfolios – AP4C

Staff analysis

This paper demonstrates how the dynamic nature of portfolios affects the asset and target profiles, and their interaction, on the basis of the DRM accounting model as it has been developed by the Board.

Staff recommendations

This paper does not ask for any additional tentative decisions from the Board.

Board discussion

One Board member commented that it is important to draw out that the change in fair value will be split into the interest driver element, recognised as interest, and the remainder which will be recognised as a fair value movement. This must be explicit as it results in an amount in interest income/expense that is not a receivable or payable.

Furthermore, it is important to consider other drivers in change of value of derivatives. This has not yet been discussed by the Board and only interest rate swaps have so far been considered. Complex instruments should be considered, as it may not be appropriate to have all fair value movements go through OCI except for the interest element.

One Board member questioned the rolling strategy in scenario B when the DRM continues rather than has a new designation and when this would be appropriate. Staff commented that in this situation they had distinguished and separated a portfolio with a continuous nature as opposed to one with a finite nature.

One Board member questioned the use of the word ‘consider’ in paragraph 55 (“the DRM accounting model must consider the difference in contractual terms”) which staff clarified meant that the difference should be reflected. Furthermore, they discussed the wording in paragraph 39 (“The allocations to the respective time buckets within the asset and target profile do not reflect when the transactions are expected to occur. Rather they reflect the expected impact on the asset profile, and the objective the entity wants to achieve”). Staff clarified that this related to growth and repricing not to when it will be originated.

One Board member commented that the layering in the model may not make it less onerous on preparers and this will be discussed further in a future meeting when performance is discussed.

Staff plan to deliver a paper relating to derivatives on basis swaps and then on performance in the future.

Correction list for hyphenation

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