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Dynamic risk management [IASB only]

Date recorded:

Cover note (Agenda paper 4)

AP 4A contained the project background and a summary of the Board’s discussions to date. See the April IAS Plus meeting summary for more details.

AP 4B contained the description of the proposed derivative financial instruments that may be used as the hedging instruments for dynamic risk management and their designation and de-designation. The paper suggest that proposed derivatives should be addressed in the first phase of Dynamic Risk Management (DRM) project.

AP 4C contained discussion on performance within the DRM accounting model. More specifically, it provides an explanation of what performance means in the context of DRM and the information that should be provided in the statement of profit or loss regarding DRM activities. This paper also discusses how the accounting would achieve consistency with the agreed-upon concepts. Finally, this paper uses scenarios discussed in previous Board meetings to demonstrate the implications of the proposals.

Summary of discussions to date (Agenda Paper 4A)

Background

The aim of the proposed DRM model is for financial statements to represent faithfully the impact of dynamic risk management activities undertaken by an entity. It aims to help users assess management’s performance by focusing on how well management was able to align the asset profile with the target profile using derivatives.

In November 2017 the Board tentatively decided that the DRM accounting model should be developed based on the cash flow hedge mechanics.

In December 2017 the Board tentatively decided the staff should develop the accounting model for DRM in two phases, i.e. firstly the staff will develop ‘core areas’ such as: (i) asset profile; (ii) target profile; (iii) derivative instruments used for DRM purposes; and (iv) performance assessment and recycling and after that the staff will develop the areas that are extensions of concepts developed during first phase. The first two of the ‘core areas’ were discussed during the February 2018 and March 2018 Board meetings. During those meetings the Board identified the qualifying criteria for financial assets and financial liabilities to be eligible for inclusion in the asset profile or target profile respectively. Furthermore, the Board tentatively decided on their allowable designations, reasons for de-designation and necessary documentation that should be completed before an entity starts applying the DRM model.  

Staff recommendation

This paper was only educational and did not contain a staff recommendation.

Discussion

This paper was not discussed during the meeting.

Derivatives used for DRM purposes (Agenda Paper 4B)

Background

In accordance with the Triennial Central Bank Survey published by Bank for International Settlements (BIS) in 2016, interest rate swaps, including basis swaps, forward starting interest rate swaps and forward rate agreements (FRAs) represented 94% of the total over-the-counter (OTC) derivatives turnover. Turnover was defined as the gross value of all new deals entered into during a given period, and was measured in terms of the notional amount of the contracts. It was used to provide a measure of the OTC market activity and a rough proxy for market liquidity. Therefore, considering that those instruments are the most commonly used in practice to manage interest rate risk, the Board recommended that those derivatives should be addressed in the first phase of the DRM project. The Board noted that they do not make distinction between exchange-traded derivatives and OTC derivatives. The information was used because firstly it was readily available and secondly OTC derivatives are more commonly used due to possibility of their customisation in the contrary to the exchange-traded contracts that are standardised.

The paper provided the description of each of the derivative financial instrument and situations when particular instruments may be used, e.g. either mitigate the interest rate risk on the financial assets and financial liabilities that are already in place (interest rate swaps) or which will be entered in the future and hence locking the interest rate of the future financial assets or financial liabilities (forward starting interest rate swaps). FRAs may be used for the same purpose , however, in the case of FRAs, exchange fixed-for-floating interest payments is for one period only while forward starting swaps exchange cash flows over multiple periods.

Furthermore, an entity may wish to align the re-pricing of the financial assets and financial liabilities, for example when financial assets re-price every 3-months to then current 3-month LIBOR rate while financial liabilities re-pricing every 1-month to then current 1-month LIBOR rate, an entity may enter into pay floating 3-month LIBOR, receive floating 1-month LIBOR interest rate swap (so called ‘basis swap’).

The paper mentioned the interest options that are sometimes used to hedge prepayment risk. Using an option based strategy entities manage cash flows based on their contractual tenors instead of allocating them into particular buckets based on prepayment expectations. However, the valuation of the options is complex due to incorporating range of possible outcomes for different set of assumptions. Therefore, due to their complexity, cost and market constraints and the fact that their use is not widespread, the Board proposes to seek external feedback on whether interest rate options should be specifically addressed in the second phase of the DRM research project as an extension of the DRM accounting model. 

Internal derivatives

The staff proposed that only the contracts external to the reporting entity can be designated as hedging instruments which is consistent with paragraph 6.2.3 of IFRS 9. Furthermore, the Basel Committee on Banking Supervision establishes strict limits on internal risk transfers between the banking and trading books. Consequently, it is likely that the relevance of internal derivatives in the context of DRM has reduced as a result.

Designations of derivatives

The staff proposed that derivatives may be designated either individually or in groups but designation documentation must be completed with sufficient level of detail to ensure that the performance assessment and reclassification requirements of the model are complied with. The Board explained that the designation of a group of derivatives could result in operational simplifications as it could reduce the amount of documentation required.

The staff proposed that an entity may designate proportion of the national amount (e.g. 50%) but it would not be allowed to designate the derivative for the portion of the time period during which the derivative is outstanding similarly to IFRS 9.

The staff’s preliminary view was that designation of derivatives should occur when the entity completes the necessary documentation requirements and that the DRM model should not allow voluntary de-designation of a derivative when the risk management objective for that particular derivative remains the same. This is similar to requirements of IFRS 9.

Staff recommendation

The staff recommended that:

  • (a) Interest rate swaps, including basis swaps and forward start swaps, and forward rate agreements (FRAs) should be addressed in the first phase of the DRM project as these will capture a significant portion of DRM hedging instruments. Given the use of interest rate options, although not absent, is not widespread due to market constraints, costs and their complex nature, the staff will seek external feedback on whether interest rate options should be specifically addressed in the second phase as an extension of the DRM accounting model.
  • (b) Only contracts with a party external to the reporting entity (i.e. external to the group or individual entity that is being reported on) can be designated within the DRM accounting model.
  • (c) Formal designation and documentation of derivatives should be required and the voluntary de-designation absent of changes in risk management strategy should be prohibited.

Discussion

One of the Board members raised the concerns about paragraph 21 of the paper (which states that the staff will seek external feedback on whether interest rate options should be specifically addressed in the second phase of the DRM research project as an extension of the DRM accounting model). The question needs to be raised carefully because there are many permutations of options and the Board doesn’t want to consider all of them. Therefore, it should be clearly explained why particular options need to be covered in phase 2 of the DRM project (including consideration of costs and benefits and potential complexity). It was agreed that the caveat will be included in this respect.  Furthermore, the Board recommended that if options will be permitted, that should be done explicitly instead of ‘silent permission’.

It was indicated by the Board members that the reference to the Basel Committee in paragraph 26 of the paper should be ‘read’ as the additional layer of information and not as a basis for their decisions.

One of the Board members raised the question as to whether derivatives after initial recognition can be transferred from the trading book and used as hedging instruments in the DRM model. The staff clarified that this will be possible, even if fair value of the derivative is not equal to zero.

Another Board member raised the question what the distinction between portfolio and group of derivatives is and whether the designation of derivatives at portfolio level is forbidden or not necessary. It was explained by the staff that the term portfolio is a defined term and means assets and target profiles. Instruments within portfolio share the same risk characteristics. However, portfolio is not a meaningful aggregation hence the term ‘group of derivatives’ was used. It was stated that currently, due to limited population of derivatives, the portfolio characteristic is met automatically but if in phase 2 of DRM project the population will be expanded, the hedging instruments used may not have the same characteristics.  It was reiterated that the derivatives may be grouped together if an entity is able to do performance assessment and required reclassifications. Furthermore, it was confirmed that the group of derivatives may be designated under one designation. 

Decision

The Board unanimously approved all of the staff recommendations.

Financial Performance (Agenda Paper 4C)

Background

The DRM accounting model has three pillars, specifically: (1) the asset profile, (2) the target profile; and (3) the derivatives used for alignment. The first two pillars are measured at amortised cost while the derivatives are measured at fair value through profit or loss (FVTPL). These measurement and recognition differences do not provide a faithful representation in the statement of profit or loss of the entity’s performance for the reporting period. Therefore, the DRM accounting model, which is based on cash flow hedge mechanics, proposes that the changes in fair value of the designated derivatives (i.e. ‘perfect derivatives’) should be deferred in other comprehensive income (OCI) and reclassified to profit or loss when certain conditions are met. Consequently, if the entity achieves perfect alignment, the results reported in the statement of profit or loss should reflect the target profile.

According to the staff’s view perfect alignment is achieved when the asset profile, in conjunction with the designated derivatives, equals the target profile. Consequently, derivatives required for perfect alignment are those derivatives that achieve a perfect transformation of the asset profile to those of the target profile. This was illustrated in two examples: The first example explains what the perfect alignment is and how to measure it. The second example presents perfect alignment in a dynamic environment, i.e. when the nature of the portfolios is changing.

In order to provide a faithful representation of performance in the statement of profit or loss through deferral and reclassification of the changes in fair value of the designated derivative instruments it is necessary to establish:

  • (a) the time period over which reclassification should occur; and
  • (b) the amount to be reclassified each period.

According to the staff’s preliminary view, the period of time or the time horizon over which an entity reclassifies the amount deferred in OCI is the time horizon of the target profile. In other words, the fair value of designated derivatives deferred in OCI should be reclassified to profit or loss over the time horizon of the entity’s target profile and at the end of the time horizon there should be nothing left in OCI. The paper provides a further example (an updated version of Scenario C from the April 2018 Agenda Paper 4C) which illustrates the concepts regarding the amount to be reclassified each period. This example implies that reclassification should be presented as part of interest income in the statement of profit or loss, however, the Board believes that the presentation within the statement of profit or loss should be discussed separately, i.e. together with the presentation and disclosure requirements of the DRM accounting model.

Furthermore, the paper discusses the testing required to assess the level of alignment and measurement of imperfection in order to establish whether the changes in the fair value of designated derivatives may be recognised in OCI and to what level. The staff is of the preliminary view that entities should be required to demonstrate that there is an economic relationship between the asset profile, designated derivatives, and the target profile in order to justify the deviation from normal accounting standards and also prove that the cash flows from the three pillars are indeed linked. The test should provide evidence of an economic relationship. The staff explains that the term economic relationship should focus on the concept of alignment between the asset and target profiles and not offsetting changes in values between the hedged item and the hedging instrument like in IFRS 9. Furthermore, the staff considered including a bright line assessment but no minimum performance threshold for risk management was proposed. The staff proposes that the existence of an economic relationship should be tested on an ongoing basis.

As discussed during April 2018 Board meeting, the DRM model is terminated when the time horizon of the asset and target profiles lapsed and nothing remained designated in the DRM accounting model. Given risk management is done on a continuous basis and it is very likely that entities will continue to manage interest rate risk, it is possible that an entity may never discontinue the DRM accounting model. However, if the asset profile or the target profile no longer meet the qualifying criteria or the risk management strategy changes, the DRM accounting has to be discontinued. In such cases, the amount accumulated in OCI may be either reclassified immediately to profit or loss or reclassified over the life of the target profile in the case when at the date of termination the cash flows from the designated assets and liabilities still exist and future transactions are still expected to occur.

The paper states that further consideration will be required regarding situations of imperfect alignment, leverage and specific events that could impact an entity’s performance. However, this paper does not cover such situations only indicates that this will be discussed at the future Board meeting.

Staff recommendations

In this paper the staff recommend that:

  • (a) The results reported in the statement of profit or loss should reflect the entity’s target profile in the case of perfect alignment. This in conjunction with the designated liabilities will ensure the net of interest income and expense will reflect the risk management strategy. Deferral and reclassification are the mechanisms by which the DRM accounting model achieves the above.
  • (b) Perfect alignment is achieved when the asset profile, in conjunction with the designated derivatives, equal the target profile.
  • (c) Reclassification should occur over the time horizon of the target profile such that, in conjunction with the asset profile, the results reported in the statement of profit or loss reflect the entity’s target profile.
  • (d) In order to apply the DRM accounting model, entities must demonstrate the existence of an economic relationship on an on-going basis.
  • (e) If an entity chooses to discontinue the DRM accounting model and at the date of termination the cash flows from the designated assets and liabilities still exist and future transactions are still expected to occur, the amount deferred in OCI should be reclassified over the life of the target profile such that the results reported reflect the target profile.

Discussion

The following issues were raised and discussed by the Board:

  • Transparency of information—the risk profile of two companies that are achieving perfect alignment with and without use of derivatives respectively will be different due to the risk inherent in the derivatives (e.g. credit risk). This circumstance should not be masked, i.e. transparency may be required by investors. The staff agreed that one statement cannot give the full picture of the DRM model and the statement of profit and loss (P&L) needs to be read in conjunction with the balance sheet. Even if the result on P&L will be similar for those two companies, the difference will be visible in the balance sheet.
  • Meaning of ‘perfect alignment’ and what would happen if there is no perfect alignment (that will be most common situation)—concerns were raised by some of the Board members that ‘perfect’ is not a defined term and may be interpreted differently by different people. It was pointed out that the paper only indicates how to achieve ‘perfect alignment’ but does not define it and, therefore, it was recommended to add ‘perfect alignment’ as a definition.

The staff explained that they currently considered only ‘perfect alignment’, which is a baseline. The current status of the project is to agree on principles and after that, the mechanics will be developed.  

  • Numerical examples presented in the paper—the Board recommended including additional assumptions and making some edits to make them clearer.
  • ‘Perfect derivative’ used for assessment and measurement of DRM model—because the ‘perfect derivative’ (instead of the hedged item) will be compared with the actual derivative, it is necessary, in the Board’s view to clarify what the credit risk assumptions should be on such a perfect derivative.
  • Meaning of ‘economic relationship’—the staff explained that the overall idea of economic relationship is similar to IFRS 9 but that it is achieved in different way. Under IFRS 9, if there is an economic relationship, the hedged item and hedging instruments will move in the opposite direction due to the same risk, i.e. economic relationship exists when there is an ‘offset’. In DRM the movement of the asset profile and the target profile will be in the same direction, i.e. economic relationship exists when there is an ‘alignment’.
  • It was indicated that there is some loose language in the paper. For example, in the used wording ‘better align’ it was questioned whether ‘better’ means that this was ‘good enough’ in the context of economic relationship. Similarly, even if the methodology of the assessment of alignment is not defined, it should be defined what is compared, i.e. what is the ‘perfection’, what is measured, etc. It was agreed that the term of ‘economic relationship’ will be clarified when the retrospective test will be discussed. It was agreed that ‘economic relationship’ will not be a ‘bright-line’ as it was in IAS 39.
  • Finally, the question was raised as to whether better justification could be provided for the amount left in OCI when DRM was discontinued and such discontinuation was due to a change in the risk management objective.

Decision

The Board supported all of the preliminary views unanimously except for recommendation (a) above, for which one Board member abstained.

Correction list for hyphenation

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