Dynamic Risk Management [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.

At this meeting the staff will discuss the role of the target profile within the Dynamic Risk Management (DRM) accounting model.

Summary of discussions to date [Agenda paper 4A]

This paper summarises the decisions the Board has made to date.

Business context

The core economic activity of some financial institutions can be described as raising funds to provide longer-term loans to customers. A change in market factors, such as interest rates, can affect interest income and interest expense. DRM is the process of understanding and managing how and when a change in market factors can affect interest income and interest expense. In the context of financial institutions, matching re-pricing dates of cash inflows and outflows is a common approach used to mitigate the effect of such changes.

Aligning the re-pricing of loans and deposits is difficult and perfect alignment may not be possible. Although a financial institution might not be able to eliminate the effect of market factors on interest income and interest expense, it can influence the speed at which those changes affect interest income and interest expense. If a financial institution decides, or is required, to proactively manage interest income and interest expense, it must decide how changes in market factors should influence interest income and interest expense. This decision reflects management’s target profile.

In practice, as management cannot force customers to originate loans that are convenient from a re-pricing perspective, derivatives are used to influence the speed of re-pricing. The derivatives transform loans such that the financial institution’s cash inflows will react to changes in market factors based on management’s target profile rather than the profile based on the loans originated by the financial institution.

The decision on how interest income and interest expense will re-price with interest rates over time future represents an entity’s target profile. For the purpose of the DRM accounting model the target profile must be consistent with an entity’s interest rate risk management objectives. As such, if the entity’s risk management objective focused on discounted cash flows, the target profile should reflect that objective.

Objective of the project

The objective of developing a new model is to improve information provided regarding risk management and how risk management activities affect the financial institution’s current and future economic resources.

The Board decided that the DRM accounting model should be developed based on the cash flow hedge mechanics. In particular, it was decided that, if derivative instruments are successful in aligning the asset profile with the target profile, changes in fair value of such derivative instruments would be deferred in Other Comprehensive Income and recycled to profit or loss as the asset profile affects the statement of profit or loss. In a situation of perfect alignment, interest income would reflect the entity’s target profile.

Asset Profile qualifying criteria

For a financial asset to be eligible for inclusion in the asset profile:

• a) it must be measured at amortised cost in accordance with IFRS 9;
• b) the effect of credit risk must not dominate the changes in expected future cash flows;
• c) future transactions, which are highly probable forecast transactions and firm commitments, must be highly probable;
• d) future transactions must result in financial assets that are classified as subsequently measured at amortised cost in accordance with IFRS 9;
• e) items already designated in a hedge accounting relationship are not eligible under the DRM accounting model; and
• f) items within the asset profile must be managed on a portfolio basis for interest rate risk management purposes.

Designation of the asset profile on a portfolio basis

Financial assets and future transactions dynamically managed for interest rate risk and meeting the qualifying criteria should be designated as part of the asset profile as a portfolio. Portfolios should be defined consistently with the entity’s risk management policies and procedures and share similar risk characteristics and, at a minimum, an entity should consider different currencies and the existence of prepayment features when defining the portfolios. Application of the DRM model should take effect from the date an entity has completed the necessary documentation to designate a specific portfolio.

Designation and the Dynamic Nature of Portfolios

Entities will have a choice to designate future transactions to be part of the asset profile but only at initial designation, provided such designation is consistent with the entity’s risk management strategy. Changes to designated portfolios resulting in updates to the asset profile are a continuation of the existing relationship and not a designation or a de-designation event.

Designation of a percentage of a portfolio

The DRM accounting model should allow for designation of a percentage of a portfolio, provided that:

• a) the designated percentage is applied consistently to all expected cash flows within the portfolio;
• b) the same percentage of a portfolio of financial assets is applied to a related portfolio of future transactions; and
• c) designation of a percentage of a portfolio is consistent with an entity’s risk management strategy.

An entity may choose to designate growth as a future transaction, and in such cases the requirement for designating a consistent percentage between portfolios of future transactions and other related portfolios would not apply.

De-Designation

An entity cannot elect to de-designate portfolios within the asset profile when the risk management objective remains the same and the financial assets in the portfolio continue to meet the qualifying criterion.

Financial assets and future transactions are de-designated when they no longer meet the qualifying criteria or when they are derecognised from the statement of financial position in accordance with IFRS 9.

Documentation

An entity will be required to formally document:

• a) The portfolio(s) of financial assets designated as part of the asset profile under the DRM accounting model.
• b) The methodology used to determine the amount of future transactions to be designated as part of the asset profile and how such designation is consistent with risk management policies and procedures; and
• c) Evidence supporting the high probability of future transactions occurring.

The documentation provided should be supported by an entity’s risk management procedures and objectives.

Target profile [Agenda paper 4B]

Staff analysis

The target profile specifies the re-pricing dates for the asset profile based on an entity’s risk management strategy. It represents the objective that management works towards achieving using DRM for a given asset profile and allows for the assessment of whether the executed derivative instruments were and continue to be effective in transforming the asset profile by defining the desired end state after completing transformation.

An entity’s asset profile must be funded. Consequently, any desired asset profile, that is captured and defined through the entity’s target profile, has to consider the entity’s financial liabilities to ensure that such a target profile is achievable. Furthermore, as DRM is the process that involves understanding and managing how interest income and interest expense will change with interest rates over time, in order to faithfully reflect DRM in financial reporting, the accounting model must consider interest expense. By considering financial liabilities when defining the target profile, it also captures the management of interest expense within the DRM accounting model.

The Target Profile: Its role within the DRM accounting model and how it is determined

The preliminary view of the staff is that the target profile specifies the re-pricing dates for the asset profile based on an entity’s risk management strategy. It represents the objective that the management works towards achieving using DRM for a given asset profile that the target profile. The determination of the target profile should take into account the entity’s risk management strategy which in turn is influenced by the contractual tenor of financial liabilities and when present and the risk management strategy when core deposits are present.

The staff also think that this will enable the determination of whether the executed derivative instruments, if any, were and continue to be effective in aligning the asset profile with the target profile for the purpose of performance assessment.

Consistency between the Asset Profile and the Target Profile

The preliminary view of the staff is that that the notionals of the asset profile and the target profile should be aligned. However, the tenors of the asset profile and target profile do not require alignment.

Time Horizon of the Target Profile

The preliminary view of the staff is that the time horizon of the target profile is the period of time over which the net of interest income and expense are managed. This applies to all target profiles irrespective if they consider the contractual tenor of financial liabilities or they the risk management strategy applied to core deposits. The time horizon of the target profile will be important when the staff discuss performance, as it defines the period of time over which the entity’s ability to manage will be assessed.

Staff questions for the Board

The staff were asking the Board if it agrees with the preliminary staff view that the:

• a) target profile represent the objective that management is working towards for a given asset profile;
• b) notionals of the asset profile and the target profile should be aligned but not the tenors; and
• c) time horizon of the target profile is the period of time over which the entity is managing the net of interest income and expense.

Discussion

Target profile

There was some discussion about the strategies the staff describe (paragraph 22 in the paper) that entities use (a) stabilise cash value of margin and (b) stabilise present value of future margin. A member asked whether the Board would need to look at both. The staff said yes, that they would be doing so. The staff were asked why the focus is on assets. The staff explained that the liability profile would be reasonably well known and the entities are trying to get the assets to match that liability profile using derivatives. Board members said that the paper did not make it clear that it is really a net view and that the target profile takes into account the liability profile. Some members said that the language creates problems because the term “margin” has a common use meaning that does not align with how it is used in the paper.

One member said that an entity’s risk management strategy will determine the target profile, not the other way around.

One member said that the objective is to manage the cash flows and not income and the paper implies that it might be the latter. The staff said they would make it clear that it is about cash.

Notionals and tenors and time horizon

One member said that when the target profile is, say, 5 years and only 2-year assets are available the risk management strategy relies on future transactions and he would like to get a sense of what the Board would allow as permissible strategies. The staff commented that they would rely on future transactions that are highly probable. One member noted that the discussions had focused on asset growth, but it is also important to consider liability growth. The notionals of the asset profile and the notionals of the liability profile need to be matched and the asset profile must reflect the liabilities.

Most of the discussion was about the clarity of language, and particularly whether the focus is on assets or the net and how liabilities fit in.

Board decisions

The Board unanimously approved all of the staff recommendations, except that the second recommendations was reworded to sat that “The notionals of the asset profile and the target profile are required to be the same, but not the tenors.”