Dynamic risk management

Date recorded:

Cover note (Agenda Paper 4)

Agenda Paper 4A contains the project background and a summary of the Board’s discussions to date. See the December 2018 meeting summary for more details.

Agenda Paper 4B discusses whether the DRM model should preclude an entity from designating certain types of strategies within the target profile.

Agenda Paper 4C discusses how an entity should present the derivatives designated within the DRM model in its financial statements.

Summary of discussions to date (Agenda Paper 4A)

Background

The aim of the proposed DRM model is for financial statements to represent faithfully the effect 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. In the first phase the IASB would focus on ‘core areas’ such as: (i) asset profile; (ii) target profile; (iii) derivative instruments used for DRM purposes; and (iv) performance assessment and recycling. In the second phase the focus would be on extensions of the concepts.

The first two of the ‘core areas’ were discussed during the February 2018, March 2018 and April 2018 Board meetings. The Board identified the qualifying criteria for financial assets in the asset profile and financial liabilities in the target profile.  The Board also tentatively decided on the allowable designations, reasons for de-designation and the documentation that should be completed before an entity starts applying the DRM model. The third and fourth ‘core areas’ were discussed during the June 2018 Board meeting. The Board tentatively decided on the types of derivatives that can be designated within the DRM model, their designation and de-designation and which derivatives will be addressed within the first phase of the DRM project. It also tentatively decided what information should be provided in the statement of profit or loss regarding DRM activities. The results should reflect the entity’s target profile in the case of perfect alignment and the reclassification should occur over the time horizon of the target profile (even in the case of voluntary discontinuation of the DRM accounting model). The Board tentatively decided that in order to apply the DRM accounting model, an entity must demonstrate that there is a continuing economic relationship.

During the September 2018 meeting, the Board discussed the measurement and assessment of imperfect alignment and how the DRM model should treat the change in risk management strategy. The Board tentatively decided that the assessment of the economic relationship should be in the form of qualitative thresholds supported by a quantitative analysis and that no ‘bright line test’ will be introduced to the DRM model. No single method of assessment was specified but an entity may compare the actual derivatives used with the benchmark derivatives. The minimum performance requirements and how they should be applied in the context of DRM model were discussed further during December 2018 meeting. At this meeting, the Board tentatively decided that an entity may apply the DRM model if designation of the asset profile, target profile and designated derivatives does not reflect an imbalance and there is an economic relationship. The Board emphasised its previous tentative decision not to define any quantitative threshold for an economic relationship and instructed the staff to seek feedback on the articulation of the strength of an economic relationship during outreach on the core model.

Staff recommendations

This paper is only educational and does not contain a staff recommendation.

Certain strategies and the target profile (Agenda Paper 4B)

In this paper, the staff discusses whether the DRM model should preclude an entity from designating certain types of strategies within target profile. The following are considered.

  • (1) Leverage—the staff uses an example when the target profile is twice of the size of asset profile (when comparing notional amounts). In this case, an entity will need to designate derivatives to increase the notional of the asset profile. This would mean that derivatives were not used to transform the financial asset designated profile but were used to create the interest cash flows in the first place. The Board tentatively decided (March 2018) that the notional of the asset profile, derivatives designated in DRM model and the target profile must be equal.
  • (2) Negative balances within target profile—the staff considers whether the designation of negative balances within the individual time buckets is allowed. The staff provides an example where the overall notional of asset profile and target profile are the same, but an entity allocates the negative amount to the first-time bucket and the much higher amount to the last time bucket. The staff tentatively concludes that the outcome of this strategy is similar to the leverage because derivatives are used to increase the size of the asset profile in the last time bucket.  
  • (3) Changes in the risk management strategy—the staff expects that the changes in the risk management should be rare. The staff is of the opinion that any frequent changes would undermine the usefulness of information provided by the DRM model. The staff proposes that an entity should clearly define the target profile and the strategy that is following so it is obvious whether the change in risk management strategy occurred. Furthermore, the clear determination of the target profile and its time horizon will preclude entities from changing its risk management strategy to achieve a specific accounting outcome that would be inconsistent with the DRM model.

Staff recommendations

The staff recommend that:

  • (a) negative balances within the target profile should not be permitted within DRM model;
  • (b) the changes to the risk management strategy and the target profile must occur infrequently; and
  • (c) the risk management strategy must be clearly documented within a specified time horizon and cannot be defined in a way that is contingent.

Discussion

There was no discussion about whether negative balances are permitted within DRM model. The staff only clarified that this is a qualifying criteria question, not when in the normal course of operation an entity finds itself overhedged and consequently with a negative balance in a time bucket because this will not disqualify the model and it will be measured and disclosed as imperfect alignment.

In respect of the second question whether the changes in risk management strategy should be infrequent and the risk management strategy should have clearly documented time horizon, a few members of the Board suggested clarifying what is meant by ‘frequent’ and be specific on the wording because frequent changes bring severe consequences, i.e. discontinuation of the DRM model. Furthermore, Board members suggested providing some examples and types of events that could affect the change of risk management strategy to give some context to the phrase ‘infrequently’.  One Board Member suggested that there should be a clearer analyse of what prompted the change in strategy and provided examples of triggers which should not cause discontinuation of the DRM model i.e. change in the product mix, macroeconomic change, result of periodic assessment of the effectiveness of DRM model.

In respect of documentation, a Board member stated that the DRM model would not work without specifying the time horizon. Another Board member was unsure what “must be clearly documented” means, i.e. at what level (seniority), what is the approval process for the properly documented strategy? In his view, the strategy should be approved at the highest level because this is a strategy and because it is a strategy and not just a reaction for a week of volatility, it should not occur frequently.

One Board member asked about changes in the operations which may occur over the time, evolutionary and not drastic change e.g. a commercial bank evolves into an investment bank causing that the tenor of assets to change and whether the target profile accommodates that or is that a change in strategy. The staff answered that changing to investment banking is pushing the boundary of applying the DRM model. However, if an entity changes the horizon of the target profile and there in no change in the type of the funding, this would be a change in the strategy.

Other Board members questioned whether the staff is trying to prevent specific behaviour, i.e. achieving a particular accounting outcome by changing the risk management strategy. The staff answered that the change will be captured by the accounting mechanics. However, this raises questions about the commitment to the long-term strategy if the strategy is changed frequently. Again, the analysis of triggers and rationale for change of the strategy are crucial.

One Board member indicated that frequent changes could be seen as akin to trading but this will mean different accounting for derivatives, i.e. changes in fair value recognised in other comprehensive income versus changed in fair value recognised in profit or loss. If frequent changes are allowed, then the accounting model will not represent true business model.

The staff added that this is no different from the concept of business model change or the transaction being no longer highly probable when the hedge accounting was disqualified prospectively. This is because the strategy is no longer what the model was trying to accommodate and the information given by the accounting is no longer accurate. It was repeated that in the phrase “clearly documented time horizon”, the time horizon is important in establishing when the amount from other comprehensive is reclassified to profit or loss and clear documentation will prevent any manipulation.

One Board member said that the DRM model is developed to address the issue of the long-term strategy, where the components of this strategy are changing regularly and are dynamic. If the strategy is changing every day, then this is not a long-term strategy with daily tuning only it is a short-term strategy more like trading. This should be explained because it relates to the problem that the Board is trying to solve. Then the requirements for application of DRM model will flow from that. 

The Board suggested some amendments to the question raised i.e. clarify that changes to risk management strategy should be infrequent in order to apply the DRM model and replace the phrase “must occur infrequently” with the phrase “is expected to occur infrequently”.

Decision

The Board tentatively agreed with the preliminary staff’s recommendations unanimously.

Presentation (Agenda Paper 4C)

In this paper, the staff discusses the presentation of amounts relating to the derivatives designated in the DRM model in the statement of financial position, other comprehensive income and in the statement of profit or loss.

Statement of Financial Position

The staff considers two possible approaches:

  • (1) to disclose the information about derivatives designated in DRM model within the notes to the financial statements; or
  • (2) to present the derivatives designated in DRM model separately from the other derivatives in the statement of financial position.

The two approaches can be supported by the requirement in paragraph 24 of IFRS 7 Financial Instruments: Disclosures to disclose separate information regarding hedging instruments designated in the hedge accounting relationships and paragraph 59 of IAS 1 Presentation of Financial Statements which requires entities to present the different classes of assets in separate line items.

The staff think that the function of the derivatives designated in the DRM model is different from those that are not designated and disaggregation would provide useful information. However, this would be more effectively communicated via disclosure than adding separate lines to the statement of financial position and increasing the length of the primary statement.

Other Comprehensive Income

The staff proposes that amounts included in other comprehensive income need not be shown as a separate line item in the statement of other comprehensive income. Note disclosure is more appropriate. The staff note that this is consistent with IAS 1: 82A and IFRS 7: 24B(b)(i). Entities are required to present separately the balances in relation to cash flow hedges or net investment hedges, but not ((in the Statement of OCI) the changes in fair value of the designated derivatives or reclassified amounts.  

Statement of Profit or Loss

The staff considers presentation of the aligned portion as part of an entity’s net interest margin.  Furthermore, the staff considers whether the misaligned portion should be presented as a separate line item within the statement of profit or loss or disclosed in the notes to the financial statements.

The staff acknowledges that the term ‘net interest margin’ is not defined in IFRS Standards but it is commonly used by financial institutions and is used to mean a subtotal that is net of interest income and interest expense derived from financial assets and liabilities. If an entity designates derivatives to transform the asset profile so it equals target profile, the amounts recognised in the income statement in relation to interest revenue from designated assets, interest expense from designated liabilities and the amounts reclassified from other comprehensive income in relation to designated derivatives are linked.  Therefore, separating these three items in the profit or loss could confuse the users of financial statements and would not faithfully represent the risk management actions of an entity in the financial statements. Furthermore, the staff considers apportioning the amount reclassified from the other comprehensive income by the affected hedged item. The staff rejects this approach because it would require separating the designated derivatives into components based on their fixed and floating leg. The staff proposes the following approaches: (i) allocate the full amount to interest revenue; (ii) allocate the full amount to interest expense or (iii) present the aligned portion as a separate line item (see chart 3 in the paper). However, the staff thinks that allocation or full amount with either interest revenue or interest expense is not appropriate because it would ignore the linked nature of the items designated and is in favour of separate presentation. As an additional argument to support its view, the staff uses the similarity with cash flow hedging on net positions under IFRS 9 Financial Instruments when the hedging gains and losses are presented in a separate line in the statement of profit or loss.  

In the case of any misaligned portion (over-hedge), the staff proposes not to include it within ‘net interest margin’ because they are in excess of those required to transform the asset profile such that it equals the target profile. The cash flows attributable to the misaligned portion serve a purpose other than risk management as it was tentatively agreed by the Board during its September 2018 meeting. Therefore, the treatment of aligned and misaligned portions should be different to present appropriately the risk management and its effectiveness. The staff further decomposes the misaligned portion into current period impact of misalignment and future period impact of misalignment and states that each of them conveys different information to users of financial statements.

The staff proposes three approaches regarding presentation of current and future misaligned portions, i.e.:

  • (1) present both current and future misaligned portions as the separate line item in the statement of profit or loss;
  • (2) present separately current and future misaligned portions as the separate line items in the statement of profit or loss; or
  • (3) disclose them in the notes to the financial statements.

They recommend option (3). The staff’s rationale for such presentation is that only over-hedge would be clearly visible in the statement of profit or loss. An under-hedge (and due to using of ‘lower of test’) will be not noticed, giving the users of financial statements the wrong impression that an entity achieved a perfect alignment.

Staff recommendations

The staff recommend that:

  • (a) disaggregation of derivatives designated in the DRM model from other derivatives should be communicated through disclosure rather than a separate line item in the statement of financial position;
  • (b) the DRM accounting model should not require presentation of accumulated changes in fair value of designated derivatives in a separate line item within other comprehensive income, but this information should be clearly communicated to users through disclosure;
  • (c) the aligned portion should be presented as part of an entity’s net interest margin in a separate line item in the statement of profit or loss. In addition, during the outreach, the staff should seek for feedback on whether the costs involved with separate presentation on the statement of profit or loss would merit the benefits of increased transparency; and
  • (d) the misaligned portion should not be presented as part of an entity’s net interest margin. In addition, the DRM model should not mandate a specific line item for presentation of misalignment, but should require disclosure of that amount on a disaggregated basis and the line item in the statement of profit or loss where misalignment is presented.

Discussion

The staff emphasised that the recommendations are in the context of the core model i.e. to focus on the most important aspects of DRM model and to develop material for outreach and discussion that support future decisions.  

Statement of Financial Position and Other Comprehensive Income

Two Board Members disagreed with the staff recommendation and were of the opinion that the nature and function of the derivatives used in a DRM model are different and they should be presented as separate line items in the primary statements. This is important and should have higher focus than just a disclosure. However, they agreed that the concept of materiality should be applied.

One Board member indicated that if the nature and function of the derivatives is different then maybe they should not be presented as one line item. However, in his opinion, the nature of the derivatives is the same but they have different function and hence they should be disclosed.

One Board member indicated that the questions asked by the staff have two aspects—whether the information about the derivatives should be disaggregated and, if disaggregated, where they should be presented. On the disaggregation part, the Board member asked whether the staff is proposing separate presentation of derivatives designated in DRM from other derivatives designated in micro-hedges. The staff confirmed that this is the case. The staff was reminded to be clear with the wording and use the terms ‘presented’ in the case of Balance Sheet or Other Comprehensive Income and ‘disclose’ in the case of disclosures.   

The Board members agreed with the staff recommendation because this is the way to provide useful information about the DRM model. The balance sheet is a structured summary and it should not be overloaded with information. It was noted, that if an entity wishes to present derivatives used in DRM model as the separate line, it should not be prohibited. At the same time, it should not be required to present them as a separate line item.

The staff clarified that the information will be always there, it is just the case of emphasis put on that information which is different for something presented in the financial statements from something disclosed in the notes.

The Board suggested amending the wording in the question from “should be communicated through disclosure” into “shall not require presentation….” to be clear that the entities may presented the disaggregated DRM derivatives on the face of balance sheet.

Decision

12 Board members tentatively agreed with the staff’s recommendations.

Statement of Profit or Loss – aligned portion

One Board member indicated that there is a requirement to present separately revenue and finance cost, however interest margin is not a defined term in IFRS. The aligned portion should be presented as the separate piece of information on the face of income statement on the basis how important that is but it should not be required to be presented as the part of net interest income, which may differ, by entity.

One Board member indicated that the aligned portion will have to be presented as a separate line because it is different in nature, i.e. it is fair value of derivatives and not interest revenue or interest expense.

Another Board Member indicated that the staff has to be careful with the terminology used in the paper. For example in the investment markets: ‘net interest margin’ is commonly understood as ‘net interest income’ and ‘the net interest margin’ would be “interest income over average earning assets”. Hence, it was slightly confusing for him. He agreed with the staff recommendation to present the aligned portion as a separate line item. The Board member indicated that the users would like to calculate ‘net interest margin’ pre- and post- of the effects of the DRM model and therefore he suggested putting the aligned portion at the bottom of the three items.  In respect of term ‘net interest income’, he suggested to include that in a new project.

Several times the parallel Primary Financial Statement (PFS) project was mentioned and whether presentation will be left for PFS project, whether the outcome of that project should feed into the DRM project or the projects will be integrated. The DRM discussion paper might acknowledge the PFS project. 

One Board member agreed with the staff recommendations on the understanding that the separate line items and the ‘net interest margin’ will accommodate all hedging activities of an entity, i.e. including micro-hedging because in other way there will be too many line items and too many sub-totals. Other Board members clarified that the revised question does not ask about sub-totals, but only whether the aligned portion of DRM derivatives (and only those derivatives) should be presented separately. Furthermore, the staff explained that the requirement to present separately all derivatives used for hedging would mean significant change and will not necessarily reflect the economics of the micro-hedges. Furthermore, it is not in the scope of Paper 4C.

The staff explained that the outreach will be a full discussion and it will happen before the DP will be issued. The idea is to test the model during outreach.

One Board member suggested asking during outreach about the usefulness and importance of the ‘net interest income’ sub-total for the users before doing anything more in about it during the DRM project.

The staff agreed that it should be clarified during outreach that even if an entity were perfectly hedged, the target profile would be not shown on the face of profit or loss because the book may be bigger than what is in the scope of DRM model. This will become even more relevant beyond the core model because if an equity’s book was included, this is a funding source and not source of interest income or expense.

The staff repeated that what they are proposing is that there has to be separate line item for an aligned portion of the DRM derivatives and that it has to be clear that the separate line item relates to both interest rate income and interest expense. The staff agreed with the Board members that the better place to show the relationship between those items is within the notes to the financial statements. The staff agreed that during an outreach they would not ask specifically about the presentation hence the Board was not asked to vote on that element of the original question. 

Decision

13 Board members tentatively agreed with the above staff’s recommendations and one abstained. 

Statement of Profit or Loss – misaligned portion

One Board member indicated that he would not ask for separate presentation or even for the specific disclosure of the disaggregated bit of misalignment because there is not much information value in that.

The Board members agreed that the misaligned portion should not be presented in the same manner as the aligned portion of DRM derivatives because in this way the information value will be lost. However, some Board members were in the opinion that the misaligned portion should be presented on the face of the income statement because there are two purposes, i.e. to present whether this is a good or bad strategy and how much the misalignment has contributed to the bottom line. These numbers may be big and quite volatile and should be seen not as part of an entity normal activity only it should be seen as part of DRM model that was not successful. Again, it was confirmed, if material, it should be separately presented. 

The staff explained that they are not proposing to hide any misalignment, it is a matter of emphasis and in the staff’s view the notes are good enough to include this information.

Decision

On the question whether the misaligned portion should be communicated clearly that is not part of the aligned portion, 13 Board members voted in favour and one abstained. 

On the question whether the DRM model should require that the misalignment has a separate line item on the face of income statement, three Board members voted in favour and one abstained.

On the question whether the amount of misalignment should be separately communicated through disclosure, 11 Board members voted in favour and one abstained. 

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