Dynamic Risk Management

Date recorded:

Mechanics of the Dynamic Risk Management (DRM) model (Agenda Paper 4A)

At this meeting, the IASB continued its deliberations on Discussion Paper DP/2014/1 Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging. During the February 2022 meeting the IASB discussed feedback and staff analysis on the mechanics of the DRM model, specifically which amounts should be recognised in the financial statements and where. The staff presented two alternative approaches in order to obtain the IASB’s initial views. In this paper, the staff presents further analysis on the alternative approaches to the mechanics of the DRM model. The paper also includes three appendices that include illustrative examples of (i) economic phenomenon of DRM, (ii) reflection of the economic phenomenon in the financial statements and (iii) a reminder of the elements of the DRM model.

The paper reiterated that the entities applying DRM of repricing risk due to changes in interest rates are using derivatives both to reduce volatility in earnings by stabilising the net interest income (i.e. cash flow variability) and to reduce variability from an economic value perspective by protecting the fair value of its assets, liabilities and future transactions. The economic phenomenon of the repricing risk being fully mitigated is illustrated in Appendix A of the paper. The objective of the DRM model is to better reflect an entity’s DRM strategies and activities, and this is consistent with the objective of general purpose of financial reporting. The staff analysed the current approach to the mechanics of the DRM model that was based on the cash flow hedge mechanics. The main concerns raised during the 2020 outreach were that items recognised in OCI would provide only information about the entity’s financial performance (reduced variability in net interest income) and not about financial position (i.e. the model would not show the effect of reduced variability in fair value). Furthermore, the volatility in equity arising from recognising the aligned portion in OCI will not provide relevant information about the economic phenomenon of DRM. To address these challenges, the staff have developed two alternative approaches and then assessed each of them as to whether the mechanics provide a faithful representation of the economic phenomenon and whether the mechanics provide relevant information to the users of financial statements.

Approach A

Mechanics

The designated derivatives would continue to be recognised at fair value in the statement of financial position, with gains or losses recognised in the statement of profit or loss. The risk mitigation intention would be recognised at fair value as a separate line item in the statement of financial position, with gains or losses recognised in statement of profit or loss.

Do these mechanics provide a faithful representation?

No. The mechanics of this approach fail to faithfully represent the dual purpose because this approach only presents how the entity reduced variability in fair value of the underlying items but do not fully represent the reduced variability of the net interest income. In the staff’s view the unwinding of the DRM adjustment may be challenging due to frequent changes to the risk mitigation intention and no direct link between that and underlying items. Furthermore, this approach may have potential implications on the second phase of the DRM project when it will be considered whether the assets measured at fair value could be designated in the DRM model (i.e. risk of double-counting of portion of fair value).

Do these mechanics provide relevant information?

There are certain shortcomings of the information provided as it neither provides insights about the fair value due to the hedged risk of the underlying items nor does it provide direct information about the extent of offset achieved between the risk mitigation intention and designated derivatives.

Approach B

Mechanics

The designated derivatives would continue to be recognised at fair value in the statement of financial position. The DRM adjustment would be recognised in the statement of financial position, as the lower of (in absolute amounts): (i) the cumulative gain or loss on the designated derivatives from the inception of the DRM model and (ii) the cumulative change in the fair value of the risk mitigation intention attributable to repricing risk from inception of the DRM model. This would be calculated using the benchmark derivatives as a proxy. The difference between the changes in fair value of designated derivatives and DRM adjustment will be recognised in in the statement of profit or loss.

Do these mechanics provide a faithful representation?

Yes. It presents both reduced variability in fair value by recognising in the statement of financial position only that portion that successfully mitigated the repricing risk (due to ‘lower of test’) and it presents reduced variability in the net interest income (due to future unwinding of the DRM adjustment). This approach would also allow future designation of assets measured at fair value. 

Do these mechanics provide relevant information?

Yes. The approach will provide information about the extent to which an entity achieved an offset.

The paper then considers the presentation of the DRM adjustment in the statement of financial position. In the staff’s view, departure from the Conceptual Framework on the definition of an asset or a liability (and when an asset or a liability may be recognised) may be justified as in this way the DRM model would provide useful information to the users of financial statements about entities’ DRM. Furthermore, the scope of such departure will be limited only to certain risk management strategies and activities.

Staff recommendation

The staff recommended changing the mechanics of the DRM model to those as described in Approach B.

IASB discussion

In general, IASB members supported the staff’s arguments as to why the mechanics of Approach B provide more faithful and more relevant information than Approach A. However, in the process, IASB members asked several questions to the staff in order to gain better understanding of the proposed mechanics of Approach B.

  • Is there any protection or counterbalances to avoid bias, not to encourage entities stating that the risk mitigation intention is higher than it actually is and then systematically under-hedge? The staff responded that the ‘lower of’ test is just about measurement mechanics and the purpose of that is to ensure the amount deferred in the balance sheet actually represents the benefits of the DRM adjustment and whether the entity achieved purpose of reducing variability from both the fair value and the future income perspective. That is different from the general meaning of under-hedging when the hedging instrument is only partially mitigating a risk exposure in the hedged item. The staff also reminded IASB members that the risk mitigation intention would need to be anchored to what an entity has actually done to manage the risk. Meaning that if the entity executed derivatives for 80, it cannot say that the risk mitigation intention is 100 as this is not evidenced by what was actually done
  • Is it fair to characterise Approach B as saying that it helps to determine how much of the change in the fair value of the derivative is deferred as the DRM adjustment in the balance sheet? If yes, then it may be helpful to describe it in that way. It was said that it was not clear whether Approach B is just the net version of Approach A where gross amounts are recognised in P&L and in the balance sheet. The staff confirmed that the balance sheet will contain the deferred fair value of the derivative (or less) depending on the ‘lower of’ test. The staff emphasised that the relationship between the risk mitigation intention and the derivative used to manage the risk gives rise to the DRM adjustment. The change in fair value of the derivative (i.e. the effective portion) is not immediately recognised in P&L. Instead, it is delayed and deferred in the balance sheet to reflect the risk management and the hedge accounting under the DRM model
  • What is meant by the ‘inception of the DRM model’ when comparing the cumulative gains or losses on designated derivatives and cumulative change in fair value of the risk mitigation intention? I.e. whether that is from the moment the entity would set up a range (target profile) as opposed to when it sets up the risk mitigation intention. IASB members were concerned that the accretion could build up and entities would struggle to identify the portion to unwind. The staff responded that it means from the first time the entity applied its DRM model under the current risk management strategy (target profile). However, because the DRM adjustment is linked to the fair value of hedged items, once the hedged items are removed from the balance sheet (i.e. its fair value is nil), the deferred amount would also be nil and so the amount that was in the balance sheet as the DRM adjustment will be recycled to P&L. As this is a rolling book, if the hedged period is, for example, 5 years on assets with a maturity of 20 years, it will always be 5 years but after the first year, it will be years 2 to 6 and year 1 will be removed
  • Why does Approach A fail to faithfully represent the dual purpose and how is that different from Approach B? The staff illustrated this with an example when the risk mitigation intention has a fair value movement of 100 and the designated derivatives have a fair value movement of 80. Under Approach A, the DRM adjustment would be based on the movement of 100 of the risk mitigation intention. However, this 100 is not really a reduced variability i.e. the reduced variability was 80. Furthermore, once the balance sheet is adjusted by 100 then that needs to go to net interest income over time and again that’s not something that reduces variability. As a comparison, under Approach B only 80 would be recognised as a DRM adjustment in the balance sheet
  • Is the fair value of the derivative recognised in the balance sheet the same as the amount calculated using the ‘lower of’ test? The staff responded that it may not always be the same and used an example of derivatives designated much later than they were executed, i.e. such derivatives will already have some fair value at designation date

IASB members agreed that Approach A fails to communicate accurately the effectiveness of the hedge. Furthermore, it was said that Approach B sets up for good disclosures going forward and for robust disclosures demanded specifically by one of the IASB members. In his view, there should be clear presentation in the balance sheet (as a separate line) and clear illustration within the notes of the relationship between derivatives and underlying items, of the size of the designated derivatives and of the size of risk mitigation intention (i.e. what are their fair values and how that changed during the period), of the description of what is the underlying item (open portfolio) and what it looks like.

In respect of departure from the Conceptual Framework, IASB members accepted that as in the end it would provide more transparent information for the users of financial statements. However, it was reiterated that such departure could only be applied to the DRM model and cannot be taken any further because the IASB wants to avoid degradation of usefulness of the Conceptual Framework in the long term. One IASB member flagged that other departures from the Conceptual Framework may be needed once the model develops. For example, remeasuring part of the equity or recognising part of the forecast transactions earlier as the proxy. It was concluded that this would be looked at once the project progresses. Furthermore, the staff added that some of these challenges would appear regardless which mechanics are applied.

IASB decision

All IASB members agreed with the staff recommendation to change the mechanics of the DRM model as described in Approach B.

Project Direction (Agenda Paper 4B)

This paper provided the staff’s analysis of the criteria in the Due Process Handbook for adding a project to the standard-setting programme and justification why the IASB should continue to use the expertise of the existing advisory bodies instead of establishing a dedicated consultative group for the project.

The staff highlighted the following criteria and arguments why the DRM project should be added to the standard-setting programme:

  • There are deficiencies in the current reporting to faithfully present the outcome of the DRM activities in the financial statements due to limitations of the accounting requirements in IAS 39 or IFRS 9 (e.g. no ‘real’ open portfolios, not possible to designate hedged exposure on net basis, not possible to designate demand deposits, dual character of the net interest rate risk position meaning that the entities are hedging both variability of cash flows and variability in fair value but current hedge accounting requires the designation of the hedge as either cash flow hedge or fair value hedge)
  • The users of the financial statements are adversely affected by the lack of alignment between financial reporting and the economics of the DRM. There is lack of transparency of financial information
  • Many entities are affected and the problem is pervasive
  • The DRM model would address the problems identified with current hedge accounting requirements and could reduce the costs because it replicates the risk management activities of the entity so there would be no need to conduct proxy hedge accounting

In respect of establishing a consultative group for the project, the staff argued that it would be better to use the expertise of the existing advisory bodies because the existing consultative groups have the relevant experience and expertise on the accounting for DRM to advise on this project. Furthermore, a dedicated consultative group would provide the IASB with feedback based on research that would require additional time and resources. However, such feedback was already obtained through previous consultations and during outreach hence it would be unnecessary effort.   

Staff recommendation

The staff recommended adding a project on DRM to the standard-setting programme and to continue to use the expertise of the existing advisory bodies instead of establishing a dedicated consultative group for the project.

IASB discussion

The discussion revolved mainly around establishing a dedicated consultative group for the DRM project. While IASB members in general agreed with the staff’s arguments as to why there is no need to establish a dedicated consultative group for the project, they also reminded that the use of such group is very effective in getting information, it is great for quality and for meeting with the public. IASB members agreed that a dedicated consultative group would consult with the specialist group of users to which the staff already has good connections. IASB members therefore believed that this will be the most effective process. However, due to the complexity of the DRM project, IASB members challenged the staff whether having a group of users and banks who can be used as the ‘sounding board’ for the ideas while the project is developed will be beneficial for the staff as it could provide many insights and add value. Furthermore, this may also be an opportunity to gather further feedback. The staff conceded that this was a fair point, however, the staff said that they were already able to reach many stakeholders in different jurisdictions through outreach. It was also said that this was not a binary decision and such consultative group could be still established in the later stage, for example after publishing an exposure draft, if that was necessary. One IASB member encouraged the staff to think whether it would be a good idea to bring together, even for a one-off public meeting, the group of users who focus on financial institution financial statements to obtain useful information about the degree of education and how the outreach is targeted as the project moves forward.

IASB decision

All IASB members agreed with the staff recommendation to add DRM project to the standard-settling programme and not to establish (at least not today) a consultative group.

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