Scope of the DRM model (Agenda Paper 4)

In this session, the IASB discussed the staff’s preliminary view on the scope of the Dynamic Risk Management (DRM) model, that is the type of risk management activities for which the application of the DRM model would be appropriate and provide useful information. The IASB was not asked to make any decision at this meeting, but questions and comments on the potential scope of the DRM model were encouraged.

In this paper the staff recalled the two approaches discussed on Discussion Paper DP/2014/1 Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging (2014 DP) for the scope of the DRM model. The staff presented their analysis on which approach would be appropriate.

Scope of the 2014 DP

The staff pointed out that DRM may be undertaken by a wide range of entities, from financial institutions to utilities or even some manufacturing entities and that the types of risks that can be dynamically managed vary. However, when developing the 2014 DP, the IASB tentatively decided to focus on the way in which banks dynamically manage their interest rate risk as a starting point for the DRM project.

The two approaches for the DRM scope were discussed and analysed in the 2014 DP. The first focussing on the DRM and the second focussing on the risk mitigation. The key difference between these approaches is related to the treatment of the unhedged portion of the underlying portfolios, but both approaches presented issues and challenges which were often interrelated.

Respondents had mixed views in response to the 2014 DP, although many preferred a scope focused on risk mitigation to a scope focused on DRM activities.

Staff analysis

The staff considered carefully the two approaches discussed in the 2014 DP when developing the DRM model, and intended to combine the best characteristics of each alternative.

For instance, identifying the Current Net Risk Position (CNOP), aggregating the variability of an entity’s financial assets and financial liabilities attributable to changes in a particular benchmark interest rate, as a starting point in the DRM model is aligned to the way an entity usually monitors and manages its net interest rate risk in practice. The CNOP ensures greater consistency between what is reflected in the financial statements and what the entity does from a risk management perspective. Therefore, the DRM model retains the advantage of a scope focused on DRM.

On the other hand, the Risk Mitigation Intention (RMI), which represents the extent to which an entity intends to mitigate the CNOP through the use of derivatives, ensures the measurement of DRM adjustment reflects the extent to which the entity’s has been successful in its risk mitigation activities. As a result, the DRM model also shares many advantages with the risk mitigation approach.

The staff presented their view on what would be the relevant characteristics of a risk management strategy and activities can be inferred from the elements of the DRM model, such as the CNOP and the RMI, as well as the business activities that give rise to the interest rate risk exposure.

Business activities that give rise to repricing risk

The staff’s view is that applying the DRM model would only be appropriate when an entity engages in maturity transformation (i.e. entities that engage in frequent borrowing and lending as part of its main business activities) as its key business activities and manages dynamic portfolio(s) of financial assets and financial liabilities with an intention to manage the repricing risk the entity is exposed to.

Dynamic risk management strategy to mitigate the net exposure to repricing risk

Applying the DRM model would not be appropriate unless an entity has a risk management strategy that focuses on managing net interest income. In the staff’s view, that would naturally exclude many entities which already reflect the effects of interest rate changes in the statement of profit or loss using fair value measurements.

Established and systematic risk aggregation processes

In the staff’s view, unless there is an established and systematic risk aggregation process, an entity would not be able to form a holistic interest rate risk view, and thus would not be able to manage its interest rate risk holistically at an entity level. Such an entity-wide risk aggregation process would also have to be more fundamental than simply combining a few portfolios and manage them together, which could be better reflected using the general hedge accounting requirement for a group of items under IFRS 9.

Access to a liquid market for raising funding and investing excess cash

The staff is of the view that that access to a liquid market for raising funding and investing excess cash, is also a relevant characteristic of the business and risk management activities for which the DRM model would provide useful information on.

IASB discussion

IASB members overall appreciated the fact that no decision was asked at this stage. One IASB member suggested to consider how specific the model is to avoid moving from a principle-based model to an operational model. A few IASB members asked about how the model would be applied by non-banking entities. One IASB member commented that the current requirements for defining, for instance, CNOP and IRM, are already a high hurdle for many non-bank entities. The staff clarified that the objective of this session was asking the members’ views on the model and use it to gather further information around what non-banks are doing for interest rate risk management. It was agreed that the next step is to prepare an outreach plan.