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IAS 39 (IFRS 9) — Embedded derivatives in negative interest rate environment

Date recorded:

Recap

At its September 2015 meeting, the IFRS Interpretations Committee discussed the issue of an interest floor at zero per cent. The submitter asked whether the floor should be separated from a floating rate host and accounted for as a derivative in a negative interest rate environment. IAS 39 requires separation of an embedded derivative if it is not closely related to its host. IAS 39.AG33(b) states that an embedded floor is closely related to the economic characteristics and the risks of the host contract if the floor is at or below the market rate of interest when the contract is issued and the floor is not leveraged in relation to the host contract. That means that a floor that is ‘in the money’ when the contract is issued requires separation.

The staff is of the view that negative interest is a form of interest as IFRS 9 indicates that in extreme economic circumstances, interest could be negative. Therefore, IAS 39.AG33(b) is also applicable in a negative interest rate environment. The staff concluded that IAS 39 contains sufficient guidance to resolve the issue raised by the submitter.

A tentative agenda decision was issued on this basis. The Committee has received three comment letters on the tentative agenda decision. All of the respondents agreed with the Committee’s view. However, they suggested that the Interpretations Committee clarify whether an entity should compare the interest rate floor based on the overall rate of interest (including a contractual spread) or based on the benchmark rate of interest. They also suggested adding guidance on determining the market rate of interest.

To address these comments, the staff proposes amendments to the agenda decision and recommends to that the agenda decision be finalised on that basis.

Committee discussion

There was broad support for the proposed agenda decision amongst the Committee members, especially for the proposal to compare the interest rate floor based on the overall rate of interest.

Several Committee members pointed out that a bifurcation of caps and floors should be relatively rare, as most of the time floor rates would be below and cap rates would be above the market interest rate at initiation.

Some Committee members proposed to clarify in the agenda decision that the rationale for not bifurcating should also be applied in a positive interest rate environment. The title of the agenda decision should therefore be changed as it would otherwise be misleading.

One Committee member suggested including an example in the agenda decision which was rejected by the Technical Director. The Technical Director argued that an example would have to be very detailed and that there was no precedence of an example in an agenda decision. As a compromise, the Chairman proposed to draft an example for the next Committee meeting that, upon agreement, could be forwarded to the Board as educational guidance.

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