International Financial Reporting Standards
Accounting for Dynamic Risk Management:
a Portfolio Revaluation Approach
to Macro Hedging
2014
The views expressed in this presentation are those of the presenter,
not necessarily those of the IASB or IFRS Foundation
© 2014 IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
At a glance
2
• The IASB is exploring an accounting approach to better
reflect dynamic risk management (DRM) activities in
entities’ financial statements.
• The Discussion Paper (DP) uses dynamic interest rate
risk management by banks for illustrative purposes.
However, the approach considered in the DP is
intended to be applicable to other risks (for example,
commodity price risk and FX risk).
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Dynamic Risk Management (DRM)
3
• DRM is a
continuous process.
• Major characteristics of
DRM include:
dynamic
 DRM is undertaken for open portfolio(s), to which new
exposures are frequently added and in which existing
exposures mature.
 As the risk profile of the open portfolio(s) changes,
DRM is updated frequently in reaction to the changed
net risk position.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Challenges under IAS39/IFRS9 hedge accounting
4
• Current hedge accounting requirements are often
difficult to apply to DRM because:
 One-to-one linkage between what is being hedged and the
hedging derivative;
 Can only indirectly accommodate DRM on a net basis
through gross designation;
 Can only accommodate open portfolios by treating them as
a series of closed portfolios with short lives;
 Allows for a degree of behaviouralisation of exposures but
this is limited.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Dynamic interest rate risk management in banks
5
The purpose of dynamic RM is usually to manage Net Interest Income
Dynamic Risk Management (DRM)
6
• DRM is a continuous process. It is undertaken for open
portfolio(s), to which new exposures are frequently added and
in which existing exposures mature. As the risk profile of the
open portfolio(s) changes, DRM is updated frequently in
reaction to the changed net risk position.
• Current hedge accounting requirements are often difficult to
apply to DRM.
Question 1—Assessing the need for an approach
Do you think there is a need for a specific accounting
approach to represent DRM in entities’ financial statements?
Why or why not?
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
The Portfolio Revaluation Approach (PRA)
7
• Exposures within open portfolios are revalued with respect to the
managed risk (for example, interest rate risk).
• Not a full fair value model.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
The PRA—continued
• The net effect between the revaluation adjustment of the managed
exposures and the fair value changes of the risk management
instruments (for example, interest rate swaps) is reflected in profit
or loss.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
8
Expected improvements with the PRA
9
 enhances information about DRM;
 reduces operational complexities such as tracking and
amortisations;
 captures the dynamic nature of risk management on a
net basis;
 considers behavioural factors;
 considers different types of risks managed in open
portfolios.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Behaviouralisation (‘core’ demand deposits)
10
amount
outstanding
Core demand deposits
time
• At a portfolio level, the ‘sticky’ nature of demand deposits leads to
the identification of a stable portion in the amount outstanding.
• These core demand deposits are deemed to be fixed rate
deposits with longer maturities for risk management purposes
(behaviouralisation).
Behaviouralisation and revaluation of the
managed exposures
11
Question 2—Behaviouralisation
For the purposes of applying the PRA, should the cash flows be
based on a behaviouralised rather than on a contractual basis,
when the risk is managed on a behaviouralised basis?
Question 3—Core demand deposits
Do you think that core demand should be included in the
managed portfolio on a behaviouralised basis when applying
the PRA if that is how an entity would consider them for DRM
purposes?
Question 4—Revaluation of the managed exposures
Do you think that the revaluation calculations provide a faithful
representation of DRM? Why or why not?
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Hedge accounting and the managed portfolios in
DRM
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
12
Pipeline transactions and equity model book
(EMB)
13
Question 5—Pipeline transactions
Do you think that pipeline transactions should be included in
the PRA if they are considered by an entity as part of its DRM?
Why or why not?
Question 6—EMB
Do you think that EMB should be included in the PRA if it is
considered by an entity as part of its DRM? Why or why not?
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Transfer pricing—Overview
14
 Business and Risk Management Structure
 Division of responsibilities between Business Unit (BU)
and ALM (Asset Liability Management):
 BU: Focus on customer margin
 ALM: Interest rate margin management possibly
dynamically
 Made operational through Transfer Pricing
 BUs raise funds from the ALM for their business
activities through transfer pricing (TP) transactions.
 ALM aggregates the risk centrally for risk
management using such TP transactions.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Identification of the managed risk in the PRA
15
 Two important features of the PRA in identifying
managed risk:
 To capture dynamic interest rate RM based on funding
index at the ALM
Revaluation with respect to ‘funding index’
 To provide operational feasibility
Transfer Pricing (TP) transactions as a practical
expedient
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Dynamic interest rate RM with respect to
funding index using TP transactions
Business unit makes a
fixed interest rate
customer loan at 7.1%
3.1% margin earned
overall by bank
Customerspecific
margin
3%
ALM funds customer
loan at internal fixed
interest rate of 4.5%
(the transfer rate)
2.6% margin earned by
business unit
Internal
funding
spread 0.5%
0.5% margin
earned by ALM
External
funding spread
0.2%
7.1% customer
interest rate
External
pricing
decision
16
Market
pricing index
(for example,
base rates)
4.1%
Internal
pricing
decision
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Market
funding index
(for example,
3-month
LIBOR curve)
3.8%
4.5%
transfer rate
PRA with respect to funding index (1)
17
 Suppose a bank has external fixed interest rate loans
with a 7.1% contractual interest rate. The BU raises
funds from the ALM at 4.5%. This means 2.6% is a
customer margin at the BU.
 The ALM raises funds that are necessary for the BU
based on funding index, for instance the 3-month LIBOR
curve, from BUs or through the market.
 Through this process, the ALM manages NII.
 The basic idea of the PRA is:
 use CFs that the BU funded from the ALM (4.5% in
the example above) as a numerator; and
 revalue the CFs with respect to the funding index.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
PRA with respect to funding index (2)
 At Day 1:
 4.5% funding transactions are identified as CFs
(numerator).
 The above CFs are discounted at 4.5%.
 No Day 1 profit or loss.
 Revaluations in subsequent periods
 Suppose funding index increases to 5%.
 Then 4.5% CFs are discounted by a 5% discount
rate.
 Consequently, revaluation adjustment (loss in the
above example) is recognised.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
18
Challenges
19
 IFRS 9 hedge accounting requires that any hedged risk
component is ‘separately identifiable and reliably
measureable’.
-- If PRA is applied with respect to funding index, it is
likely some eligibility criteria for the identification of
the managed risks would need to be considered.
 It is not always possible to identify a ‘known’ funding
source for particular exposures.
-- Banks may use more than one funding indexes, say
1‐month LIBOR curve and 3-month LIBOR curve.
-- Banks do not necessarily match up particular
assets as being funded by particular liabilities.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Transfer pricing transactions
20
• The DP’s preliminary views are that transfer pricing transactions can be
considered for the purpose of identifying the level of the managed risk
(numerator of the revaluation calculation) and the revaluation of the latter
(denominator of the revaluation calculation).
• Transfer pricing accommodates behaviouralisation (eg prepayable
mortgages and core demand deposits). Accordingly, revaluing the exposures
using transfer pricing would incorporate the behaviouralised risk profile
embedded in the exposures.
• For these reasons, the DP presents the use of transfer pricing transactions as
providing operational feasibility to the PRA.
Question 7—Transfer pricing transactions
Do you think that transfer pricing transactions would provide a good
representation of the managed risk in the managed portfolio for the purposes
of applying the PRA? To what extent do you think that risk transferred to ALM
via transfer pricing is representative of the risk that exists in the managed
portfolio?
Scope of the application of the PRA
21
• The scope has significant implications for the information
provided to users of financial statements and on how
operationally feasible the application of the PRA will be for an
entity.
• The DP considers two scope alternatives:
– Focus on dynamic risk management
– Focus on risk mitigation (sub-portfolio approach,
proportional approach)
Scope of the application of the PRA—continued
22
Risk positions
Outside of
DRM
Within DRM
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
Portfolio
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Focus on
DRM
Focus on risk
mitigation
(sub-portfolio
approach)
Focus on risk
mitigation
(proportional
approach)
Scope of the application of the PRA
23
• The scope has significant implications for the information provided to
users of financial statements and on how operationally feasible the
application of the PRA will be for an entity.
• The DP considers two scope alternatives:
– Focus on dynamic risk management
– Focus on risk mitigation (sub-portfolio approach, proportional
approach)
Question 8—Scope of the application of the PRA
Do you think that the PRA should be applied to all managed portfolios
included in an entity’s DRM or should it be restricted to circumstances
in which an entity has undertaken risk mitigation through hedging?
Why or why not? If you do not agree with either of these alternatives,
what do you suggest, and why?
Presentation
Statement of financial position
• Line-by-line gross up
• Separate lines for aggregate adjustments to assets and
liabilities
• Single net line item
Statement of comprehensive income
• Actual net interest income presentation
• Stable net interest income presentation
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
24
Statement of comprehensive income—Actual NII
presentation
IFRS 9
25
PRA—Actual NII presentation
Interest revenue
Interest revenue
Interest expense
Interest expense
Net interest income from derivatives (DRM)
Net Interest Income (NII)
Net Interest Income (NII) after DRM
Revaluation effect from DRM
Net income from derivatives
Net income from derivatives (trading)
Profit or loss
Profit or loss
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Disclosure themes
26
1. Qualitative information on the objectives and
policies for DRM.
2. Qualitative and quantitative information on the net
open risk position(s) and its impact on the
application of the PRA.
3. The extent to which the PRA represents DRM.
4. Quantitative and qualitative information on the
impact of DRM on the current and future
performance of an entity.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Alternative approach–PRA through OCI
27
• Under the alternative approach, the net effect of the
revaluation of the future cash flows of the managed
portfolios and the changes in the FV of risk management
instruments (eg interest rate swaps) is recognised in OCI
rather than in P/L.
• However, there are important conceptual and practical
issues:
 It breaks an assumption in the DP that all risk
management instruments are measured at FVTPL;
 Gross presentation of internal derivatives no longer nets
to zero in P/L;
 Recycling from OCI to P/L.
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Alternative approach–PRA through OCI
28
Question 10—PRA through OCI
Do you think that an approach incorporating the use of OCI should
be considered? Why or why not? If you think the use of OCI
should be incorporated in the PRA, how could the conceptual and
practical difficulties identified with this alternative approach be
overcome?
Questions
29
• Compared to existing accounting, does the
information that would result from the PRA give you
better information about an entity’s DRM activities?
• If no, why not?
• What other information might you need or want
to know?
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
Questions or comments?—Thank you
© IFRS Foundation. 30 Cannon Street | London EC4M 6XH | UK. www.ifrs.org
30