The IASB's Discussion Paper on Accounting for Dynamic Risk...
Transcript of The IASB's Discussion Paper on Accounting for Dynamic Risk...
The IASB's Discussion Paper on Accounting for
Dynamic Risk Management - Evaluation of
Comment Letters
Working Paper16/01
Edgar Löw/Sebastian Mauler1
Frankfurt School of Finance and Management
1 Please send comments to [email protected] or [email protected]
TABLE OF CONTENTS
1. Introduction ................................................................................................................................. - 1 -
2. Overview: Discussion Paper on Accounting for Dynamic Risk Management ............................ - 2 -
3. Approach to Comment Letter Evaluation .................................................................................... - 5 -
4. Evaluation of Comment Letters................................................................................................... - 8 -
4.1 Difficulties with Current Standard and Need for a New Approach ..................................... - 9 -
4.1.1 Question 1: Need for a Specific Accounting Approach ............................................ - 11 -
4.1.2 Question 2a: Difficulties with Current Standard ....................................................... - 12 -
4.1.3 Critical Appraisal....................................................................................................... - 14 -
4.2 Scope of the PRA and Discussion About Obligatory Application .................................... - 15 -
4.2.1 Question 15: Scope of the PRA ................................................................................. - 17 -
4.2.2 Question 16: Mandatory or Optional Application ..................................................... - 23 -
4.2.3 Critical Appraisal....................................................................................................... - 25 -
4.3 Behaviouralisation within the PRA ................................................................................... - 27 -
4.3.1 Question 4: Elements of Behaviouralisation ............................................................. - 30 -
4.3.2 Question 9: Core Demand Deposits .......................................................................... - 36 -
4.3.3 Critical Appraisal....................................................................................................... - 39 -
4.4 Presentation of the PRA within Financial Statements ....................................................... - 40 -
4.4.1 Question 18: Presentation Alternatives ..................................................................... - 43 -
4.4.2 Critical Appraisal....................................................................................................... - 47 -
4.5 Overall Evaluation of the PRA .......................................................................................... - 48 -
4.5.1 Question 2b: PRA as Potential New Accounting Concept ........................................ - 48 -
4.5.2 Critical Appraisal....................................................................................................... - 52 -
4.6 Summary of Evaluation Results ........................................................................................ - 53 -
5. Outlook on Next Steps .............................................................................................................. - 55 -
5.1 IASB’s Evaluation of the Comment Period ...................................................................... - 55 -
5.2 Considered Approaches ..................................................................................................... - 56 -
5.3 Project Plan: Disclosures First........................................................................................... - 57 -
6. Conclusion ................................................................................................................................. - 59 -
REFERENCE LIST ........................................................................................................................... - 61 -
TABLE OF FIGURES
Figure 1: Dynamic risk management within banks ............................................................................. - 3 -
Figure 2: The Portfolio Revaluation Approach ................................................................................... - 4 -
Figure 3: Comment letters by group .................................................................................................... - 6 -
Figure 4: Group composition of users and preparers of financial statements ..................................... - 6 -
Figure 5: Questions answered by frequency ....................................................................................... - 7 -
Figure 6: Evaluation of Question 1 ................................................................................................... - 11 -
Figure 7: Evaluation of Question 2a .................................................................................................. - 13 -
Figure 8: Scope alternatives of the PRA ........................................................................................... - 15 -
Figure 9: Evaluation of Question 15a ................................................................................................ - 17 -
Figure 10: Evaluation of Question 15b – Combination of risk mitigation scope and IFRS 9 ........... - 20 -
Figure 11: Evaluation of Question 15d ............................................................................................. - 22 -
Figure 12: Evaluation of Question 16a .............................................................................................. - 23 -
Figure 13: Evaluation of Question 16b ............................................................................................. - 23 -
Figure 14: Pipeline transactions ........................................................................................................ - 28 -
Figure 15: Core demand deposits ...................................................................................................... - 29 -
Figure 16: Evaluation of Question 4a ................................................................................................ - 31 -
Figure 17: Evaluation of Question 4b ............................................................................................... - 33 -
Figure 18: Evaluation of Question 4c ................................................................................................ - 34 -
Figure 19: Evaluation of Question 9a ................................................................................................ - 36 -
Figure 20: Evaluation of Question 9b ............................................................................................... - 38 -
Figure 21: Presentation alternatives in the statement of financial position ....................................... - 41 -
Figure 22: Actual net interest income presentation ........................................................................... - 42 -
Figure 23: Stable net interest income presentation ............................................................................ - 43 -
Figure 24: Evaluation of Question 18a .............................................................................................. - 44 -
Figure 25: Evaluation of Question 18b.............................................................................................. - 46 -
Figure 26: Evaluation of Question 2b................................................................................................ - 49 -
Figure 27: Predominant views on analyzed questions....................................................................... - 54 -
Figure 28: Proposed project plan ....................................................................................................... - 57 -
LIST OF ABBREVIATIONS
ALM – Asset Liability Management
CU – Currency Unit
DP – Discussion Paper
ED – Exposure Draft
EMB – Equity Model Book
FVTPL – Fair value through profit and loss
IASB – International Accounting Standards Board
IRS – Interest rate swap
OCI – Other Comprehensive Income
PRA – Portfolio Revaluation Approach
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1. Introduction
For several years, the International Accounting Standards Board (IASB) has been
seeking to develop an accounting solution that allows entities to better depict dynamic
risk management in their financial statements, for example in the context of interest rate
risk managed by a bank’s treasury department. Putting the problem with the existing
standard IAS 39 and upcoming standard IFRS 9 in a nutshell, portfolios being hedged as
open and dynamic groups for economic purposes are currently forced into closed and
static hedges for accounting purposes. This in turn leads to a periodical need for re-
designations, thereby introducing complexity as well as ineffectiveness.2 On April 17
th
2014, the IASB published the Discussion Paper (DP) on Accounting for Dynamic Risk
Management: a Portfolio Revaluation Approach to Macro Hedging as a next step in
relation to its Dynamic Risk Management Project. Until May 2012, this project was part
of IFRS 9 Phase 3: hedge accounting but was separated as the IASB realized that a new
approach for dynamic risk management would take more time than initially expected.
This allowed the board to continue to finalize IFRS 9 according to plan while at the
same time developing new ideas in a dynamic context.3 The resulting DP contains an
entirely new accounting concept for dynamic risk management, namely the Portfolio
Revaluation Approach (PRA). According to this concept, dynamically managed
positions included in the PRA would be revalued for changes in the managed risk
through profit and loss while risk management instruments would be measured at fair
value through profit and loss (FVTPL). The net effect on profit and loss of both
measurements would then capture the overall success of an entity’s dynamic risk
management. Besides the discussion on the PRA, the DP also contains further
significant elements, for example elements of behaviouralisation which are common
practice in risk management but challenging to display within an accounting
framework. From publication in April until October 17th
2014 the public was invited to
submit comment letters and thereby answer up to 26 questions posted by the IASB.
During this period 123 letters4 were submitted which are publicly available at the
IASB’s website.
2 Cf. IFRS Foundation (ed.) (2010), p. 2.
3 Cf. IFRS Foundation (ed.) (2014a).
4 Comment letters provided jointly by a group of authors were only counted once, despite being uploaded
as separate comment letters on the IASB’s website.
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Despite some publications summarizing commentators’ aggregated views as well as
brief descriptions of reasoning regarding the important topics5, there was not yet created
sufficient transparency on the outcome of this comment period. This working paper
aims to contribute to further transparency by analyzing all submitted comment letters
with respect to the most significant questions. On the one hand, this analysis will be
conducted quantitatively by stating clearly the outcome of these questions, thereby
carving out respondents’ preponderant views. On the other hand, major arguments will
comprehensively be discussed, especially where views differ. In addition to this
analysis, implications of the predominant views will be examined and evaluated.
The working paper starts by providing an overview on the main topics of the DP,
thereby focusing on describing the mechanics of the PRA which is at the heart of the
IASB’s proposal. In a next step, the approach to the evaluation of all comment letters is
described, especially how the analyzed questions were chosen and the way they were
analyzed. Subsequently, the most significant questions are evaluated quantitatively and
qualitatively. The last part describes decisions taken by the IASB since the end of the
comment period and provides an outlook on future next steps.
2. Overview: Discussion Paper on Accounting for Dynamic
Risk Management
This chapter provides an overview on the DP being analyzed, thereby laying the
foundation for further discussions. After a short definition of dynamic risk management,
a brief introduction to dynamic risk management in the context of a bank’s treasury
department is given. This is followed by a description of the mechanics of the PRA. The
chapter closes with a perspective on the other major issues covered in the DP.
According to the IASB, dynamic risk management usually has the following
characteristics: First, “…risk management is undertaken for open portfolio(s), to which
new exposures are frequently added and existing exposures mature.”6 Second, “…as the
risk profile of the open portfolio(s) changes, risk management is updated on a timely
basis in reaction to the changed net position.”7 Thus, frequent changes in risk exposures
and adequate reactions as well as the focus on net positions can be seen as main pillars
of dynamic risk management.
5 On this see for example Hori, H./Ah Kun, A. (2015).
6 IFRS Foundation (ed.) (2014b), p. 24.
7 IFRS Foundation (ed.) (2014b), p. 24.
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Figure 1: Dynamic risk management within banks
Source: own representation, adapted from IFRS Foundation (ed.) (2014c), p. 4.
Figure 1 depicts how dynamic risk management within banks is usually conducted. On
the liability side, demand deposits, term deposits and bonds are used to raise funds for
lending activities. Sometimes, also equity is considered part of dynamic risk
management on the liability side. This issue will be discussed later in section 4.3.1. The
lending activities on the asset side may inter alia include mortgages, corporate loans as
well as corporate or government bonds. It can be seen that both sides may consist of
variable as well as fixed interest rate financial instruments. Mismatches may now arise
due to different amounts of fixed versus variable instruments, different maturities or
further reasons, thereby leading to potential volatility in the bank’s net interest income.
These mismatches are usually addressed by a central treasury unit responsible for Asset
Liability Management (ALM), with the aim to maintain a stable interest margin on a
portfolio of assets and liabilities.8 The ALM therefore combines assets and liabilities
with both fixed and variable interest rate instruments, and manages the resulting net risk
exposure on a portfolio basis by entering into suitable hedging instruments, for example
interest rate swaps (IRS). Taking the illustration of the DP as an example, a bank might
have a net open risk position of 50 Currency Units (CU), as it has net fixed interest rate
assets and net variable interest liabilities of CU 50, each within the same maturity time
band. The ALM closes this risk position by entering into a CU 50 pay fixed and receive
variable IRS, also known as payer swap, as a risk management instrument.9 This action
hedges the interest rate risk involved and hence stabilizes the interest margin. However,
in a dynamic context this is not the end: As new exposures are added while others
mature, the risk profile evolves over time. This in turn might require further hedging
activity.
8 Cf. Spall, C./Tejerina, E./Harding, T. (2014), p. 9.
9 Cf. IFRS Foundation (ed.) (2014b), p. 21.
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Due to several shortcomings, which will be discussed in section 4.1, current accounting
standards do not allow for a faithful depiction of the dynamic risk management’s
economics in the financial statements. To address this issue, the PRA presents a new
accounting approach to align dynamic risk management as described above with
respective representation in financial statements. This step might enable users of
financial statements to better evaluate the performance of an entity by profit source and
corresponding risk.
Figure 2: The Portfolio Revaluation Approach
Source: adapted from IFRS Foundation (ed.) (2014c), p. 6.
Figure 2 illustrates the functionality of the PRA: On the one hand, exposures’ cash
flows included in the PRA would be revalued only for changes in the risk being
managed, for example interest rate risk, using the present value technique. These
revaluation adjustments would be immediately recognized in profit and loss. Changes in
unmanaged risks, like credit risk, would not be revalued over time. Hence, the PRA
would not be a full fair value model. On the other hand, risk management instruments,
for example an IRS, would be revalued at FVTPL. If the risk has been perfectly hedged,
both effects would exactly offset each other, thereby leaving profit and loss unchanged.
If the two effects do not offset, either intentionally or unintentionally, the net effect
would be depicted in the statement of comprehensive income.10
As an alternative to
showing the net effect in profit and loss, the IASB also considers to show the net effect
in Other Comprehensive Income (OCI). However, as the feedback on this alternative
was rather cautious, this will not be further analyzed in this working paper.11
A detailed
10
Cf. IFRS Foundation (ed.) (2014c), p. 6 f. 11
Cf. Hori, H./Ah Kun, A. (2015), p. 8.
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analysis of the PRA with the net effect shown in profit and loss, especially by looking at
commentators’ views on this suggestion, will follow in section 4.5.
Besides the general discussion on the PRA, the DP covers several other issues
surrounding a new accounting approach on dynamic risk management. Two major
issues are whether the PRA should be applied optionally or obligatory as well as which
scope, either dynamic risk management or risk mitigation, should be chosen. A detailed
analysis of this controversy will follow in section 4.2. Another significant topic is
whether behavioral factors should be allowed within the PRA. This contains the
inclusion of so-called core demand deposits, pipeline transactions and the Equity Model
Book (EMB) as well as the question whether expected cash flows rather than
contractual cash flows should form the basis for exposures within the dynamically
managed portfolio. These questions will be further discussed in section 4.3. A further
question being covered in section 4.4 is how the effects of the PRA should be best
depicted in the statement of financial position as well as the statement of comprehensive
income. Finally, though it is not the focus of this working paper, the IASB raises the
question whether the PRA could be applied to other types of risks, like foreign currency
or commodity price risk and could thus also find a broader application in nonfinancial
corporations.
As comment letters form the basis for the analysis of these fundamental questions, the
next chapter demonstrates the chosen approach to the evaluation of all submitted
comment letters.
3. Approach to Comment Letter Evaluation
This chapter provides insight into the formed commentator groups, the selection
process of questions to be further analyzed as well as the evaluation process itself.
Overall, the DP posted 26 questions which cover all issues where the IASB tried to seek
further input from involved stakeholders.12
At the end of the six month comment period,
123 distinct comment letters were submitted and are now publicly available at the
IASB’s website. In a first step, eleven commentator groups were formed in order to
allow for an explicit analysis of the significant stakeholders’ views in the following
sections.
12
Cf. IFRS Foundation (ed.) (2014b), p. 105 ff.
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Figure 3: Comment letters by group
Source: own representation.
As can be seen from Figure 3, the largest party of respondents constitutes the aggregate
banking industry, namely banks and banking associations (in sum 37 comment letters),
followed by domestic standard setters (18 comment letters) and nonfinancial
corporations as well as nonfinancial associations (in sum 16 comment letters). Financial
markets associations (15 comment letters), having the common need to derive
significant information from financial statements, consist of regulatory bodies, like the
European Central Bank or the Basel Committee on Banking Supervision but also of
explicit analysts, like the CFA Society or the Securities Analysts Association of Japan.
Figure 4: Group composition of users and preparers of financial statements
Source: own representation.
Figure 4 contains the detailed composition of financial markets associations and the
aggregate banking industry. It can be argued that financial markets associations, in the
following summarized as users of financial statements have an intense focus on
Financial markets associations Aggregate banking industry
(users of financial statements) (preparers of financial statements)
Banks:
Mortgage Bankers Association, Japanese Bankers
Association, The Hong Kong Association of Banks, WSBI-
ESBG, Australian Bankers' Association, Swedish Bankers'
Association, European Association of Public Banks,
European Association of Co-operative Banks, European
Banking Federation, The Spanish Banking Association,
Dutch Banking Association, The Canadian Bankers
Association, French Banking Federation, International
Banking Federation
International Organisation of Securities Commissions,
European Securities and Markets Authority, Taiwan Stock
Exchange Corporation, The Securities Analysts
Association of Japan, International Swaps and Derivatives
Association, Association for Financial Markets in Europe,
Institute of International Finance, CFA Socitety UK,
European Insurance and Occupational Pensions Authority,
Basel Committee on Banking Supervision, Securities and
Exchange Board of India, European Central Bank, The
Corporate Reporting Users Forum
KBC Group NV, KFW, National Australia Bank, DBS Bank
Ltd, Australia and New Zealand Banking Group Limited,
Erste Group Bank AG, Commerzbank AG, BNP Paribas,
Rabobank, ING Bank NV, Banco Bradesco S.A., Standard
Chartered, HSBC Holdings plc, Coventry Building Society,
Barclays PLC, Crédit Agricole SA Group, UBS UK, Lloyds
Banking Group plc, The Commonwealth Bank of Australia,
Nationwide Building Society, Deutsche Bank AG, Groupe
BPCE
Banking Associations:
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transparency, understandability and a faithful representation of the effects of dynamic
risk management within financial statements. Opposed to that, the aggregate banking
industry, in the following summarized as preparers of financial statements, might be
more focused on low earnings volatility as well as operationality. This simplified
assumption forms the rationale for a looking at these two parties in greater detail, as
views with regard to controversial questions might differ due to at least partly
conflicting interests. The focus on the banking industry was chosen as the DP’s focus is
mainly on dynamic interest rate management within commercial banks.
In a next step, the frequency of questions answered was selected as the criterion for
which questions to analyze in further detail. This approach assumes that questions
answered most frequently are questions of high importance to commentators whereas
questions with a rather low frequency are either less important or do only affect a
smaller group. As some comment letters were not answered question by question but in
free text, best judgement was used in order to decide which questions count as being
answered. With respect to ambiguous cases, every answer except the specific statement
no comment / not applicable as well as a statement with an identical meaning, was
counted as an answer. Overall, a question counted as answered if at least one of the sub-
questions (if applicable) was answered.
Figure 5: Questions answered by frequency
Source: own representation.
Figure 5 shows how often the respective questions have been answered within the
entirety of all comment letters. Out of this analysis, five distinct themes have been
identified. The first theme focuses on difficulties with current standards in a dynamic
risk management context. It includes Question 1 (Need for an accounting approach for
dynamic risk management) and Question 2a (Current difficulties in representing
dynamic risk management in entities’ financial statements) and will be evaluated in
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section 4.1. The second theme, covered in section 4.2, deals with the two possible scope
alternatives of the PRA and the question whether the application of the PRA should be
optional. Theme two comprises Question 15 (Scope) as well as Question 16 (Mandatory
or optional application of the PRA). Theme number three, covered in section 4.3 and
consisting of Question 4 (Pipeline transaction, EMB and behaviouralisation) and
Question 9 (Core demand deposits), deals with different possible elements of
behaviouralisation within the PRA. The fourth theme will be evaluated in section 4.4. It
focuses on Question 18 (Presentation alternatives) and discusses different alternatives
for the presentation of the PRA within financial statements. All issues discussed in the
preceding themes will lead to the last theme in section 4.5. This theme provides an
evaluation of commentator’s view with regard to the PRA concept in general by
analyzing Question 2b (“Do you think the PRA would address the issues
identified?”13
).14
The next chapter forms the key part of this working paper: For every theme, all 123
comment letters will be analyzed in depth, stating both the frequency of advocates and
opponents (or similar, depending question type) for each question. Furthermore,
principal reasoning by opposing point of views are illustrated and its implications are
discussed.
4. Evaluation of Comment Letters
Each of the five themes identified in chapter three will be analyzed following a similar
pattern: At the beginning of each section, the main facts and mechanics of the issue to
be evaluated are presented. Subsequently the question(s) of the respective theme are
evaluated quantitatively, with the specific characteristic of each evaluation depending
on the question type. It is also examined whether views differ significantly between two
diverse commentator groups: Due to a potential conflict of interest between preparers
and users of financial statements, as described in chapter 3, the aggregate banking
industry as well as financial markets associations are analyzed more closely. This is
followed by a presentation of the primary lines of argumentation made by opposing
camps. Every section closes by discussing the impact of a future decision in context of
the existing accounting framework.
13
IFRS Foundation (ed.) (2014b), p. 105. 14
Cf. IFRS Foundation (ed.) (2014b), p. 105 ff.
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4.1 Difficulties with Current Standard and Need for a New
Approach
This theme comprises Questions 1 and 2a of the DP and evaluates respondents’ views
on whether a specific accounting approach is needed for dynamic risk management.
Furthermore, it is discussed whether commentators think that the DP correctly identified
the obstacles with current hedge accounting requirements.
According to IAS 39 Financial Instruments: Recognition and Measurement, all
derivatives are recognized on the balance sheet and subsequently measured at FVTPL.
In contrast, many assets (e.g. loans and receivables) and liabilities (e.g. bonds),
especially in a commercial banking environment, are measured at amortized cost. This
so-called mixed measurement model gives rise to an accounting mismatch that would, if
not addressed by hedge accounting, lead to volatility in the statement of comprehensive
income.15
In order to address this mismatch, IAS 39 allows for two types of hedging
relationships, namely a fair value hedge and a cash flow hedge.16
With a fair value
hedge, the hedging instrument (e.g. derivative) continues to be revalued at FVTPL
while the hedged item (e.g. loan) is revalued with regard to changes in the hedged risk.
With a cash flow hedge, the effective proportions of gains and losses of the hedging
instrument is recognized in OCI and later matched with the respective hedged cash
flows while the measurement of the hedged item remains unchanged.17
In addition to
these micro hedging relationships, the IASB integrated a portfolio hedge of interest rate
risk into IAS 39 which allows for hedging a portfolio of financial assets and liabilities
against changes in the interest rate. This method involves ten steps which have to be
repeated frequently.18
However, many banks find this portfolio hedge difficult to apply
in practice and do not believe that it provides useful information about their risk
management activities.19
In July 2014, the IASB finalized its project to improve accounting for financial
instruments in the aftermath of the financial crisis by publication of IFRS 9. The
application of the new standard becomes mandatory starting January 1st 2018 and will
15
Cf. Christian, D./Lüdenbach, N. (2013), p. 35 f. 16
The hedge of a net investment in a foreign operation is ignored for sake of clarity, despite being the
third hedging relationship according to IAS 39.86 17
See IAS 39.86 to IAS 39.101, IFRS. 18
Cf. Löw, E. (2015), p. 590 ff. 19
Cf. IFRS Foundation (ed.) (2014b), p. 11 f.
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replace IAS 39.20
In general, the mixed measurement model, as described above,
remains in place. Also, despite some changes and relaxations, the main mechanics of a
fair value hedge (i.e. changing the measurement of the hedged item), a cash flow hedge
(i.e. deferring gains and losses on the hedging instrument) as well as the portfolio fair
value hedge of interest rate risk in accordance with IAS 39 remain unchanged.21
These
three types of hedging relationships are now briefly examined in the light of a dynamic
risk management context. Starting with the fair value hedge and going back to the
example of the DP introduced in chapter 2, the hedging instrument to hedge the net
open risk position of CU 50 (receive fixed / pay variable) would be the IRS of CU 50.
As a fair value hedge requires a so called one-to-one hedge designation, a suitable
hedged item has to be identified, for example 33.33% of a CU 150 fixed interest rate
loan portfolio. However, as the risk profile evolves over time, new hedges and thereby
new hedge accounting relationships would be required. This introduces operational
complexity but often also ineffectiveness, because it might not be possible to find a one-
to-one hedge designation that perfectly mimics the economics of a hedge which was
conducted in dynamic context. At the core, the same result also holds for the portfolio
fair value hedge of interest rate risks in accordance with IAS 39.22
Finally, a so-called
macro cash flow hedge could be used, i.e. using a cash-flow hedge to manage the
interest rate risk on a net basis.23
As opposed to the fair value hedge, CU 50 of variable
interest rate liabilities would be designated as hedged item. As the risk profile changes
subsequently, new hedge designations would be required for additional hedging
activities, which also induce operational complexity. In addition, it is not always
guaranteed that sufficient variable interest rate liabilities are available.24
In summary, it
can be seen that all three hedge accounting types make it difficult to allow for a faithful
representation of dynamic risk management within financial statements, mainly by
forcing economically open portfolios into closed and static portfolios for hedge
accounting purposes.
Besides the challenges mentioned above, dynamic risk management in practice also
involves behaviouralisation of certain elements, like including core demand deposits or
deemed exposures in the ALM. Yet, it is not possible to achieve hedge accounting for
these positions as they are either deemed constant in value or do not satisfy the
20
Cf. Lloyd, S. (2014), p. 1 ff. 21
Cf. Ozawa, T. et al. (2013), p. 8 ff. 22
Cf. IFRS Foundation (ed.) (2014b), p. 18 ff. 23
Cf. Ozawa, T. et al. (2013), p. 9. 24
Cf. IFRS Foundation (ed.) (2014b), p. 20 f.
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accounting definition of assets or liabilities. In order to avoid profit and loss volatility in
this context, entities seek for other possible hedged items as alternatives. This type of
so-called proxy hedging is again inconsistent with the economics driving risk
management.25
A detailed discussion of behaviouralisaition will follow in section 4.3.
4.1.1 Question 1: Need for a Specific Accounting Approach
The first question of the DP reads as follows: “Do you think that there is a need for a
specific approach to represent dynamic risk management in entities’ financial
statements? Why or why not?”26
As described in chapter 3, the analysis will start with a
quantitative evaluation of the comment letters, followed by the primary lines of
argumentation. Analyzing the 107 comment letters which answered the respective
question yields the following result:
Figure 6: Evaluation of Question 1
Source: own representation.
The majority (59.8%) thinks, as can be seen from Figure 6, that there is a need for a
specific accounting approach for dynamic risk management. Opposed to that, 24.3% do
not support this view whereas 15.9% are undecided or do not state a clear statement in
their answer. With regard to this question, the views of preparers of financial statement
(represented by the aggregate banking industry) and users of financial statements
(represented by financial market associations) do not differ: Roughly 70% of both
groups support a specific accounting approach.
For opponents of a specific accounting approach for dynamic risk management, two
major lines of argumentation can be identified. First, and most often mentioned, is the
argument that, instead of introducing an entire new model, the current standard IAS 39 -
or IFRS 9 respectively - should be improved. This includes, inter alia, the relaxation of
requirements around designation, the incorporation of behavioural expectations and
core demand deposits, designation of pipeline transactions as hedged items and the
25
Cf. IFRS Foundation (ed.) (2014b), p. 13 f. 26
IFRS Foundation (ed.) (2014b), p. 22.
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overall accommodation of open portfolios within the existing standards. As the joint
comment letter of ACTEO, AFEP and MEDEF, three associations of French
entrepreneurs, puts it: “We believe that the current need is solely to complement the
general hedging model that is not suitable for all hedging policies. (…) We believe that
the discussion paper has appropriately identified current weaknesses (…) and that the
sole objective of this project should be to resolve them.”27
The second reasoning for an
objection of a specific approach for dynamic risk management is that commentators
seek instead for an accounting approach for macro hedging. They think that the
approach should mainly focus on eliminating accounting mismatches that are onerous or
sometimes unable to address within the current environment. For most commentators
this means that a new approach should coexist with IAS 39 / IFRS 9 and only be applied
when risks have been actually mitigated. For example, EFRAG “(…) does not believe
there is need for a specific accounting approach to represent dynamic risk management
per se (...). The objective of a macro hedge accounting model should therefore be
limited to risk mitigation.”28
It can be stated that those objecting a specific accounting
approach for the second reason, predominantly equate the approach for dynamic risk
management stated in Question 1 with the dynamic risk management scope of the PRA
which will be discussed in section 4.2.1.
Supporters of a specific approach for dynamic risk management by a large majority
affirm this question due to current hedge accounting issues, as described in section 4.1,
within a dynamic risk management environment: “The current hedge accounting
approaches set out in IAS 39 and IFRS 9 do not represent well the dynamic risk
management activities of banks. (…) Therefore, our members support strongly the
IASB’s project to develop a better way to reflect dynamic risk management.”29
Whether all commentators agree with the IASB’s description of the main issues that
entities face with regard to hedge accounting in a dynamic risk management context
will be evaluated in the next section.
4.1.2 Question 2a: Difficulties with Current Standard
Section 4.1 set out the DP’s description of limitations of the current standard: As current
hedge accounting requirements of IAS 39 / IFRS 9 call for designation of individual
27
Marteau, P./Soulmagnon, F./Lepinay, A. (2014), p. 3. 28
Flores, F. (2014), p. 4. 29
Bradbery, D./Corbi, A. (2014), p. 3.
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hedging relationships they treat an open portfolio as a series of closed portfolios.30
In
addition, behaviouralisation of cash flows, core demand deposits and deemed exposures
- like pipeline transactions - cannot be considered for hedge accounting purposes. With
Question 2a, the IASB wants to reassure that all important aspects have been covered by
asking: “Do you think that this DP has correctly identified the main issues that entities
currently face when applying the current hedge accounting requirements to dynamic
risk management? Why or why not? If not, what additional issues would the IASB need
to consider when developing an accounting approach for dynamic risk management?”31
Question 2a was answered by 92 commentators:
Figure 7: Evaluation of Question 2a
Source: own representation.
Figure 7 affirms that the majority (79.3%) agrees with the IASB’s description of
obstacles with current standards. 16.3% are undecided or not clear in their response
while only 4.3% disagree. Again, views between preparers and users of financial
statements do not differ, as both groups show an approval rate above 85%. This is not
surprising as both groups might rather have different views on how to overcome current
limitations.
The small group disagreeing with the description mainly consists of insurance
associations indicating that insurers’ assets and liabilities are not always measured at
amortized cost. Instead, they might hold assets that are measured at fair value through
OCI or liabilities at fulfillment value through OCI. Although the new insurance contract
standard IFRS 4 Phase 2 still needs to be finalized, the American Academy of Actuaries
advises: “A dynamic hedge accounting model should address the full range of valuation
methodologies for hedging instruments and for assets and liabilities containing hedged
risk.”32
30
Cf. IFRS Foundation (ed.) (2014b), p. 12. 31
IFRS Foundation (ed.) (2014b), p. 23. 32
Reback, L. (2014), p. 3.
- 14 -
Within the group of supporters of the description responses do not differ strongly: To a
large extent the IASB’s description is briefly confirmed or the explanation of key
obstacles is repeated.33
A general remark made by several commentators, even by those who agree with the
IASB’s description, is the need to consider also the characteristics other types of risk. It
is stated that the IASB’s illustration is mainly focused on interest rate risk management
of a typical commercial bank and does thus not capture the entire universe of risk
management and the respective obstacles in a dynamic risk management context. The
Japan Foreign Trade Council states explicit challenges with regard to hedging of
commodity, foreign exchange, cross-border transactions and the associated hedge
accounting. For instance, a company might hedge an open portfolio of claims on a
country with sovereign risk via a credit default swap. In this case it would be difficult to
identify a specific hedged item for an individual hedging relationship.34
4.1.3 Critical Appraisal
In sum, the first theme is mainly uncontested: The majority agrees with the IASB’s
description of current hedge accounting requirements. It is understandable that the DP
has a strong emphasis on interest rate management in a banking environment as this is
the area where problems become most apparent. A detailed analysis of other types of
risk could be conducted if a specific approach for dynamic risk management found
general approval and stood the test in practical application. In fact, the evaluation of
Question 1 revealed that the need for such an approach is existent. In that respect, the
PRA might serve as one approach to fit the commentator’s needs. However, it remains
to be verified in section 4.5 whether this is actually the case. The pivotal question is
how such an approach, be it the PRA or a different suggestion, should be designed:
Should the focus be on dynamic risk management, meaning that all dynamically
managed exposures are included and revalued even if they are not hedged? Or should
the focus be on risk mitigation, where only hedged positions are captured? This
question is closely interrelated with the discussion about obligatory or mandatory
application of a new approach. The answers to these issues will define whether a new
approach aims to faithfully depict dynamic risk management in accounting or rather to
33
On this see for example Machenil, L. (2014), p. 5. 34
Cf. Hirao, Y. (2014), p. 1 ff.
- 15 -
facilitate the reduction of accounting mismatches resulting from the mixed
measurement model.
4.2 Scope of the PRA and Discussion About Obligatory
Application
The first theme was focused on current problems with accounting for dynamic hedging
and a prospective new accounting approach, without specific focus on the PRA. The
following theme deals with Questions 15 and 16 of the DP. It will be filtered which of
the two scope alternatives of the PRA is preferred by commentators and whether the
application of the PRA should be mandatory or optional.
Dynamic risk management is a continuous process and can be divided into three
elements: Identification, analysis (e.g. by the use of sensitivity analysis) and mitigation
of risk via hedging activity.35
The two scope alternatives discussed in the DP, namely a
focus on dynamic risk management and a focus on risk mitigation, differ with regard to
the treatment of those elements:
Figure 8: Scope alternatives of the PRA
Source: adapted from Spall, C./Tejerina, E./Harding, T. (2014), p. 38.
As Figure 8 shows, a focus on dynamic risk management treats all elements of dynamic
risk management equally: The presence of any one of these elements would result in an
inclusion of the respective portfolio into the PRA. Thus, the PRA would be applied to
all managed portfolios, even if there has been no hedging activity. In a banking
environment, this scope would often include the entire banking book, as it is usually
managed dynamically. In effect, this would mean that all dynamically managed loans
and receivables of a bank would be revalued with regard to changes in the benchmark
35
Cf. IFRS Foundation (ed.) (2014b), p. 56.
- 16 -
interest rate. In this case, the financial statement would provide a complete picture on
the interest rate risk position of the bank. Consistent with the actual economic position,
potential volatility in profit and loss could arise if a bank leaves net open risk positions
unhedged, either intentionally or unintentionally.36
The second alternative, a focus on
risk mitigation, only captures exposures when all three elements of dynamic risk
management are undertaken. Hence, only risk positions that have actually been hedged
will be included and a decision not to hedge a net open risk position would not result in
volatility in profit and loss.37
Within the DP, two approaches are described in order to
apply the risk mitigation approach in practice: The first approach, called sub-portfolio
approach, allows an entity to select sub-portfolios within an entire dynamically
managed portfolio for which risk mitigation has been actually undertaken. Referring to
Figure 1, this could hypothetically mean that, despite the entire portfolio being within
the responsibility of ALM, only interest rate risk for mortgages and term deposits has
been hedged. The risk position of other assets and liabilities remain unhedged. In this
case, if the entity chose to apply the sub-portfolio approach, only the mortgages and
term deposits would be included in the PRA and revalued accordingly. The second
approach, called proportional approach, would lead to a determination of the hedged
position as a proportion of a dynamically managed portfolio. In this case, the example
of only hedging the mortgages and term deposits would yield a different result:
Assuming, for sake of simplicity, that all assets and equal in value (33.33% for each
asset and liability category), 33.33% of the entire dynamically managed portfolio would
be included in the PRA and revalued subsequently.38
The example shows that the risk
mitigation scope would continue to require some form of designation, either in form of
sub-portfolios or proportions, and might thus limit the potential to reduce complexity.
Regarding the question on whether the PRA should be optional or mandatory, it should
be noted that so far, hedge accounting has always been optional in application. In
addition, this question has to be carefully evaluated in light of general hedge accounting
requirements according to IAS 39 / IFRS 9, the chosen scope alternative, and resulting
interdependencies.39
For instance, if the PRA would be mandatory and the scope on
dynamic risk management, the cash flow hedge, as described in section 4.1, would no
36
Cf. IFRS Foundation (ed.) (2014b), p. 57. 37
Cf. IFRS Foundation (ed.) (2014b), p. 58 f. 38
Cf. IFRS Foundation (ed.) (2014c), p. 11. 39
Cf. Garz, C./Wiese, R. (2014), p. 295.
- 17 -
longer be available for entities managing their portfolios in a dynamic way.40
A detailed
discussion of these conceptual questions will follow at the end of this section.
4.2.1 Question 15: Scope of the PRA
Question 15 of the DP deals with the two scope alternatives of the PRA and consists of
four sub-questions. Sub-question 15a focuses on finding out which scope alternative is
preferred by commentators and asks: “Do you think that the PRA should be applied to
all managed portfolios included in an entity’s dynamic risk management (i.e. a scope
focus on dynamic risk management) or should it be restricted to circumstances in which
an entity has undertaken risk mitigation through hedging (i.e. a scope focused on risk
mitigation)?”41
Overall, 105 comment letters posted an answer to Question 15a:
Figure 9: Evaluation of Question 15a
Source: own representation.
Figure 9 provides a clear answer to this sub-question: 82.6% of all answers prefer a
scope limited to risk mitigation. Opposed to that, only 6.7% prefer a scope focused on
dynamic risk management while 10.5% are not clear in their answer. Within this sub-
question, the evaluation shows a difference between the preparers and users of financial
statements: Whereas within the group of financial markets associations at least 9%
would welcome a scope focused on dynamic risk management, no single commentator
in the aggregate banking industry would prefer this broader scope. This might be
explained by the initial presumption that banks have a strong focus on low earnings
volatility which is – as explained below - rather given by a focus on risk mitigation.
The small group supporting the dynamic risk management scope most often claims that
only this alternative provides a complete picture of an entity’s economic position: With
the possibility to see the entire risk position, including both hedged and unhedged
exposures, important and decision-useful information would be provided. The German
Insurance Association remarks: “We believe that appropriate reflection of dynamic risk
40
Cf. IFRS Foundation (ed.) (2014b), p. 63. 41
IFRS Foundation (ed.) (2014b), p. 62.
- 18 -
management activities of reporting entities is essential for the purposes of useful
financial statements. (...) If there is an uncovered exposure to economic risks like
interest risk, it should be depicted in primary financial statements.”42
Second, it is
argued that the chance for arbitrary manipulation of profit and loss could be reduced:
“(…) investors will always have a concern that some preparers may be tempted to
choose the accounting option that is most flattering to results. We recommend removing
the temptation to use PRA only on portfolios of loans where this leads to a more
favourable near term P&L [i.e. profit and loss] result, meaning that a broad scope of
application that covers all exposures subject to dynamic risk management would seem
more appropriate.”43
It should be noted that this concern would be most relevant if the
application of the PRA were optional. In this case, an optional application and a risk
mitigation scope would add an additional alternative to the existing general hedge
accounting of IAS 39 / IFRS 9 and might thus only be used when it benefits earnings
results. A final argument of proponents of a dynamic risk management scope is that this
alternative would increase comparability of financial statements. By including not only
the portion that has been hedged, this scope would level the playing field for all entities
applying the PRA.44
Arguments for the large group of supporters of a risk mitigation scope can be divided
into negative (i.e. why the dynamic risk management scope is not supported) and
positive (i.e. why a risk mitigation scope is preferred) reasoning. On the negative
reasoning side, and most often mentioned, is the fact that a scope on dynamic risk
management would in effect challenge or even override classifications of IFRS 9 Phase
1. According to this standard, a financial asset shall be measured at amortized cost if it
fulfills two conditions: The objective of the entity’s business model is to hold the asset
and collect the contractual cash flows and the contractual terms of the asset give rise to
specified cash flows that are solely payments of principal and interest thereof.45
In
effect, IFRS 9 Phase 1 confirms the measurement of loans and receivables according to
IAS 39 (i.e. amortized cost.). A scope on dynamic risk management would often include
the entire banking book into the PRA and thus change the measurement of those assets
from amortized cost to revaluation according to changes in the managed risk. The only
42
Wehling, A./Saeglitz, H.J. (2014), p. 6. 43
Lee, P./Miemietz, M./Goodhart, W. (2014), p. 3. 44
On this see for example Wehling, A./Saeglitz, H.J. (2014), p. 6 f. 45
Cf. Ernst & Young (ed.) (2011), p. 4.
- 19 -
reason for this would be the fact that these positions are subject to regular monitoring.46
The second negative argument is that, according to opponents of a dynamic risk
management approach, this alternative would lead to undue volatility in profit and loss.
According to the Canadian Bankers Association, banks do not manage risk in such
precision that the full risk exposure is constantly eliminated. This would practically not
be feasible and also extremely costly. Hence, this alternative could lead to significant
profit and loss volatility which is the opposite intent of risk management.47
Also,
commentators mention that the dynamic risk management scope could in fact lead to a
fair value like measurement, as not only interest rate risk but also liquidity risk and
credit risk are managed in a dynamic way, though often not being explicitly hedged.48
The last negative reasoning builds on the second argument by stating that the dynamic
risk management scope leads to counterintuitive results and could thereby incentivize
not to hedge at all: “(…) an approach of this nature could result in an entity that does
not conduct dynamic risk management appearing to be less risky than an entity that
does. This is because the entity that does not apply dynamic risk management would be
outside of the scope of the accounting model and would consequently account for its
portfolios in accordance with IFRS 9.”49
The first positive reasoning (i.e. why a risk
mitigation scope is preferred) is that the aim of the PRA should to address accounting
mismatches. According to the European Association of Public Banks the PRA should
stick to the original objective of hedge accounting which is to address the different
measurement of assets and liabilities on the one hand and derivatives on the other
hand.50
Cleary, a scope focused on risk mitigation would be better suited than the
dynamic risk management alternative as it includes only exposures subject to hedging
activities. Finally, supporters of a risk mitigation scope think that this alternative
faithfully reflects dynamic risk management and thus provides decision-useful
information. According to the Canadian Accounting Standards board “(…) preparers
think that the risk mitigation approach is more in line with their entities’ current risk
processes and reflects the appropriate level of detail about the risks that the entity has
chosen to mitigate. The strategies of financial institutions focus on mitigating risks and
leaving certain positions unhedged when a level of risk is tolerable.”51
46
On this see for example Mulch, S. (2014), p. 22 f. 47
Cf. Hannah, D. (2014), p. 22. 48
Cf. Bancaria, A. (2014), p.5. 49
Adams, M. (2014), p. 15. 50
Cf. Mulch, S. (2014), p. 22. 51
Mezon, L. (2014), p. 4.
- 20 -
Question 15b invites commentators to provide input on the usefulness of the
information that would result from the application of the PRA under each scope
alternative. Furthermore, the IASB asks whether involved parties think that a
combination of the PRA limited to risk mitigation and the hedge accounting
requirements in IFRS 9 would provide a faithful representation of dynamic risk
management.52
As the general comments on usefulness of information can hardly be
evaluated quantitatively, the subsequent analysis is focused on the combination of the
risk mitigation scope and hedge accounting of IFRS 9. This part of sub-question 15b
was explicitly answered by 28 comment letters:
Figure 10: Evaluation of Question 15b – Combination of risk mitigation scope and IFRS 9
Source: own representation.
As can be seen from Figure 10, 60.7% think that the PRA under risk mitigation scope in
combination with hedge accounting of IFRS 9 would faithfully depict dynamic risk
management while 10.3% do not share this view. This roughly matches with the result
of 15a, which is also logical: Those supporting a scope on risk mitigation would be
most likely hesitant to argue that the joint application with current hedge accounting
does not faithfully depict dynamic risk management.
Implicitly, arguments made against the risk mitigation scope in Question 15a can be
also applied to Question 15b: For example, unhedged positions have to be also included
in order to provide full picture of an entity’s economic position. Explicitly, opponents
state further reasons: First, the National Australian Bank argues that with the above-
mentioned combination proxy hedging, namely the designation of hedges that do not
reflect underlying economics, will continue to exist.53
Second, HSBC suspects that
“combining PRA limited to risk mitigation and IFRS 9 hedge accounting may result in
even more complex accounting, particularly if it is difficult to define the scope of the
PRA and sufficiently differentiate it from hedge accounting for individual instruments
52
Cf. IFRS Foundation (ed.) (2014b), p. 62. 53
Cf. Gallagher, S. (2014), p. 9.
- 21 -
and closed portfolios.”54
Lastly, Termer argues that for a faithful depiction of dynamic
risk management mandatory disclosures would be needed that show the profit and loss
impact of various scenarios.55
Commentators who support a combination of the risk mitigation scope and hedge
accounting according to IFRS 9 to a large extent mention that this scope alternative
faithfully depicts their risk management in a dynamic environment. For instance, KfW
bank claims that short term present value changes, which would apply to the entire
banking book within the dynamic risk management scope, are of no relevance to
estimate the capacity of the entity to achieve a long-term stable margin. Present value
movements might be considerable even if the future positive interest margin is not in
question. They think that a “(…) focus on risk mitigation in combination with hedge
accounting according to IFRS 9 will provide much more useful information on the
business to generate a long term periodic interest income based on contracted effective
interest rates.”56
As another argument, it is mentioned that the combination of both
would equip entities with the necessary accounting alternatives to reflect their
individual risk management strategies and objectives.57
Within Question 15c the IASB wants to learn about the operational feasibility of
applying the PRA for each scope alternative.58
In general, most respondents see
operational challenges for both scope alternatives. This includes the development of
new systems and procedures which will be costly and time-consuming.59
When
comparing both scope alternatives, the majority states that a scope focused on dynamic
risk management would be less challenging and operationally easier to implement.
According to Commerzbank, tracking and amortization issues associated with the sub-
portfolio and proportional approach could be reduced and a greater use of existing risk
management data could be realized.60
Despite this view, many commentators conclude
that they accept the higher operational challenges of a risk mitigation scope as it is, in
their eyes, the appropriate accounting concept. In this context, Deutsche Bank states:
“(…) the Bank would not want to reduce complexity at the cost of providing misleading
54
Picot, R. (2014), p. 12. 55
Cf. Termer, T. (2014), p. 13. 56
Fuchs, E. (2014), p. 10. 57
On this see for example PricewaterhouseCoopers International Limited (ed.). (2014), p. 12. 58
Cf. IFRS Foundation (ed.) (2014b), p. 62. 59
On this see for example Schroeder, N. (2014), p. 3. 60
Cf. Rave, H./Kehm, P. (2014), p. 7.
- 22 -
financial information. Therefore we do not believe that the operational challenges (…)
should be the primary consideration (…).”61
The final sub-question 15d asks whether answers 15a-c would change if other risks
than interest rate risks would be considered. This includes for example commodity price
risk and foreign exchange risk.62
Overall, 45 respondents answered this sub-question:
Figure 11: Evaluation of Question 15d
Source: own representation.
According to Figure 11, 75.6% state that their answers would not change in the light of
other risks while only 2.2% do think they would change their answers. As answers do
not fundamentally change, it can be deducted that respondents predominantly think that
dynamic risk management of other types of risk in general conforms to dynamic risk
management of interest rate risk.
The only respondent stating that their answer would change is EDF Group, a French
electric utility company. In essence, EDF group claims that it manages its commodity
risk using cash flow hedges which would no longer be available under the PRA,
assuming mandatory application. Using the revaluation methodology of the PRA
instead would no longer reflect the aim of the hedge as period mismatches would arise.
EDF concludes that the PRA is not adapted to commodity risk management.63
Most commentators answered this sub-question briefly by only stating that their answer
would not change considering other types if risk. Some respondents briefly note that
other types of risks are managed in a similar way, without giving further input.64
Despite the overall consent, few authors indicate that including other types of risk in the
PRA is not a high priority and that the IASB should first focus on interest rate risk. One
61
Dohm, K./Nordgren, M. (2014), p. 6. 62
Cf. IFRS Foundation (ed.) (2014b), p. 62. 63
Cf. Viandier, M. (2014), p. 2. 64
On this see for example Patrigot, N. (2014), p. 8.
- 23 -
respondent even notes that including other types of risk might result in a considerable
delay of the project.65
4.2.2 Question 16: Mandatory or Optional Application
With Question 16 the IASB wants to get respondents’ feedback on whether the
application of the PRA should be optional or mandatory. On the one hand, sub-question
16a focuses on a dynamic risk management scope and asks whether in this case the
application of the PRA should be mandatory. This part was answered by 75 comment
letters:
Figure 12: Evaluation of Question 16a
Source: own representation.
According to Figure 12, 89.3% are against a mandatory application of the PRA in case
of a scope focused on dynamic risk management while only 5.3% support this.
On the other hand, sub-question 16b asks the same question but this time with regard to
a scope on risk mitigation.66
Several respondents state that they limited their answer to
this part as it relates to their preferred scope alternative. This sub-question was
answered by 96 commentators:
Figure 13: Evaluation of Question 16b
Source: own representation.
Figure 13 shows a similar pattern as the previous evaluation. 92.7% object a mandatory
application of the PRA within a risk mitigation scope and only 4.2% would welcome
65
Cf. Middleton R. (2014), p. 7. 66
Cf. IFRS Foundation (ed.) (2014b), p. 64.
- 24 -
mandatory application. Parallel to Question 15, differences between preparers and users
of financial statements can be observed: Both parties have one supporter of a mandatory
application. However, due to the smaller group size, financial markets associations
show a conformation rate of 11% versus 3% in the aggregate banking industry.
Evaluation of arguments will be conducted jointly for both sub-questions as
predominant patterns of reasoning are identical. Supporters of a mandatory application
firstly note that this would increase comparability among financial statements. For
instance, the CFA Society of the UK is concerned that “(…) making the PRA optional
would reduce comparability because it would be harder to compare the financial
statements of those banks that use it with those banks that choose not to.”67
Second,
Lloyds Banking Group notes that making the application optional would fail to reach a
closer alignment between dynamic risk management and accounting which would be
the IASB’s objective. This is the case because entities would be able to choose between
applying IFRS 9 and the PRA for dynamically managed portfolios.68
It is likely that the
decisive argument for the one or the other will rather be profit and loss impact than
faithful depiction of risk management activities. This view is also shared by the
European Securities and Markets Authority, though being undecided about the matter. It
is noted that a mandatory application would result in a more faithful representation of
the economic effects of risk management.69
For both scope alternatives, advocates of an optional application present four distinct
arguments. First and most often mentioned is the fact that an optional application would
be consistent with optional application of hedge accounting of IAS 39 / IFRS 9. With a
mandatory application mismatches between those two concepts would arise which
might be difficult to follow for users of financial statements. For example, FAS AG
thinks that both concepts have the goal to represent the impact of risk management in
financial statements. Hence, they “(…) can see no reason why the static approaches
should be shown voluntary but dynamic approaches mandatory.”70
Second, it is claimed
that risk management strategies differ among banks which requires flexibility in the
choice of the fitting accounting alternative. The International Energy Accounting Forum
states that entities should be able to adopt the accounting guidance that best reflects the
67
Lee, P./Miemietz, M./Goodhart, W. (2014), p. 4. 68
Joyce, D. (2014), p. 17. 69
Maijoor, S. (2014), p. 16. 70
Huthmann, A. (2014), p. 11.
- 25 -
economics of their transactions.71
The third line of reasoning is centered on the
definition of dynamic risk management. As this definition would trigger application in
case of a mandatory PRA, it would represent a crucial part of the new project. Yet,
opponents of a mandatory application think that it would be difficult to agree on a clear
definition, given the variety of risk management practices. Even if an agreement could
be reached, the practical application of such a definition would be difficult, judgmental
and also hard for auditors to verify.72
Lastly, respondents argue that for some entities
the implementation cost and efforts for applying the PRA, as discussed in sub-question
15c, could outweigh the benefits for users of financial statements. The German Banking
Industry Committee claims that implementation cost would frequently bear no relation
to the benefit derived from applying the PRA and would thus breach the principle of
proportionality.73
Respondents conclude that entities should be enabled to assess by
themselves whether the cost-benefit relation supports an application of the PRA or not.
A general comment made by several commentators is that, despite a potential optional
application, ceasing of the application of the PRA should not be allowed as long as
dynamic risk management remains unchanged.74
This should help to prevent an
opportunistic start and stop of the PRA.
4.2.3 Critical Appraisal
In consolidation, also the second theme reveals a clear picture about respondents’
views: A combination of the risk mitigation scope and an optional application would be
preferred by a large group in case the PRA were to be introduced. It should be noted
however, that this does not mean that a large majority would actually support the PRA
with such features. A general evaluation of the PRA concept is detached from Question
15 and 16 and will follow in section 4.5. Several commentators reject the PRA in
general but still opted for an optional application with a risk mitigation scope in case of
a realization of the project as this would least affect them. The remainder of this section
will discuss two distinct variations of the PRA, their motivations and their implications:
An optional PRA with a scope focused on risk mitigation and a mandatory PRA with a
scope focused on dynamic risk management.
71
Cf. Susin, J. (2014), p. 20. 72
On this see for example Clifford, T. (2014), p. 8. 73
Cf. Peters, D. (2014), p. 13. 74
On this see for example Schneiß, U./Fieseler, U. (2014), p. 14.
- 26 -
The motivation for an optional application and a risk mitigation scope can be described
as providing entities with a new tool to address accounting mismatches in a dynamic
risk management context while at the same time limiting interference with existing
standards and procedures. There would be no conflict of the PRA with hedge
accounting according to IFRS 9 / IAS 39. Hence, entities could choose from an
extensive toolbox of accounting choices ranging from cash-flow hedge, fair value
hedge, portfolio hedge of interest rate risk to fair value option and the PRA. It is
understandable that a PRA with these features is most appealing to the preparers of
financial statements: Also the IASB acknowledges that this would give banks flexibility
to address accounting mismatches individually and thus allow for a better management
of profit and loss volatility.75
However, this flexibility comes with three drawbacks.
First, it is unlikely that banks will use this flexibility mainly to faithfully depict their
individual dynamic risk management strategy. Rather, they will opt for the accounting
choice that optimizes profit and loss. Second, an optional PRA with a risk mitigation
scope would add to the already extensive patchwork of hedge accounting requirements
and might thus make it even more difficult for users of financial statements to evaluate
the success of an entity’s dynamic risk management. Third, though entities grant this a
lower priority, a PRA with these features would most likely fail to reduce operational
complexity.
A mandatory application of the PRA with a dynamic risk management scope would, on
the other hand, faithfully depict the economic effects of dynamic risk management,
thereby also revealing when risk positions were left unhedged. The argument that a
PRA with those features does not faithfully depict dynamic risk management because
some positions cannot be hedged or are left unhedged as they swing within certain
acceptable risk limits does not seem entirely convincing: If a position is unhedged,
either intentionally or unintentionally, an entity has to face the economic consequences.
It is thus hard to understand why users of financial statements should not see the
resulting effects in profit and loss. Also, a PRA with a focus on dynamic risk
management would be less complex as tracking and amortization of proportions or sub-
portfolios dropped out. Of course, also this combination has its drawbacks. First, it
would in effect override classification for bank loans according to IFRS 9 Phase 1, as
described in section 4.2.1. Second, cash-flow hedges would no longer be available for
dynamically managed portfolios and third, the definition as well as the application of
75
Cf. IFRS Foundation (ed.) (2014b), p. 64.
- 27 -
the definition of dynamic risk management will pose significant challenges. Finally, a
one-size-fits-all approach might lead to issues on an individual bank level, either
because it fails to give consideration to every peculiarity of different risk management
practices or because implementation costs might be considerable compared to the size
of the dynamically managed portfolio.
In summary, both variations have a right to exist and the decision depends on to the
desired objective of the PRA. If the objective is to mainly reduce the accounting
mismatches that currently arise, a scope on risk mitigation and an optional application
seems appropriate. If, however, the objective is to more faithfully depict dynamic risk
management in financial statements, a scope focused on dynamic risk management with
mandatory application appears to be the right choice. The aggregate banking industry
clearly stated their preference as their focus seems to be mainly on reducing accounting
mismatches. Users of financial statements, represented by financial market associations,
showed a higher tendency towards the second alternative but still by majority opted for
the optional application with a risk mitigation scope. This might be surprising, but
shows that this party seems to also grant high priority to limited interference with IFRS
9 Phase 1, namely not to challenge amortized cost measurement for large parts of the
banking book. Also, some entities have to include further considerations: For instance,
the European Central Bank fears that higher profit and loss volatility might be
detrimental to financial stability.76
The IASB, as the actual standard setter, clearly stated
the objective of the DP, namely to develop a new model that enhances the usefulness of
information provided by financial statements while at the same being operational.77
A
scope focus on dynamic risk management and a mandatory application of the PRA
seems to be more appropriate to achieve that goal. How the IASB consolidated the
different views by also taking into account their own objective will be discussed in
chapter five.
4.3 Behaviouralisation within the PRA
The third theme deals with the potential inclusion of pipeline transactions, EMB and
core demand deposits in the PRA as well as behaviouralisation of certain elements like
expected prepayments of certain assets, for example mortgages. The inclusion of these
items would broaden the scope compared with current hedge accounting requirements
76
Cf. Constancio, V. (2014), p. 2. 77
Cf. IFRS Foundation (ed.) (2014b), p. 10.
- 28 -
of IAS 39 / IFRS 9. Again, this section starts with a brief overview of the issues before
moving to the evaluation of adhesive Questions 4 and 9.
The DP describes pipeline transactions as forecast volumes of drawdowns on fixed
interest rate products at advertised rates. These transactions should not be confused with
forecast transactions used in IFRS 9 as the trait highly probable is not a necessary
precondition for pipeline transactions.78
Figure 14: Pipeline transactions
Source: adapted from Spall, C./Tejerina, E./Harding, T. (2014), p. 18.
Figure 14 illustrates the concept of a pipeline transaction: A bank might for example
advertise mortgages at a fixed rate of 1.8%, consisting of funding cost of 1.5% and a
customer margin of 0.3%. For reputational reasons the bank considers this rate as
binding, although neither the bank nor the customer has yet a contractual commitment.
Interest rate risk now arises due to possible changes in the funding rate: If the market
funding rate increased to 1.6% the bank would stick to the previously advertised rate
despite higher funding cost. As part of its dynamic risk management activities, the bank
estimates the likely volume of drawdowns on a behaviouralised basis and manages the
resulting fixed interest rate exposure in its ALM.79
The inclusion of pipeline transaction
in the PRA seems appropriate from a practical point of view as this would further align
risk management with accounting. However, conceptual difficulties arise as this would
result in recognition in the balance sheet and subsequent revaluation of a financial
instrument before an entity becomes party to the transaction.80
According to Spall et al., the idea behind the EMB is that the return required by equity
holders can be viewed as a combination of a fixed rate base return similar to interest and
a variable residual return resulting from total net income. The fixed rate base return
provides a continuous compensation to equity holders for providing funding. Some
entities, particular banks, include the fixed rate base return on equity into their ALM
78
Cf. IFRS Foundation (ed.) (2014b), p. 26. 79
Cf. Spall, C./Tejerina, E./Harding, T. (2014), p. 18. 80
Cf. IFRS Foundation (ed.) (2014b), p. 26.
- 29 -
and treat it as a fixed interest rate liability along with other exposures. This is
sometimes called replication portfolio.81
Going back to Figure 1, this would mean that a
new exposure, a replication portfolio representing the fixed rate base return on equity, is
added to existing liabilities, namely demand deposits, term deposits and bonds. Again,
such an element would closer align risk management and accounting but at the same
time raise conceptual issues as equity is considered a residual parameter according to
the Exposure Draft (ED) for a Revised Conceptual Framework for Financial Reporting.
Hence, equity does not satisfy the definition of assets and liabilities.82
From a contractual perspective, demand deposits have a variable interest rate and can be
withdrawn any time at the customer’s discretion. However, banks observe that a certain
amount, called core demand deposits, is typically left as a deposit for a long and
generally predictable time.83
This phenomenon is illustrated in Figure 15:
Figure 15: Core demand deposits
Source: adapted from IFRS Foundation (ed.) (2014c), p. 9.
In a risk management context, banks treat core demand deposits often as a term fixed
interest rate exposure and include it into their ALM. By doing so, they consider the
behavioural rather than contractual features of these deposits. For instance, if a bank has
an overnight asset portfolio that is entirely funded by demand deposits, there would be
theoretically no need for risk management activity. However, it is usually observed that
interest payable on demand deposits is usually not constantly repriced in line with
market interest rates. Thus, if market interest rates were to fall, net income would be
lower as interest income on the asset side contracts but interest expense on the liability
side stays constant. Consequently, the bank might treat the core element of those
deposits as longer term fixed interest rate liability and enter into a corresponding receive
81
Cf. Spall, C./Tejerina, E./Harding, T. (2014), p. 20. 82
Cf. IFRS Foundation (ed.) (2015a), p. 11. 83
Cf. IFRS Foundation (ed.) (2014b), p. 33.
- 30 -
fixed and pay variable IRS, also known as receiver swap. Assuming that the deemed
core element stays insensitive to changes in the market interest rate, net income would
be stabilized.84
Current hedge accounting requirements of IAS 39 / IFRS 9 do not allow
for a fair value hedge as, by definition, demand deposits do not contain fair value risk
with regard to changes in the interest rate. If demand deposits are non-interest bearing,
which is often the case in the current low interest environment, they do also not qualify
for a cash flow hedge as there is no volatility in cash flows.85
An inclusion of core
demand deposits in the PRA would solve this problem and would hence closer align
risk management and accounting.
Besides pipeline transactions, EMB and core demand deposits the IASB explores in
general whether cash flows should be considered on a behaviouralised rather than a
contractual basis for purposes of applying the PRA. This inter alia includes prepayment
risk. For instance, a bank might hold a mortgage portfolio of CU 500 with maturity in
two years and a fixed interest rate. As the bank expects CU 50 to be prepaid after one
year, it treats the entire portfolio as CU 50 one year and CU 450 two year fixed rate
assets for dynamic risk management purposes. If the PRA allowed for a
behaviouralisation of cash flows, this portfolio would also be treated as such for
accounting purposes. If contractual cash flows were the obligatory parameter, the
portfolio would be treated as CU 500 two year fixed rate assets for accounting purposes,
thus representing a mismatch between accounting and actual risk management.86
As this
simplified example already shows, behaviouralisation of cash flows in the PRA also
entails introducing considerable judgement about future events flowing into accounting
figures.
4.3.1 Question 4: Elements of Behaviouralisation
Question 4 asks for respondents’ views on the inclusion of pipeline transactions, EMB
as well as behaviouralisation in general within the PRA. Sub-question 4a starts with
pipeline transactions and asks whether they should be allowed for inclusion if an entity
considers them part of their dynamic risk management. Thereby, operational feasibility,
84
Cf. IFRS Foundation (ed.) (2014b), p. 34. 85
Cf. Spall, C./Tejerina, E./Harding, T. (2014), p. 23. 86
Cf. IFRS Foundation (ed.) (2014b), p. 29.
- 31 -
usefulness of information and consistency with the conceptual framework should be
taken into consideration.87
103 comment letters responded to this sub-question:
Figure 16: Evaluation of Question 4a
Source: own representation.
It can be seen from Figure 16 that 63.1% support the inclusion of pipeline transactions
while 16.5% oppose this view. 20.4% do not state a clear answer in their response. The
aggregate banking industry supports this step with an approval rate of 71%. In contrast,
only 42% of the financial markets associations would welcome the inclusion of pipeline
transactions in the PRA while 50% of this group would reject it. This matches with the
initial presumption that both groups have at least partly conflicting interests: On the one
side, for preparers of financial statements, an inclusion would close a further gap
between risk management and accounting and would thus promote operationality as
well as potentially reduced earnings volatility. On the other side, users of financial
statements might tend to reject the inclusion as pipeline transactions inter alia rest on
subjective assumptions made by management which are difficult retrace.
Opponents of an inclusion mainly foreground the conflict with the conceptual
framework. According to Deloitte, in many cases pipeline transactions represent
forecast transactions with a higher degree of uncertainty where recognizing the asset
would be inconsistent with basic accounting principles such as the definition of assets
and liabilities in the conceptual framework.88
This view is also bolstered by the ED for a
Revised Conceptual Framework for Financial Reporting: According to this definition
“an asset is a present economic resource controlled by the entity as a result of past
events. An economic resource is a right that has the potential to produce economic
benefits.”89
Pipeline transactions do neither represent an economic resource, as the
entity possesses no right, nor does the entity have control over it. Thus, the inclusion of
pipeline transactions would conflict with the conceptual framework. As a second
argument, several respondents fear that an inclusion of pipeline transaction grants 87
Cf. IFRS Foundation (ed.) (2014b), p. 28. 88
Cf. Poole, V. (2014), p. 5. 89
IFRS Foundation (ed.) (2015a), p. 41.
- 32 -
significant discretion to management which might be prone to earnings management.90
Finally, some opponents mention several difficulties involved in actual implementation.
This includes inter alia the exact timing of drawdown of future anticipated volumes
which are merely based on assumptions.91
Supporters of an inclusion to a large extent note that today pipeline transactions play an
important part in dynamic risk management of banks. Hence, if the goal is to further
align dynamic risk management and accounting, they need to be considered. In that
respect, Ernst & Young states that “if the solution is to reflect actual risk management,
as understood by the banks, then all relevant exposures, including EMB and pipeline
transactions, would have to be eligible for inclusion within that solution.”92
Furthermore, many proponents acknowledge the conflict with the conceptual
framework but concede that this has a lower priority as they seek for a pragmatic
solution and a faithful presentation in financial statements.93
Lastly, some supporters
even claim that only including pipeline transactions would not be enough and go one
step further: They opt for an inclusion of all forecast transactions in the PRA. For
instance, the Institute of Public Auditors in Germany states that many entities manage
risk arising from forecast transactions dynamically and excluding these transactions
would not be appropriate. They relegate to cash flow hedges which already allow
forecast transactions to be designated as hedged items.94
A general remark made by a couple of respondents is that criteria for inclusion of
pipeline transactions need to be defined precisely and that detailed disclosures on
included exposures are inevitable.95
Sub-question 4b asks commentators: “Do you think that EMB should be included in the
PRA if it is considered by an entity as part of its dynamic risk management? Why or
why not?”96
Again, the same issues as for sub-question 4a should be taken into
consideration. This part was answered by 85 respondents:
90
On this see for example Chien, L. (2014), p. 3. 91
Cf. Chng, S. (2014), p. 2. 92
Clifford, T. (2014), p. 6. 93
On this see for example Buggle, S. (2014), p. 6. 94
Cf. Schneiß, U./Fieseler, U. (2014), p. 6. 95
On this see for example Wong, E. (2014), p. 3. 96
IFRS Foundation (ed.) (2014b), p. 28.
- 33 -
Figure 17: Evaluation of Question 4b
Source: own representation.
In summary, 56.5% support an inclusion of the EMB in the PRA whereas 32.9% reject
this. Despite being more contested than sub-question 4a the result is still unambiguous.
While the aggregate banking industry shows an approval rate of 84%, financial markets
associations reject the inclusion by 67% while only 25% are supportive. Once more, this
can be explained by the potentially conflicting interests of preparers and users of
financial statements, as argued in sub-question 4a.
Compared to the evaluation of the inclusion of pipeline transactions in the PRA, major
lines of argumentation broadly stay the same for the EMB. Again, those who reject the
inclusion of the EMB in the PRA, mainly point out a conflict with the conceptual
framework. According to the ED for a Revised Conceptual Framework for Financial
Reporting, “equity is the residual interest in the assets of the entity after deducting all its
liabilities. (…) In other words, they are claims against the entity that do not meet the
definition of a liability.”97
In that respect the Basel Committee on Banking Supervision
claims that including the EMB in the PRA would mean a significant departure from the
conceptual framework as equity forms a residual and does not have a fixed guaranteed
return. Hence, assuming such a fixed return on equity, combined with respective
revaluation according to changes in the interest rate, would be inconsistent and also
suggesting that a bank’s equity has a quality which it does not and cannot possess.98
Furthermore, respondents also fear subjectivity of the assumptions made in case of an
inclusion which might be - parallel to pipeline transactions - susceptible to earnings
management.99
Lastly, some respondents note that the cash flow hedge of IAS 39 /
IFRS 9 already allows for an indirect way to depict the effects of the interest rate risk in
the financial statements. Though this procedure is operationally more burdensome, they
see it as the right way as it does not require the direct revaluation of equity.100
97
IFRS Foundation (ed.) (2015a), p. 46. 98
Cf. Ingves, S. (2014), p. 7. 99
On this see for example Jang, J. (2014), p.6. 100
Cf. Maijoor, S. (2014), p. 7.
- 34 -
Supporters of an inclusion of the EMB in the PRA largely mention that hedges in
context with the EMB play a crucial part in dynamic risk management and need to be
included for the sake of a faithful representation. For instance, the International Swaps
and Derivatives Association states that without hedging activity for equity funding, net
interest income could be highly volatile, especially for banks which mainly hold assets
with a variable interest rate. They conclude that “in order to represent this risk
management in accounting it is imperative that deemed interest rate risk positions from
EMB are eligible for inclusion in any accounting solution for dynamic risk
management.”101
Second, respondents recently see an even stronger need for a solution
as equity is becoming a more significant source of funding due to changes in regulation
that require entities to fundamentally increase their equity ratios.102
Finally, as for
pipeline transactions, many supporters acknowledge a conflict with the conceptual
framework but encourage the IASB to grant this a lower priority. For example, UBS
Bank claims: “Accounting standards have a history of making exceptions to principles
(…) in cases where the needs of financial statement users outweigh the perceived
benefit of rigid adherence to principles that do not provide the best representation of
economic reality. Hence, given the importance of the EMB as an exposure that is
central to the risk management activities of many banks, an exception to accommodate
this case seems warranted.”103
The final sub-question 4c asks whether for purposes of applying the PRA, cash flows
should be based on a behaviouralised rather than on a contractual basis.104
As shown in
the introduction to section 4.3, this inter alia refers to prepayment expectations for
mortgages. Overall, 101 letters answered this sub-question:
Figure 18: Evaluation of Question 4c
Source: own representation.
101
Bradbery, D./Corbi, A. (2014), p. 6. 102
On this see for example Patrigot, N. (2014), p. 7. 103
Tovey, M./Lasik, M. (2014), p. 5. 104
Cf. IFRS Foundation (ed.) (2014b), p. 28.
- 35 -
According to Figure 18, 88.1% think that cash flows should be formed on a
behaviouralised basis within the PRA while only 3.0% would prefer cash flows on a
contractual basis. The evaluation shows that there is a broad agreement among the
different groups. Preparers as well as users of financial statements, have one supporter
each for cash flows on a contractual basis. Due to the smaller group size, financial
markets associations have 9% supporters of a contractual basis versus 3% in the
aggregate banking industry.
The most prominent argument pro contractual cash flows is also a concern posted by
undecided respondents: The revaluation of a behaviouralised portfolio affecting profit
and loss is very dependent on management’s assumptions and projections, which are
arbitrary and difficult to verify.105
This discretion might hence rather be used for
earnings management than for a faithful depiction of dynamic risk management.
Additionally, DBS Bank doubts the predictive value of the models used for
behaviouralisation and assumes that they are subject to modeling pitfalls. For instance,
loan prepayments for mortgages might be driven by other factors than interest rates, for
example the property market, and are thus difficult to forecast. Any changes to the
prediction of behaviouralisation are subsequently likely to cause significant volatility in
profit and loss.106
Supporters of a PRA with cash flows on a behaviouralised basis mainly find this feature
crucial to a new model that has the aim to align dynamic risk management and
accounting. The International Banking Federation considers behaviouralisation of
exposures a major step forward. It is noted that, when the risk is managed on a
behaviouralised basis, then, for accounting purposes, cash flows should also be based on
a behaviouralised rather than on a contractual basis.107
Further, several respondents note
that behaviouralisation is not an entirely new concept and already included in IFRS
standards. For instance, the European Securities and Markets Authority argues that the
concept is already applied to the portfolio fair value hedge of interest rate risks in
accordance with IAS 39, where cash flows are rather modeled on a behaviouralised
basis than on a contractual basis.108
Another example is, according to Standard
Chartered Bank, the assessment of impairment for revolving facilities in IFRS 9.109
105
Cf. Chua, K. (2014), p. 5. 106
Cf. Chng, S. (2014), p. 2. 107
Cf. Scutt, S. (2014), p. 4. 108
Cf. Maijoor, S. (2014), p. 6. 109
Cf. Innes-Wilson, C. (2014), p. 2.
- 36 -
Again, some supporters of a behaviouralisation acknowledge that sticking to the
contractual features of assets and liabilities would be consistent with the conceptual
framework but think that this has a lower priority compared to a faithful representation
of dynamic risk management in financial statements.110
If behaviouralised cash flows formed the basis for the PRA, several respondents note
that a solid framework as well as disclosures would be needed in order to ensure
transparency and also prevent the abuse of such a feature.111
4.3.2 Question 9: Core Demand Deposits
Within Question 9, the IASB wants to learn about commentators’ views on the
inclusion of core demand deposits in the PRA, as described in section 4.3. In sub-
question 9a, it is asked whether “(…) core demand deposits 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 dynamic risk management purposes.”112
85 comment
letters responded specifically to this sub-question:
Figure 19: Evaluation of Question 9a
Source: own representation.
Figure 19 provides a clear result: 87.1% support the inclusion of core demand deposits
while only 5.9% reject this. Approval rates between preparers and users of financial
statements are 90% and above and thus relatively equal.
As a first line of reasoning, opponents of the inclusion refer to the IASB’s statement in
the DP, stating that the inclusion of core demand deposits would raise significant issues
concerning the recognition of revaluation gains and losses. In that respect, the IASB
notes that it is in some cases difficult to assess whether changes in core demand deposits
are the result of customers’ behavior, the reflection of bank’s actions responding to its
110
On this see for example Gallagher, S. (2014), p. 4. 111
On this see for example Kilesse, A./Boutellis-Taft, O. (2014), p. 8. 112
IFRS Foundation (ed.) (2014b), p. 37.
- 37 -
assessment of interest rate risk or other factors.113
Depending on the final form of the
PRA, differentiation could be necessary as varying causes might have a distinct impact
on profit and loss. DBS Bank agrees with this challenge by stating that it is often
impossible to isolate interest risk from customers’ idiosyncratic behavior.114
Further, the
Norwegian Accounting Standards Board claims that the inherent uncertainty about
estimates for core demand deposits is so high that the principle of relevance outweighs
the expected faithful representation.115
As for the different sub-questions of Question 4,
recurring patterns of argument can also be observed: First, opponents claim that
assumptions flowing into the behaviouralisation of core demand deposits are arbitrary,
difficult to verify and thus prone to potential manipulation.116
Second, some
commentators see conceptual issues as IFRS 13.47 in essence states that a financial
liability with a demand feature contains no fair value risk.117
As for behaviouralisation in general, supporters of an inclusion of core demand deposits
claim that this would constitute a key aspect of a new model. According to the Canadian
Bankers Association core demand deposits form a base pillar of the strategy of a retail
banking institution.118
Also Commerzbank notes that “(…) core demand deposits are
such a crucial and significant part of the management of a bank’s risk position that
without them, there would be no proper representation of risk management since the
reported interest rate risk position would be distorted.”119
Following supporters’
arguments, failure to permit the inclusion would lead to an incomplete dynamic risk
management approach that would not be utilized by most banking institutions.
Furthermore, the inclusion of core demand deposits in the PRA would reduce the need
for proxy hedging which is at least operationally burdensome and often also imperfect.
PricewaterhouseCoopers emphasizes that this is especially problematic for banks
focusing on retail funding and loans: These banks might not have additional balance
sheet items which can be used for proxy hedge designation.120
Finally, Lloyds Banking
Group explicitly states what most commentators at least implicitly acknowledge: There
is some element of subjectivity to core demand deposits, for example in relation to
deemed amount and duration. However, this should not detract from the conceptual
113
Cf. IFRS Foundation (ed.) (2014b), p. 36. 114
Cf. Chng, S. (2014), p. 2. 115
Cf. Kvaal, E. (2014), p. 7. 116
On this see for example Chien, L. (2014), p. 5. 117
Cf. Vaessen, M. (2014), p. 9. 118
Hannah, D. (2014), p. 15. 119
Rave, H./Kehm, P. (2014), p. 14. 120
Cf. PricewaterhouseCoopers International Limited (ed.) (2014), p. 8.
- 38 -
argument pro inclusion which is to further align dynamic risk management and
accounting.121
Sub-question 9b, the last part to be analyzed in this section, asks whether respondents
think that guidance would be necessary for entities to determine the behaviouralised
profile of core demand deposits.122
66 comment letters responded to this sub-question:
Figure 20: Evaluation of Question 9b
Source: own representation.
As a result, 31.8% would prefer guidance on the behaviouralisation of core demand
deposits while 57.6% think specific guidance is not necessary. Within the group of users
of financial statements 50% would prefer guidance while for preparers of financial
statements only 14% think so. One explanation for this significant divergence could be
that users of financial statements rather tend to prefer guidance as common procedures
increase transparency and understandability. Opposed to that, further guidance could
mean less discretion for preparers of financial statements and also potentially a higher
operational burden as existing behaviouralisation procedures for core demand deposits
might have to be adapted to conform to respective new guidelines.
Proponents of further guidance claim that this would reduce the potential for abuse that
comes with the discretion of behaviouralising core demand deposits. For example, the
Federation of European Accountants argues that guidelines would be necessary “(…) to
avoid instances of abuse of the concept of core demand deposits in order to present
favourable results (e.g. avoiding volatility in the profit or loss).”123
Further, supporters
note that guidance on the factors that should be taken into account would ensure
consistency and thus also comparability among different financial statements.124
Opponents of guidance on behaviouralisation mainly claim that risk management,
including the treatment of core demand deposits, differs from bank to bank. According
121
Cf. Joyce, D. (2014), p. 11. 122
Cf. IFRS Foundation (ed.) (2014b), p. 37. 123
Kilesse, A./Boutellis-Taft, O. (2014), p. 11. 124
Cf. Poole, V. (2014), p. 10.
- 39 -
to the Canadian Bankers Association, the investment of demand deposits is a key
executive level decision based on various factors. In that respect, individual judgment is
required to determine the appropriate term for modeling of core demand deposits which
can be accomplished through different reasonable methods.125
Hence, flexibility should
be granted to accommodate the individual risk management objectives and strategies.
Further, Commerzbank notes that providing guidance and thus putting limits on what is
allowed would prevent banks from using already existing risk management data and
thus increase operational costs.126
A comment made by several respondents, irrespective of the opinion on additional
guidance, is that disclosures are needed to improve understandability and comparability.
However, it is also noted that these disclosure requirements should be subject to
considerations regarding commercially sensitive information.127
Additionally, a couple
of commentators note that there should be a periodic review of the used behavioural
profile for core demand deposits by entities, also referred to as internal back-testing.128
4.3.3 Critical Appraisal
Compressing commentator’s views on the third theme, respondents in aggregate support
the inclusion of all types of behaviouralisation in the PRA. This includes pipeline
transactions, EMB, core demand deposits as well as the general behaviouralisation of
cash flows for purposes of applying the PRA. However, despite supporting the inclusion
of core demand deposits, financial markets associations view pipeline transactions and
the EMB critically: While 50% of users of financial statements reject the inclusion of
pipeline transactions, even 67% reject the inclusion of the EMB. Opposed to the second
theme focused on the scope alternatives, the conflict is not between either solely
reducing accounting mismatches or a faithful depiction of dynamic risk management. In
this section, tensions rather arise between a faithful depiction of dynamic risk
management and a partial conflict with the conceptual framework as well as sensitivity
to manipulation.
If all discussed elements of behaviouralisation were included in the PRA, a maximum
of convergence between risk management and accounting could be reached. Especially,
core demand deposits and the general behaviouralisation of cash flows seem to be
125
Cf. Hannah, D. (2014), p. 16. 126
Cf. Rave, H./Kehm, P. (2014), p. 14 f. 127
On this see for example Schraa, D. (2014), p. 9 f. 128
On this see for example Ludolph, S. (2014), p. 12.
- 40 -
perceived as central and key aspects of a new model. On the downside, full alignment
with the conceptual framework could no longer be maintained: As shown above,
pipeline transactions would conflict with the definition of assets and liabilities while the
inclusion of the EMB would conflict with the definition of equity. Also, all elements are
based on subjective assumptions made by management which are difficult to verify and
thus prone to earnings management. Hence, concerns, as expressed by users of financial
statements, have to be seriously considered.
In light of the IASB’s objective on a new model, which is to provide useful information
while at the same time being operational, a general decision pro inclusion of
behaviouralised elements seems appropriate: Allowing for the inclusion closer aligns
risk management and accounting which should overall enhance usefulness of the
information provided by financial statements and reduce operational complexity.
Threats of manipulation, which contradict the IASB’s objective, could at least partly be
contained by sufficient safeguards and disclosures. For instance, if a bank substantially
deviates from common industry practice with regard to behaviouralisation, this could
potentially be spotted in the notes by security analysts and subsequently be criticized.
This example underlines the need for detailed disclosure if behaviouralised elements
were to be included in the PRA. Operationality of a new model would clearly be
enhanced as the need for proxy hedging would terminate. A deviation of the conceptual
framework could be justified by the argument that in this special case, the inclusion of
these elements is so central to providing decision-useful information that it outweighs
the need for strict adherence to principles. Of course, one-time deviations from the
accounting framework have to be considered carefully, as they can constitute a trigger
for further calls for adjustments. Having closed the discussion about potential elements
of behaviouralisation, the next theme will focus on the presentation of the PRA within
financial statements.
4.4 Presentation of the PRA within Financial Statements
Theme number four discusses different presentation alternatives for effects of dynamic
interest rate risk management in the statement of financial position and the statement of
comprehensive income. Thereby, the evaluation of the DP’s corresponding Question 18
will be covered.
The IASB suggests three distinct alternatives for the statement of financial position:
Line-by-line gross up, separate lines for aggregate adjustments to assets and liabilities
- 41 -
(aggregate adjustment alternative) and single net line item. The example of the DP is
used to illustrate the differences among those alternatives:
Figure 21: Presentation alternatives in the statement of financial position
Source: adapted from IFRS Foundation (ed.) (2014b), p. 67.
As shown in Figure 21, within the line-by-line gross up alternative the carrying amount
of exposures within the managed portfolio will be adjusted to reflect the revaluation for
the managed interest rate risk. For example if the value of retail loans increased from
CU 1000 to CU 1011 due to changes in the benchmark interest rate, retail loans would
be shown as CU 1011 in the statement of financial position. In contrast, for the
aggregate adjustment as well as the single net line item alternative, asset and liability
classes will continue to be shown on an amortized cost basis, where applicable. For the
aggregate adjustment alternative, one separate line item will be shown for dynamic risk
management evaluation for assets and one for liabilities. In the example above, the
aggregate adjustment line shows a dynamic risk management revaluation of CU 21 on
the asset side and CU (50) on the liability side. The single net line item approach will
only show the net effect of CU (29) which is the sum of the aggregate adjustment line
for assets and liabilities.129
For the statement of financial position, two distinct presentation alternatives are
suggested, namely the actual net interest income presentation as well as the stable net
interest income presentation. Again, the example of the DP is used to illustrate the
differences between the two suggestions. In this specific example, a bank has a portfolio
129
Cf. IFRS Foundation (ed.) (2014b), p. 66 f.
DR/(CR)
Fair value
Assets
Retail loans 1000 11 1011 1000 1000
Commercial Loans 750 30 780 750 750
Debt securities 500 (20) 480 500 500
Dynamic risk management revaluation 21
Derivatives 25 25 25 25
Liabilities
Deposits (400) 5 (395) (400) (400)
Issued debt securities (1500) (40) (1540) (1500) (1500)
Firm commitments (15) (15)
Dynamic risk management revaluation (50) (29)
(29) 25
4
Profit or loss from dynamic risk
management activities
Amortized
cost
Revaluation
adjustment Aggregate
adjustment
Single net
line item
Line-by-line
gross up
Presentation alternatives in the statement
of financial position
- 42 -
of six year fixed interest rate loans which is totally funded with variable interest rate
liabilities, based on 6-month Libor. The interest rate of the loan portfolio is 4%
annually, whereof 1% represents the initial customer margin. Furthermore, the bank
decides to hedge 80% of the resulting interest rate risk by entering into a six year pay
fixed and receive variable IRS.130
Figure 22: Actual net interest income presentation
Source: adapted from IFRS Foundation (ed.) (2014b), p. 71.
Figure 22 illustrates the presentation of subsequent periods for the actual net interest
income alternative. Interest revenue shows the actual revenue for the six month period,
which is fixed with 2% semi-annually in this example. Interest expense shows the actual
interest expense, based on the prevailing 6-month Libor rate. Next, net interest from
dynamic risk management depicts the net interest accrual from all risk management
instruments – in this example the difference from paying fixed and receiving 6-month
Libor. All three numbers together yield net interest income which constitutes the actual
interest income in the respective period. In this example, this number results from 80%
of the interest income being fixed due to the IRS while the unhedged 20% vary with the
prevailing 6-month Libor rate. The revaluation effect from dynamic risk management
represents the net effect of fair value changes of derivatives and revaluation changes
from the dynamically managed portfolios, as described by the mechanics of the PRA.
Finally, net interest income and the revaluation effect together yield the total profit and
loss for the respective period. In essence, the actual net interest income presentation
would show how dynamic risk management has altered net interest income in the
reporting period while at the same time providing information on mismatches in
anticipated future net interest income.131
130
Cf. IFRS Foundation (ed.) (2014b), p. 69 f. 131
Cf. IFRS Foundation (ed.) (2014c), p. 12.
in CU 30 Jun 20X1 31 Dec 20X1 30 Jun 20X2 31 Dec 20X2
Interest revenue 2.0 2.0 2.0 2.0
Interest expense (1.49) (1.37) (1.24) (1.61)
Net interest from dynamic risk management (0.01) (0.10) (0.21) 0.09
Net interest income 0.5 0.53 0.55 0.48
Revaluation effect from dynamik risk management 0.25 0.21 (0.67) (0.52)
Total profit/loss for the 6 month period 0.75 0.74 (0.12) (0.04)
- 43 -
Figure 23: Stable net interest income presentation
Source: adapted from IFRS Foundation (ed.) (2014b), p. 72.
The effects of the stable net interest income presentation are shown in Figure 23.
Interest expense is identical to the actual net interest income presentation, showing the
prevailing 6-month Libor rate in the subsequent periods. The presentation of interest
revenue shows a significant difference: Instead of showing the actual numbers, interest
revenue is altered in a way that the customer margin, subsequently shown in net interest
income below, is kept constant at 0.5% semi-annually, or 1% annually respectively. The
revaluation effect from dynamic risk management then represents the net effect of fair
value changes of derivatives and revaluation changes from the dynamically managed
portfolios less the stabilization impact reported in net interest income that was actually
not achieved. In summary, the stable net interest income would assume that a bank’s
risk management objective is to stabilize net interest income and would imply that this
goal is actually achieved. The revaluation effect would provide aggregate information
on the success of that objective for both current and future net interest income.132
It is
important to note that, despite different ways of presentation, both alternatives show
exactly the same profit or loss in each period.
4.4.1 Question 18: Presentation Alternatives
Sub-question 18a focusses on the three distinct alternatives for the presentation of the
effects of dynamic interest rate risk management in the statement of financial position,
as introduced previously. The IASB asks: “Which presentation alternative would you
prefer in the statement of financial position, and why?”133
In sum, 85 respondents
answered explicitly:
132
Cf. IFRS Foundation (ed.) (2014b), p. 73. 133
IFRS Foundation (ed.) (2014b), p. 73.
in CU 30 Jun 20X1 31 Dec 20X1 30 Jun 20X2 31 Dec 20X2
Interest revenue 1.99 1.87 1.74 2.11
Interest expense (1.49) (1.37) (1.24) (1.61)
Net interest income 0.5 0.5 0.5 0.5
Revaluation effect from dynamik risk management 0.25 0.24 (0.62) (0.54)
Total profit/loss for the 6 month period 0.75 0.74 (0.12) (0.04)
- 44 -
Figure 24: Evaluation of Question 18a
Source: own representation.
As can be seen from Figure 24, the vast majority prefers the single net line item
alternative (70.6%), followed by aggregate adjustment (15.3%) and line-by-line gross
up (5.9%). It should be noted that multiple answers were allowed as some respondents
agreed with two alternatives while rejecting the other. No differences can be observed
between financial markets associations and the aggregate banking industry: With 72-
73% both groups strongly prefer the single net line item approach.
Supporters of the line-by-line gross up presentation predominantly claim that this
alternative would faithfully represent the economics as the actual financial position is
shown separately for each line item.134
Furthermore, greater transparency of the
accounting adjustments made to items on the balance sheet would be ensured.135
To a large extent, proponents of the aggregate adjustment alternative also support the
single net line item approach while rejecting line-by-line gross up. They note that both
suggestions are clear and concise while the line-by-line gross up would be onerous to
provide and will require greater levels of investment. Lloyds Banking Group
acknowledges that there might be an interest in the concentration of interest risk by
source but thinks that this information should be provided in the notes. A granular
breakdown in the statement of financial position, as envisaged by a line-by-line gross
up, would divert the attention from the overall position at the reporting date.136
Furthermore, some respondents note that line-by-line gross up would not be in line with
the approach taken for portfolio hedge of interest rate risk in IAS 39 where separate
lines for aggregate adjustments to assets and liabilities are applied.137
Supporters’ arguments for a single net line item presentation can be divided into
conceptual and operational arguments. With regard to conceptual arguments,
134
On this see for example Ono, Y. (2014), p. 22. 135
Cf. Peach, K. (2014), p. 16. 136
Cf. Joyce, D. (2014), p. 19. 137
Cf. Poole, V. (2014), p. 15.
- 45 -
respondents first and foremost note that the single net line item is consistent with the
dynamic risk management’s focus on the net open risk position. KPMG states that
dynamic risk management inter alia involves the “(…) mitigation of the net open risk
position arising from managed portfolios, and (…) does not focus on the risks arising
from individual assets or liabilities.”138
In that context, several respondents also note
that, as the focus is not on the risk of individual positions, the allocation of the result
from a net position to individual gross positions would be artificial and would thus not
provide any relevant information.139
Another argument made by several supporters of
the single net line item approach is that the other two alternatives would lead to the
presentation of assets and liabilities that may not, or not yet, exist. This includes inter
alia new suggested elements of the PRA like EMB or pipeline transactions.140
As the
final conceptual argument, some proponents note that the single net line item
presentation would depict assets and liabilities in the statement of financial position in
accordance with IFRS 9 Phase 1 which improves understandability for users of financial
statements.141
For instance, loans and receivables would continue to be depicted at
amortized cost without the inclusion of revaluation adjustments. As shown in Figure 20,
the respective revaluation adjustments of loans and receivables would instead flow into
the single net line item of dynamic risk management revaluation. As an operational
argument, many respondents claim that other alternatives than the single net line item
would require tracking which would increase operational complexity and costs. The
European Securities and Markets Authority acknowledges that “(…) portfolios can be
composed of both assets and liabilities, and assigning the revaluation adjustment to both
categories separately would require tracking.”142
Accordingly, even though a
breakdown to individual assets and liabilities would be most onerous, the aggregate
adjustment alternative would also not reduce operational complexity in their view.
Irrespective of the view on the three alternatives, several commentators indicate that
consideration should be given to the impact on financial ratios. Nationwide Building
Society states: “We are concerned about the impact that alternative presentations may
have on key ratios such as the impact on the leverage ratio and on further financial and
risk performance indicators that are calculated from underlying balance sheet values.”143
138
Vaessen, M. (2014), p. 16. 139
On this see for example Peters, D. (2014), p. 15. 140
On this see for example Ludolph, S. (2014), p. 19. 141
Cf. Rave, H./Kehm, P. (2014), p. 22. 142
Maijoor, S. (2014), p. 17. 143
Faull, M. (2014), p. 7.
- 46 -
This concern is backed by the increasing importance of financial ratios in existing and
future banking regulation measures, for instance the Basel III framework.
The second part of Question 18, sub-question 18b, seeks commentators’ input on the
two alternatives for the statement of comprehensive income and asks: “Which
presentation alternative would you prefer in the statement of comprehensive, and
why?”144
In sum, 80 comment letters responded to this part:
Figure 25: Evaluation of Question 18b
Source: own representation.
Figure 25 provides an unambiguous result: 88.8% support the actual net interest income
presentation while no respondent prefers the stable net interest income alternative.
11.3% are undecided or not clear in their answers. As this result is entirely explicit, no
separate evaluation of preparers and users of financial statements’ views is required.
Three distinct patterns of argument can be observed for the actual net interest income
presentation. First, commentators focus on the explanatory power of net interest income
in the actual net interest income presentation: Accordingly, actual results would be
presented as it is shown how dynamic risk management activity has altered the net
interest income in the reporting period. This is preferred to an artificial net interest
income as reported by the stable net interest income presentation.145
Second,
respondents acknowledge the informative value of the item revaluation effect from
dynamic risk management in the actual net interest income presentation. As net interest
from dynamic risk management flows into actual net interest income of the reporting
period, the revaluation effect is shown separately and thus solely shows mismatches in
anticipated future net interest income.146
This is preferred to the stable net interest
income alternative where the item revaluation effect from dynamic risk management
would also contain a revision of net interest income that was initially shown but not
actually achieved. Taking the first two arguments together, supporters note that the
144
IFRS Foundation (ed.) (2014b), p. 73. 145
On this see for example Schneiß, U./Fieseler, U. (2014), p. 14. 146
On this see for example Bertl, R. (2014), p. 13.
- 47 -
actual net interest income presentation best reflects the dynamic risk management
process within banks and is thus more valid. Barclays Bank concludes that the actual net
interest income approach “(…) provides the most transparent and useful
information.”147
As the last line of reasoning, respondents prefer the actual net interest
income alternative as they explicitly reject the stable net interest presentation.
Commentators claim that this alternative would be artificial and also potentially
misleading. For instance, KPMG claims that the stable net interest income approach
does not paint a true picture of an entity’s ability to stabilize the net interest margin.
This is due to the fact that net interest income is presented as if it has been fully hedged
rather than showing actual risk management activity. They conclude that “(…)
presenting the actual economic outcome of hedging net interest income [as represented
by the actual net interest income alternative] may avoid the potential for misleading
financial statement users.”148
4.4.2 Critical Appraisal
Choosing the right presentation alternatives is crucial to a new accounting model. The
joint comment letter by University of Siegen and Lucerne notes: “(…) Presentation is
the key question of the DP per se. Having in mind the overall aim of financial
statements in form of providing decision-usefulness for current and potential investors,
only a good presentation of risk management activities can make a decisive contribution
to that.“149
In sum, respondents are clear with regard to the questions of the fourth
theme: The single net line item alternative is preferred for the statement of financial
position while the actual net interest income presentation is seen as the right choice for
the statement of comprehensive income.
With regard to the single net line item approach, respondents’ argument concerning the
focus on the net position seems convincing. Also, this approach would allow for
comprehensive presentation of revaluation effects while continuing to depict assets and
liabilities in accordance with IFRS 9 Phase 1. In sum, this choice would allow for a
clear and concise presentation without significant changes to current treatment of
balance sheet items. If required by users of financial statements, a further breakdown of
revaluation adjustments could be shown in the notes.
147
Adams, M. (2014), p. 18. 148
Vaessen, M. (2014), p. 17. 149
Menk, M./Rissi, R./Spillmann, M. (2014), p. 18.
- 48 -
The actual net interest income presentation for the statement of comprehensive income
seems to be clearly preferable. It presents actual results and allows for a separation of
the impact of risk management activity on net interest income in the reporting period
from expected impact on future net interest income. Opposed to that, the stable net
interest income would provide an artificial net interest income while mixing the
revaluation effect from dynamic risk management with corrections to the previously
shown artificial number. This procedure seems unnecessarily complex and opaque and
is thus unlikely to provide decision-useful information.
4.5 Overall Evaluation of the PRA
So far, respondents’ views on difficulties with current standards IAS 39 / IFRS 9 as well
as the overall need or an accounting approach for dynamic risk management have been
evaluated. Also, questions related to the basic principles of such an approach, with a
focus on the PRA, were discussed. This included the preferred scope alternative, the
inclusion of specific elements of behaviouralisation as well as the potential presentation
in financial statements.
The evaluation of Question 1 showed that the majority (59.8%) feels a need for a
specific accounting approach for dynamic risk management. Also, sub-question 2a
revealed that respondents, to a large extent (79.3%), agree with the IASB’s description
of main issues with current hedge accounting requirements. As a final step, it remains to
be evaluated whether commentators in general support the PRA as a potential new
approach to account for dynamic risk management.
4.5.1 Question 2b: PRA as Potential New Accounting Concept
The PRA, as introduced in chapter 2, seeks to solve issues with current standards IAS
39 / IFRS 9 as it releases entities from static one-to-one hedge accounting designations
by looking at the managed portfolio and respective hedging instruments holistically.
Sub-question 2b reads as follows: “Do you think that the PRA would address the issues
identified? Why or why not?”150
It should be noted that the wording of this question
could be seen in a rather narrow context by only asking for respondent’s view on
whether the detected issues of Question 2a would be addressed by the PRA or not.
However, due to the absence of any further question in the DP on respondents’ overall
opinion on the PRA, a vast majority of commentators understands this question in a
150
IFRS Foundation (ed.) (2014b), p. 23.
- 49 -
broader sense. This means that they state whether they in general support or reject the
PRA and also, compared to other responses, provide rather extensive reasoning.
Consequently, the subsequent evaluation of this question will follow this broader
interpretation and will filter out whether the PRA is generally supported as a potential
accounting concept for dynamic risk management or not. In addition to the
interpretation issue, this question does not distinguish between the two scope
alternatives, as described in section 4.2.1, although this turns out to be an important part
in respondents’ answers to this sub-question. In order to address this, the criterion for
evaluation is chosen as follows: If a respondent in his or her answer to sub-question 2b
generally supports the PRA under at least one scope alternative, for instance the risk
mitigation scope, the answer is counted as a Yes. If, however, a respondent within this
sub-question explicitly or implicitly rejects the PRA under both scope alternatives, the
answer is counted as a No. Overall, 105 comment letters answered this central question:
Figure 26: Evaluation of Question 2b
Source: own representation.
As Figure 26 shows, this sub-question is highly contested: 26.7% think that the PRA
would address the issues identified and would thus, due to the broader intepretation,
support the PRA concept in general. Out of these 28 supporters, 15 explicitly state in
this part that they would not support the PRA with a dynamic risk management scope.
Opposed to that, 31.4% do not think that the PRA, irrespective of the scope alternative,
would solve the issues identified and thus generally reject it. The remainder, 41.9%, is
undecided or does not give a clear statement. The comparably high proportion of
undecided respondents can be explained by several comments stating that the DP covers
relevant topics on a relatively high level and that further details are needed for a final
decision.151
Also, due to the complexity of the subject, some respondents suggest to
conduct an outreach program before reaching a decision.152
Within the aggregate
banking industry, 27% support the PRA while for financial markets associations 30%
151
Cf. Östros, T./Stenhammar, M. (2014), p. 3. 152
Cf. Dignam, S./Ward, R. (2014), p. 1 f.
- 50 -
support the PRA. Thus, only a small difference between users and preparers of financial
statements can be observed.
Those supporting the PRA concept in general mainly claim that this concept would
closer align dynamic risk management and accounting. Accordingly, they state that the
PRA would address, at least to a large extent, the current problems analyzed in section
4.1, for example that dynamically managed portfolios would no longer be forced into
closed and static hedge relationships which are arbitrary.153
For instance, the Chartered
Accountants Ireland note in their response that “(…) developing an approach that can be
more readily applied to open portfolios is also welcomed as it is widely acknowledged
that the current hedge accounting model works well for closed portfolios but has
significant limitations when applied in a dynamically managed environment.”154
Secondly, and also frequently mentioned, is the argument that the PRA would facilitate
a reduction in operational complexity. This line of reasoning is interrelated with the first
argument as complexity reduces due to individual hedge designations being waived.155
As described in section 4.2 this effect would be highest for a dynamic risk management
scope as the risk mitgation scope continues to require desiginations, either in the form
of sub-portfolios or proportions. Finally, proponents of the PRA welcome elements of
behaviouralisation that would go along with an introduction of the PRA. UBS Bank
emphasizes, as discussed in section 4.3, that one of the key issues faced by banks is the
current inability to designate as hedged items certain exposures that are included in
dynamic risk management and mitigated through the use of derivatives. The PRA,
including all elements of behaviouralisation, would no longer force entities to designate
hedged items that serve as proxy but allow for an accounting solution that directly
reflects the exposure being managed.156
Opponents of the PRA concept mainly have a different view with regard to operational
complexity. In their eyes, the PRA would not only fail to reduce but even increase
operational complexity.157
Specifically, the Association of Accountants and Financial
Professionals in Business argues that the implemenetation of the PRA under either
scope alternative will create significant operational complexities: As the PRA presented
a completely new classification and measurement model, significant system
153
On this see for example Southgate, C. et al. (2014), p. 7. 154
Kenny, M. (2014), p. 1. 155
Cf. Chien, L. (2014), p. 3. 156
Cf. Tovey, M./Lasik, M. (2014), p. 3 f. 157
On this see for example Kvaal, E. (2014), p. 7.
- 51 -
development and other operational changes would be required to capture the necessary
information.158
Second, several commentators remark that the PRA concept is only
suitable to a specific hedging strategy, which is to manage risk on a revaluation basis.
However, according to this group, there is a variety of ways to perform risk
management which also have to be considered.159
As one example, Groupe BCPE
claims that many banks choose to manage their interest rate risk on a cash flow basis
rather than on a revaluation basis.160
Another example is given by Mazars, believing
that banks rather manage the sensitivity of their interest margin.161
Commentators
conclude that, due to the consideration of only one risk management practice, the PRA
cannot serve as an overall accounting concept for dynamic risk management. The last
pattern of argument made by proponents of the PRA was already discussed within
Question 1: Several opponents reject the PRA as they think - rather than introducing a
new accounting approach - existing standards IAS 39 / IFRS 9 should be improved. As
explained in section 4.1.1, accommodation of open portfolios and consideration of
behavioural elements like core demand deposits are seen as main pillars for
improvement. Commentators note that the replacement of IAS 39 by IFRS 9 will
already result in more flexibility and thus provide a good starting point for further
relaxations. Hydro-Québec concludes in their answer: “(…) We believe that it would be
more appropriate to keep the current general model, but to relax certain rules, as for
instance, by amending the definition of a hedged item.”162
As a general remark, a large part of insurance companies and insurance associations
note that the PRA has to include further considerations for the insurance sector. In this
context, Allianz SE points out three aspects: First, they remark that the insurance
industry generally has a strong interest in an accounting approach for dynamic risk
management. However, the PRA as discussed in the DP was developed for a banking
environment with amortized cost as the predominant measure. Hence, secondly, such an
approach needs to facilitate risk mitigation for other sets of measurement, for example
between current fulfillment value according to upcoming standard IFRS 4 Phase 2 and
158
Cf. Schroeder, N. (2014), p. 3. 159
On this see for example Innes-Wilson, C. (2014), p. 2. 160
Cf. Patrigot, N. (2014), p. 5. 161
Cf. Barbett-Massin, M. (2014), p. 3. 162
Croteau, L. (2014), p. 2.
- 52 -
amortized cost under IFRS 9. Finally, Allianz notes that the overall extent of accounting
mismatches can only be identified after finalization of IFRS 4 Phase 2.163
4.5.2 Critical Appraisal
This last theme closed with the evaluation of comment letters with regard to the overall
view on the PRA concept. It was shown that opponents of the PRA slightly outnumber
supporters, while the majority is undecided or does not provide a clear statement. This
is a close run and does not mean that the concept in general should no longer be
pursued.
Confronting arguments of supporters and opponents of the PRA, one finds that major
lines of arguments are difficult to reconcile: While one side states that the PRA would
reduce operational complexity, the other side states the opposite. For a person standing
outside, a fair judgement proves difficult. In fact, it might be the case that both sides are
part of the truth: In spite of waving one-to-one designations, new systems would be
required to collect and prepare information for purposes of presenting the PRA in
financial statements. In the end, it might be an individual analysis whether benefits
outweigh costs. Another contradictory point is that proponents consider the PRA to
closer align risk management and accounting, while opponents state that many risk
management practices will not be covered. In that respect, it should be noted that
revaluation according to changes in the managed risk, as described by the PRA, uses the
present value technique. This principle of discounting future cash flows to determine
current values is a concept that is broadly accepted and widely applied in finance.
Though some risk management practices might focus on other aspects, this principle of
finance can hardly be entirely ignored in any risk management strategy. Hence,
revaluation according to changes in the risk being managed should, at least to a certain
extent, depict an entities success in mitigating risk irrespective of the individual
strategy.
Beside the general reconciliation of arguments, it is important to note that many
commentators from different parties reiterate their critical view on a dynamic risk
management scope: 33 of all answers to sub-question 2b explicitly state that they reject
such a scope although this was not even part of the question. Combining the evaluation
of sub-question 15a with sub-question 2b it becomes clear that the PRA with a dynamic
163
Kanngiesser, S./Sauer, R. (2014), p. 1 ff.
- 53 -
risk management scope is rejected by the large majority of commentators. In contrast, a
PRA with a risk mitigation scope, especially in combination with optional application,
has realistic chances to find general acceptance. As described in the critical appraisal of
the results of Questions 15 and 16, a risk mitigation scope, in combination with optional
application, would allow entities to address accounting mismatches in a dynamic
hedging environment. However, this can be seen as merely an extension of the hedge
accounting toolkit which might potentially be primarily used for earnings management.
A holistic depiction of dynamic risk management will be difficult as only hedged
positions would be included in the PRA, thus providing no information about open risk
positions and respective economic effects. In that respect, a dynamic risk management
scope would in most instances allow for a faithful depiction of dynamic risk
management by also showing the economic effects of unhedged positions. However, as
mentioned before, measurement for a large part of the banking book would be changed
from amortized cost to revaluation in accordance with changes in the managed risk, for
example the benchmark interest rate. It is understandable that this is perceived as a
threat by preparers of financial statements: First, potentially sensitive information will
be released, for example effects of unhedged risk positions and respective profit and
loss effects. This might in turn lead to unpleasant questions by critical investors.
Additionally, profit and loss volatility might also increase due to the continuous
revaluation of all exposures being dynamically managed.
While the larger part of commentators is skeptical about the PRA, especially with a
dynamic risk management scope, section 4.2.3 showed that a PRA with such features
would most likely fit the IASB’s objective of enhancing the usefulness of information
provided by financial statements while at the same being operational. The fifth chapter
will show how the IASB reconciled the different views on the PRA. Before moving to
this chapter, the next section will provide a consolidated view on important evaluation
results.
4.6 Summary of Evaluation Results
The last five sections focused on a step-by-step analysis of the most important questions
of the DP, as described in chapter three. As the quantitative analysis was supplemented
by the confrontation of predominant lines of reasoning, this section will close the
chapter by providing a brief summary of the main results.
- 54 -
Figure 27: Predominant views on analyzed questions
Source: own representation.
Figure 27 shows the key result for each question analyzed. On the left, the subject of
each question is briefly restated, followed by the predominant view on the respective
part. On the right, the percentage rate of answers that share the adhesive predominant
view is given.
Section 4.1 revealed that respondents agree with the IASB description of difficulties
with current standard IAS 39 / IFRS 9 in a dynamic hedging environment. Also,
commentators mainly agreed that there is a need for a specific accounting approach for
dynamic risk management. The following section 4.2 showed that respondents clearly
prefer an optional application of the PRA with a scope focused on risk mitigation which
means that only hedged exposures would be included. With regard to the inclusion of
behaviouralized elements, as discussed in section 4.3, respondents in aggregate mainly
support all suggested elements. This includes pipeline transactions, the EMB, core
demand deposits as well as cash flows on a behaviouralised basis for purposes of
applying the PRA. Concerning the presentation in financial statements, respondents
clearly prefer the single net line item alternative for the statement of financial position
and the actual net interest income method for the statement of comprehensive income.
Section 4.5 revealed that commentators have diverging views with regard to the PRA in
general. While, according to this evaluation, one third of all commentators thinks that
the PRA would address the problems identified, the majority of respondents is
undecided on whether they should support the PRA or not.
Q1 Need for a specific accounting approach confirmed 59.8%
Q2a Difficulties with current standard as described in the DP correctly identified 79.3%
Q15a Preferred scope alternative risk mitigation 82.6%
Q15b Combination of risk mitigation scope and IFRS 9 faithful depiction 60.7%
Q15c Operational feasibility of both scope alternatives both challenging N/A
Q15d Change of answers 15a-c in light of other risks no 75.6%
Q16a Mandatory or optional PRA: dynamic risk management scope optional 89.3%
Q16b Mandatory or optional PRA: risk mitigation scope optional 92.7%
Q4a Inclusion of pipeline transactions in the PRA supported 63.1%
Q4b Inclusion of EMB in the PRA supported 56.5%
Q4c Cash flows on behaviouralised or contractual basis behaviouralised 88.1%
Q9a Inclusion of core demand deposits supported 87.1%
Q9b Guidance on behaviouralisation of core demand deposits not needed 57.6%
Q18a Presentation alternative in statement of fin. position single net line item 70.6%
Q18b Presentation alternative in statement of compr. income actual net interest income 88.8%
Section 4.5 Q2b Identified difficulties addressed by the PRA undecided 41.9%
Section 4.2
Section 4.3
Section 4.4
% of answers that share
predominant viewPredominant viewSubjectQuestion
Section 4.1
- 55 -
The next chapter will demonstrate how the IASB took respondents’ feedback into
consideration, especially how it decided to deal with the ambiguous feedback on the
PRA in general.
5. Outlook on Next Steps
In May 2015, the IASB issued a staff paper by Yamashita and Dasgupta including a
proposed project plan for the Dynamic Risk Management Project and the adhesive PRA
concept. This chapter will first provide a brief overview on the IASB’s evaluation of the
comment period, as presented in the paper. It will then discuss the different approaches
considered on how to move forward with the project. The chapter will close by
visualizing the proposed project plan which was subsequently accepted by the IASB on
May 20th
2015.
5.1 IASB’s Evaluation of the Comment Period
In a first step, the above-mentioned staff paper analyses the results of the comment
period from the IASB’s perspective. It is argued that there are conflicting views
between preparers and users of financial statements which are hard to reconcile: On the
one hand, preparers would focus on the reduction of accounting mismatches in dynamic
risk management while keeping flexibility to apply other hedge accounting techniques.
Accordingly, a faithful representation in financial statements would be granted a rather
low priority. On the other hand, users of financial statements would generally support
the PRA, some even with a dynamic risk management scope, as they primarily seek a
faithful depiction of dynamic risk management in financial statements. A point where
both groups of stakeholders agree would be the inclusion of behaviouralised elements,
especially core demand deposits.164
This broadly matches with the tendencies revealed
during the evaluation in this working paper, though there are some exceptions to this:
For instance, the evaluation results of this working paper did not reveal a general
acceptance of the PRA concept by users of financial statements. Also, users of financial
statements expressed a skeptical view on pipeline transactions and the EMB which
remains unmentioned in the paper. These deviations can be explained by two reasons:
First, the term user of financial statements is defined more broadly in this working
paper, as it also includes regulatory and supervisory bodies. The rationale behind this is
164
Cf. Yamashita, Y./Dasgupta, K. (2015), p. 3 ff.
- 56 -
that such institutions, for instance the European Central Bank, also use financial
statements as primary sources of information about an entity. Opposed to that, the staff
paper analyses regulators’ views separately. As a second possible explanation, the staff
paper also considered 50 additional outreach meetings conducted during the comment
period.165
These were not included in the population of this working paper. Despite
slight differences and sometimes comparably weaker correlations in this working paper,
both results point at the different interests of involved parties and congruently show the
challenge in reconciling stakeholders’ opposing views.
5.2 Considered Approaches
Facing this challenge, the paper considers several ways how to move forward with the
project. The first option considered was to maintain the status quo, meaning that hedge
accounting options of IAS 39 / IFRS 9, including the fair value hedge accounting for a
portfolio of interest rate risk, would remain the only tools to address accounting
mismatches in dynamic risk management. However, the comment period revealed that
there is a consensus about the need for a project to address current challenges in the area
of accounting for hedges of open portfolios, also because proxy hedge accounting
stands for indirect presentation of risk management and operational complexity. Taking
into account further reasons, like the need for behaviouralisation of certain elements, the
paper concludes that maintaining status quo is no optimal solution.166
As a second option, the paper considers different models that were suggested by
respondents during the comment period of the DP. This includes the amendment of fair
value hedge accounting for a portfolio of interest rate risk of IAS 39, the use of cash
flows of derivatives to calculate the adjustments to offset fair value changes from
hedged items as well as selected deferral of fair value changes in derivatives in OCI.
The paper states that these suggestions are not fully developed solutions and lack
considerations with regard to usefulness of information provided as well as consistency
with the conceptual framework. In conclusion, the paper suggests using these alternative
models as assistance instead of taking them forward actively. This could for example
mean that certain elements are picked from the proposals in case they prove useful.167
165
Cf. Yamashita, Y./Dasgupta, K. (2015), p. 1. 166
Cf. Yamashita, Y./Dasgupta, K. (2015), p. 6 ff. 167
Cf. Yamashita, Y./Dasgupta, K. (2015), p. 9 f.
- 57 -
The third option would be to make the project a disclosures-only project, meaning that
recognition and measurement would not be considered for a new approach to depict
dynamic risk management in financial statements. Instead, the information would only
be provided in the notes to the primary financial statements. Parallel to the option of
remaining the status quo, the paper concludes that this alternative fails to address
problems with current hedge accounting requirements, including the continuing need for
proxy hedging or the demand to include behaviouralised elements, like core demand
deposits.168
As a final option, the paper suggests to start with disclosures on dynamic risk
management activity and consider recognition and measurement requirements
afterwards. Three distinct advantages of this approach are mentioned: Firstly, this
alternative would directly deal with information that both users and preparers agree to
be useful. This is the case as there is less diversity on the specification of disclosures
about dynamic risk management activity than for recognition and measurement. For
instance, several preparers would be willing to provide extensive disclosure despite
preferring a risk mitigation scope for the PRA. Secondly, decisions on recognition and
measurement could subsequently build on the knowledge collected during the
disclosures only phase. Finally, this approach would grant flexibility and methodology
to try and explore how to best reconcile the diversity in views on recognition and
measurement.169
5.3 Project Plan: Disclosures First
Due to the distinct advantages of the disclosures first alternative, the staff paper
recommends choosing this approach and proposes the following project plan:
Figure 28: Proposed project plan
Source: own representation.
168
Cf. Yamashita, Y./Dasgupta, K. (2015), p. 11 f. 169
Cf. Yamashita, Y./Dasgupta, K. (2015), p. 11 f.
- 58 -
Figure 28 illustrates the three project phases as suggested by the paper. The first phase
will focus on disclosures-only by considering “(…) information that is currently
provided to users by entities in the form of existing GAAP, non-GAAP measures and
regulatory requirements and build on the previous work done by staff when developing
the DP in the area.”170
The key focus will be on how to best address the need to better
understand drivers and sources of an entities’ net interest income via disclosures. With
regard to behaviouralisation, the staff will explore present regulatory requirements
demanding entities to disclose details about assumptions and models for core demand
deposits in order to ensure transparency. Once the appropriate range of disclosures in
the financial statements has been determined, the IASB could move on to the second
phase. During this phase, the IASB could benefit from the experiences and knowledge
from the first phase with a clearer picture on how to reconcile varying information
needs among stakeholders within primary financial statements via recognition and
measurement. The final stage will include considerations of other types of risk being
dynamically managed, for instance foreign exchange or commodity price risk. The
inclusion of other types of risk at a later stage could inter alia be justified by the fact
that the comment period revealed a rather low priority for other risks while most
pressing needs were articulated for dynamic interest rate risk management. Due to the
opposing views that prevailed during the comment period, the paper suggests to
constitute an Expert Advisory Panel to assist the IASB in developing a new approach
for accounting for dynamic risk management. However, this should happen at a later,
not yet defined stage, as a term of reference and a necessary skill set for participants
should first be definied. According to the paper, this is best possible after further
deliberations by the IASB.171
The staff paper formed the basis for the discussions at a public meeting of the IASB
from May 18-20th
2015 in London. On May 20th
2015, the IASB discussed the next
steps as proposed by the paper and in unison agreed to follow the proposed project plan
as outlined. The IASB tentatively decided “(…) that it should first consider how the
information needs of constituents concerning dynamic risk management activities could
be addressed through disclosures before considering those areas that need to be
addressed through recognition and measurement; to prioritise the consideration of
170
Yamashita, Y./Dasgupta, K. (2015), p. 11. 171
Cf. Yamashita, Y./Dasgupta, K. (2015), p. 10 ff.
- 59 -
interest rate risk and consider other risks at a later stage in the project; and to establish
an Expert Advisory Panel at a later stage in the project.”172
6. Conclusion
The evaluation of all comment letters with regard to key questions of the DP was
driven by the goal to create further transparency on the outcome of the comment period.
Beside the quantitative analysis of these questions, an explicit focus was on the
confrontation of opposing arguments for individual problems.
This working paper revealed that the view on the PRA concept in general is not
homogeneous and remains to be further discussed. It was shown that the different views
are underpinned by substantial arguments that need to be seriously considered.
Especially due to the high number of commentators being unclear or undecided on their
view, many respondents argued that more details on the mechanism would be needed to
come to a final decision. Despite some ambiguous results, the evaluation also revealed
areas with a high degree of consensus. This includes for example the identification of
problems with current standards IAS 39 / IFRS 9. Being on the same side with regard to
the problems provides a solid basis to develop ideas on how to overcome these. Also,
respondents mainly agree that there is a need for a specific accounting approach for
dynamic risk management. Hence, the IASB can confidently refrain from adapting
general hedge accounting according to IAS 39 / IFRS 9 and continue to develop a
suitable model for accounting for dynamic risk management from scratch. Further,
respondents seem to prefer an optional application of the PRA with a risk mitigation
scope which, as explained previously, mainly addresses accounting mismatches arising
from dynamic risk management. Lastly, respondents in aggregate broadly agree that a
new standard should include behaviouralised elements, especially core demand
deposits, which seem to play a significant role in a commercial bank’s risk management
activity.
Besides the evaluation of questions on an aggregate level, specific analysis was
conducted for preparers of financial statements, namely the aggregate banking industry
and users of financial statements, represented by financial markets associations. This
procedure was founded on the initial presumption that both groups might have at least
partly conflicting interests in respect of the depiction of dynamic risk management in
172
IFRS Foundation (ed.) (2015b).
- 60 -
financial statements. With regard to the evaluation of the PRA in general, no significant
differences did prevail: Both parties show an ambiguous result, each with a significant
share of supporters, opponents and undecided entities. While users of financial
statements in general also support an optional application of the PRA with a risk
mitigation scope, a comparably higher share also opted for a dynamic risk management
scope and a mandatory application. Differences also prevailed for certain elements of
behaviouralisation: While both parties mainly agree on the inclusion of core demand
deposits, users of financial statements emphasize conflicts with the conceptual
framework as well as involved subjectivity for pipeline transactions and the EMB.
Further research is necessary on how risk management is practiced in reality within
different banks. The topic is much too important to just rely on the argumentations of
banks. If risk management should be illustrated within the financial statements there has
to be a certain (accounting) system (being in line with the framework of accounting)
worked out. Within that research there is a need for a comparison of both regimes, the
accounting system where earnings managements should be restricted and internal risk
management where companies are free in the structure. Afterwards it has to be shown
qualitatively as well as quantitatively which part of internal risk management and
treasury activity cannot be included into an external accounting system and how big the
information lag would be. In summary, despite the consensus on several questions,
some parts of the evaluation showed conflicting interests that have to be balanced
carefully in the future.
In its search for consensus on recognition and measurement, the IASB should clearly
keep in mind which goal it wants to pursue. Especially, considerations on which
exposures to include are of high importance. They have to be based on a sound decision
about the ultimate goal of the project. This should not be either a decision to focus on
accounting mismatches and reduce earnings volatility or a decision to focus on a faithful
depiction of the effects of an entity’s dynamic risk management by also showing profit
and loss effects of open risk positions. A decision in favor of avoiding accounting
mismatch would open the question why at all derivatives should be on balance if
afterwards the entire effect would be eliminated from profit or loss. The global financial
crisis showed that there is an increasing need for transparency on a bank’s risk position.
As these risk positions usually are managed dynamically, a new approach on accounting
for dynamic risk management constitutes a significant pillar to enhance transparency.
- 61 -
Thus, a solid accounting standard in the area of accounting for dynamic risk
management has the potential to further stabilize the financial system as a whole.
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The paper in this or similar form has never been submitted as an assessed piece of work
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____________________________________________________________________________ City, Date Sebastian Mauler