Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach To
22 October 2014
IASB
30 Cannon Street
London EC4M 6XH
Response to discussion paper:
Accounting for Dynamic Risk Management: a Portfolio Revaluation Approach to
Macro Hedging
The Financial Reporting and Analysis Committee (FRAC) of the CFA Society of the UK (CFA UK) welcomes the opportunity to respond to the IASB’s discussion paper DP/2014/1 on the important subject of hedge accounting, notably with a view to dynamic risk management. With the value of interest rate and other derivatives amounting to hundreds of trillions of dollars their importance for an entity’s financial health and the need for transparent recognition in companies’ financial statements cannot be overemphasised.
CFA UK represents more than 10,000 investment professionals working across the financial sector including asset managers, buy-side analysts, sell-side analysts and credit rating analysts, among others. For advocacy purposes in the field of financial reporting, these members are represented by the Financial Reporting and Analysis Committee.
Our committee primarily comprises investors and other users of financial statements who look at a wide range of companies in a wide range of sectors. Our aim in responding to the above DP is to provide the perspective of users of financial statements about the accounting for dynamic risk management. We are not experts in the internal risk management practices of banks and therefore cannot speak to the manner in which preparers view the risks and exposures, or the mitigation thereof, arising from their business or hedging activities. As far as we are able to judge, the DP appears to capture a wide range of situations that may arise in the context of hedging by banks as well as some companies operating in other sectors.
In order to help our understanding of the key issues we arranged a meeting with one of your staff, Mariela Isern, on 17 September. A follow-up discussion between IASB staff member Kumar Dasgupta and three of the undersigned took place on 6th October.. This meeting notably focussed on the issue of behaviouralisation and also included a discussion of broader issues. Based on the DP and discussions with your staff, we understand that some preparers find the current hedge accounting rules regarding fair value and cash flow hedges difficult to apply in practice. Key challenges include the requirement to treat open portfolio hedges essentially as a series of closed portfolio hedges. We understand that preparers attribute this treatment to the current accounting standard not recognising the dynamic nature of managing risk exposures and the related economic hedging activities. Preparers are concerned that current hedge accounting rules can exacerbate the volatility of profits and losses recognised in the P&L, and that this excess volatility does not reflect the underlying economic reality and thus may not represent a true and fair view. We understand further that the application of current accounting rules poses particular challenges in the context of banks’ interest rate risk management processes, while accounting for other forms of exposure (e.g. currency risk) and hedge accounting in other industries are perceived as less problematic.
We understand from our discussions with your representatives that the purpose of the discussion paper is to seek input on general principles of dynamic risk management, which will be considered in a subsequent exposure draft on potential new or modified accounting standards. As such, we take an integrated view of the DP and prefer to focus our response on the general principles which we believe should guide the formulation of accounting rules, rather than responding separately to each question raised in the DP in isolation.
- Overarching principles
In the following, we summarise general principles that we deem to be important in the context of dynamic risk management and hedge accounting.
Investors need to understand gross as well as net exposure, by type of exposure. Since most hedging instruments do not present a “perfect” hedge (i.e. the correlation in price movement between the underlying and the hedge is not perfect) and given the counterparty risk associated with any hedge, we believe that it is vital for investors to understand an entity’s exposure (and changes in exposure) to various types of risk (interest rate, currency, credit etc) on a gross as well as a net basis.
Exposures and hedges are managed at a portfolio level and are dynamic by nature. We agree with the general view presented in the DP that in some circumstances companies hedge risk exposures arising from portfolios rather than from single assets, and that designating a specific item as a hedge for a specific asset or liability would in many cases seem arbitrary, meaning that the general hedging approach is not appropriate.
Financial statements have not been designed to be “forward-looking”. The balance sheet should provide a snapshot of assets and liabilities on the balance sheet date, while the P&L and cash flow statement reflect profits and cash flows generated during the period. Timing mismatches are dealt with through OCI, while management forecasts form a key part of the narrative, rather than the actual set of financial statements. We generally do not advocate reflecting anticipated future events and exposures in the P&L.
Accounting standards need to be broadly applicable. This includes applicability to all industries and different types of exposure (i.e. interest rate, FX, credit and other risks). We recognise the heterogeneity of business models in different industries and thus acknowledge the need for industry-specific guidance. We would in fact regard the practicality of applying an accounting standard across all industries as the “acid test” for the standard; inapplicability reveals inherent flaws in the standard that may simply be less visible in some industries. As such, we do not advocate industry- or exposure-specific standards and would encourage the IASB actively to consider how any new standard might apply across sectors and not just in a single circumstance. We also note the substantial incremental cost investors would have to incur if they have to understand industry-specific accounting standards.
All accounting rules should be consistent and aligned with the Conceptual Framework. It is clearly a significant step to provide a different accounting treatment for a single circumstance. We need to take great care over such a step, and ensure that it is a worthwhile one. Often, volatility in reported results provides useful information to investors about how well management is managing and mitigating risk and it should not always be masked or smoothed.
Accounting standards should not alter the manner in which firms are managed. Whenever accounting standards are perceived by company management as not fully reflecting economic reality, we should consider the risk that management may avoid transactions that it deems to be in the company’s interest, but which could result in a distorted view. It is worth noting, however, that whilst the current hedge accounting rules are thought to result in excess P&L volatility particularly where interest rate risk is concerned, the substantial global interest rate derivatives volume does not suggest to us that banks are “under-hedging” their interest rate exposure to avoid being penalised.
The potential for abuse and issues with the auditability of information should be taken into account. We are particularly wary of deemed exposures, as the inability to recognise related assets or liabilities likely reflects the difficulties associated with verifying and valuing such exposures. Behaviouralisation assumptions, even if carried out with the best intentions, will likely be difficult for auditors to verify in all but the simplest transactions, i.e. we need to consider the risk that the cost of conducting a full audit of behavioural assumptions could become prohibitive. Whilst the example provided about the behaviouralisation of core demand deposits is well-suited to illustrating the concept, we would expect many banks to offer a wide range of products that are either far more complex or limited to a smaller number of customers, implying more binary outcomes that might be more difficult to behaviouralise.
With the above guiding principles in mind, we comment on a number of specific aspects in the following.
- Scope
The discussion paper proposes a Portfolio Revaluation Approach (PRA) to macro hedging that reflects some of the risk management techniques that banks use. Under this approach, both the changes in the fair value of the interest rate derivatives and the gain/loss from revaluing the risk managed exposures (e.g. fixed rate mortgages) are both recognised in the income statement. While the consultation focuses on interest rates and banks, it is clear that the logic of the approach could in due course be extended to cover other areas of risk and companies other than banks, which have the same issues around hedging portfolios of assets.
In terms of the scope of application of a PRA, 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 result, meaning that a broad scope of application that covers all exposures subject to dynamic risk management would seem more appropriate. At the least we would argue that the treatment should be required where the bank manages the risks in a way consistent with the PRA approach – a ‘through the eyes of management’ approach. Even if neither of these approaches is deemed appropriate, some standards requiring a consistency of treatment of portfolios over time would seem to us a sensible safeguard. There needs to be some basis for the auditors to challenge management decisions in these matters.
- Income statement presentation
Regarding the presentation of the PRA in the income statement we would favour the Actual Net Interest Income version over the Stable Net Interest Income version. The former would lead to more granularity in interest income reporting, with the income from interest hedging derivatives being shown separately to the income from trading derivatives.
- Disclosure themes
Regarding the four disclosure themes considered in the discussion paper we would favour quantitative and qualitative information on the impact of dynamic risk management on the current and future performance of an entity. This would give investors information to judge the effectiveness of the risk management activity and form a basis for discussions with management.
- Other observations
We are 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.
Another concern for us would be the alternative approach to PRA accounting suggested in the DP, which would take the impact of macro hedging through OCI as opposed to the P&L. OCI generally receives much less attention from investors than the P&L. If banks were somehow able to book macro-hedging losses through OCI but take profits (such as internal derivative transactions) through the income statement this would clearly present a misleading picture of performance.
- Behaviouralisation, pipeline transactions and equity model book
We are concerned about the behaviouralisation approach. This introduces a considerable degree of subjectivity into the reporting, which will be difficult for auditors to challenge and difficult for investors wholly to trust. The expected lack of consistency across banks is also likely to create a degree of challenge for investors. This could only be even partly addressed by detailed disclosures on relevant calculations, including assumptions and sensitivities, and even then these are the sorts of assumptions that are likely to appear reasonable until the market reality proves them entirely wrong, undermining confidence in corporate reporting. We would therefore tend to the view that where management does apply the behavioural approach to deposits and uses this as part of its overall risk management this should be disclosed in the discussion of risk management and mitigation in the management commentary, but should not form part of the IFRS financial statements and notes.
We take a similar view on deemed exposure arising from pipeline transactions, which may or may not materialise in the shape and form and to the extent predicted by management. The risk of a “failed hedge” should always be made visible and quantified, since even a slight delay in the occurrence of anticipated exposure could result in illiquidity. We would strongly encourage the IASB to seek views on the subject from non-bank preparers, notably industrial companies, to draw parallels to their supply chain management and forecasting, and related hedging practices. It could be argued that estimating and hedging future input costs for industrial companies bears similarities to the estimation of future funding costs of banks (of which behaviouralisation of core demand deposits is one component), and that banks’ pipeline transactions are similar to offers to transact that companies from other industries put out (e.g. pharmaceutical companies need to be prepared to continuously supply patients who take a drug chronically). Conceivably, many companies simply put in place cash flow hedges on a rolling basis to mitigate much of the resulting exposure.
With respect to the equity model book, we would encourage the IASB to seek extensive input on the construction and valuation of replication portfolios by banks and companies from other industries, and to consider the general issues arising in the context of deemed exposures as noted earlier, prior to considering inclusion of the related hedge accounting under the PRA. The choice and valuation of assets and liabilities and related exposure in a replication portfolio and the necessity to hedge these exposures does not appear intuitive, giving rise to scope for abuse and issues with auditability.
We would welcome further discussions on the issues raised in this response.
Yours sincerely,
Paul Lee
Co-chair, Financial Reporting and Analysis Committee
CFA Society of the UK
Marietta Miemietz
Co-chair, Financial Reporting and Analysis Committee
CFA Society of the UK
Will Goodhart,
Chief Executive
CFA Society of the UK
About CFA UK and CFA Institute
The CFA Society of the UK (CFA UK) represents the interests of more than 10,000 leading members of the UK investment profession. The society, which was founded in 1955, is one of the largest member societies of CFA Institute and is committed to leading the development of the investment profession through the promotion of the highest ethical standards and through the provision of continuing education, advocacy, information and career support on behalf of its members. Most CFA UK members have earned the Chartered Financial Analyst® (CFA®) designation, or are candidates registered in CFA Institute’s CFA Program. Both members and candidates attest to adhere to CFA Institute’s Code of Ethics and Standards of Professional Conduct.
CFA Institute is the global association for investment professionals. It administers the CFA and CIPM curriculum and exam programs worldwide; publishes research; conducts professional development programs; and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry. CFA Institute has more than 100,000 members in 140 countries, of which more than 90,000 hold the Chartered Financial Analyst (CFA) designation.