Ernst & Young Global Limited
Becket House
1 Lambeth Palace Road
London
SE1 7EU
Tel: +44 [0]20 7980 0000
Fax: +44 [0]20 7980 0275
ey.com
Tel: 023 8038 2000
Fax: 023 8038 2001
www.ey.com/uk
International Accounting Standards Board
30 Cannon Street
London,
EC4M 6XH
17 October 2014
Dear IASB members,
Invitation to comment – Discussion Paper DP/2014/1 Accounting for Dynamic Risk
Management: a Portfolio Revaluation Approach to Macro Hedging
Ernst & Young Global Limited, the central coordinating entity of the global EY organisation,
welcomes the opportunity to offer its views on the Discussion Paper DP/2014/1 Accounting
for Dynamic Risk Management: a Portfolio Revaluation Approach to Macro Hedging (the DP)
issued by the International Accounting Standards Board (the Board) in April 2014.
We welcome the Board’s efforts to develop an accounting approach that better reflects the
dynamic risk management activities of banks and, thereby, to remove the need for an EU
‘carve out’.
We believe that preparers will be best placed to provide feedback on whether the portfolio
revaluation approach (PRA) results in a faithful representation of their dynamic risk
management, and that users’ comments will be most pertinent on the usefulness of the
information provided as a consequence of application of the PRA.
In our view, the DP identifies the main issues with respect to application of existing hedge
accounting solutions to banks’ risk management activities. However, there is probably a more
fundamental issue that risk management encompasses certain objectives and issues that are
not necessarily capable of being fully reflected in financial statements except, possibly,
through disclosure. We are concerned that the DP attempts to ‘stretch’ the conceptual
framework and redefine the boundaries of financial reporting in order to find a compromise
solution, while still falling short of what banks believe is needed to fully reflect their actual
risk management activities.
By way of example, contrast the risk management objectives and activities of a commodity
trader with those of a manufacturing company that has to purchase commodities as an input
to its production processes. In the first case, risk management is likely to be capable of being
faithfully reflected in financial statements, as the trader’s objective of controlling its fair value
exposures is consistent with how these exposures might be reflected in the statement of
financial position. In the second case, the price exposures related to future manufacturing
inputs are not reflected in the financial statements and any risk management activities
(except to the extent that there is hedging activity) would be better addressed through
footnote disclosures. Banks’ management of their future net interest rate margin is often
closer to the second example than the fair value-based model explored in the DP.
Ernst & Young Global Limited is a company limited by guarantee registered in England and Wales No. 4328808 .
2
The challenges raised by the DP would be even more evident if the PRA were applied to
entities other than banks. The DP would need to consider matters such as whether an oil
company should measure changes in the fair value of its oil reserves in its statement of
financial position, or whether a manufacturing company should reflect its structural foreign
risk that arises because its future purchases and sales are denominated in different
currencies, just because they chose to manage their risks dynamically but only mitigate part
of these risks.
In the context of these preliminary concerns, it is clear that any solution which seeks to
reflect fully the dynamic risk management activities of banks will need to include exposures
that are calculated on a ‘behaviouralised’ basis. Critically, the approach will need to allow the
revaluation of demand deposits, otherwise it will not successfully achieve the objectives of
the project. For many banks, exposures described as ‘equity model book’ (EMB) and ‘pipeline
transactions’ in the DP also comprise a significant element of their dynamic risk
management. If the solution is to reflect actual risk management, as understood by banks,
then all relevant exposures, including EMB and pipeline transactions, would have to be eligible
for inclusion within that solution. To do otherwise would not fully represent the dynamic risk
management of the banks, as they see it.
The DP notes the Board’s concerns about including ‘sub-benchmark’ exposures as
‘benchmark’ exposures within the PRA. If preparers manage sub-benchmark risk such that
risks from the negative spread remain the responsibility of the business unit generating the
sub-benchmark exposure, with only the benchmark risk contained within dynamic risk
management, then an accounting solution that seeks fully to represent risk management will
somehow need to replicate this division.
Another area of difficulty is the role of ‘bottom layers’ within risk management strategies. We
understand that most banks assume that there is a bottom layer within prepayable portfolios
that will not be prepaid, and which is managed as if it were not prepayable, using nonoptional hedging instruments such as swaps. As such, the banks tend to hedge less than the
amount of loans that are expected not to prepay, so as to create a ‘buffer’ in case prepayment
levels are higher than expected. It would not be consistent with their objective of reflecting
their risk management activity, if profit or loss volatility from unexpected prepayments were
to be recognised if this buffer is not breached. We note that, unlike demand deposits,
prepayable assets are not homogeneous, as they will have different contractual due dates
and rates. Hence, any solution would need to be applied to assets grouped by tenor. We
believe that an approach could be developed to introduce a bottom layer that would result in
information that better reflects the actual risk management approach, but it would not be
operationally simple to apply.
The DP discusses two scoping alternatives: one with a focus on dynamic risk management;
and the other with a focus on risk mitigation. The problem with focusing on dynamic risk
management is that it assumes that the objective of banks’ risk management is to manage
exposures to changes in fair values. Therefore, to record income volatility from intentionally
unhedged positions is inconsistent with how banks would describe their objective of dynamic
risk management, which would normally be to limit volatility in their future net interest
margin. A similar point could be made about a corporate that dynamically manages its
commodity price risk.
3
Accordingly, a focus on risk mitigation would probably be more appropriate as a possible
compromise between financial reporting principles on the one hand and the objectives of
actual risk management on the other. We expect that preparers will be able to provide
constructive comments about how a focus on risk mitigation could be applied in practice. We
recognise that this is likely to lead to a stop/start approach that will require tracking and
amortisation. Consequently, this will not deliver the operational simplicity that was one of the
Board’s initial objectives. However, we understand that banks generally would support a more
complex approach if it better reflects their risk management objectives and activities.
Similarly, we would not support mandatory application of the approach. Mandatory
application would require a very clear definition of what constitutes dynamic risk
management, which may be difficult to agree, given the variety of practice. Applying such a
definition could also be very difficult and judgemental, making it challenging to audit.
We believe that disclosures will be a very important aspect of this project. Dynamic risk
management differs from entity to entity and qualitative and quantitative disclosures will help
understanding diversity in application of the PRA. This initiative should be designed to mesh
with the current IFRS 7 requirements rather than simply be additional to them. The objective
should be to require enhanced disclosures of the ‘banking book’ risks to which banks are
exposed, and how they are managed and mitigated. Such disclosures might include the
impact of dynamic risk management on future net interest income.
Some preparers would prefer to adjust the IFRS 9 hedge accounting model to expand the
range of items that qualify for designation, to include demand deposits, etc., and provide
additional transparent information on dynamic risk management in their disclosures, rather
than implementing a wholesale change to their accounting. Further consideration should be
given to the role of disclosures and whether there is a worthwhile alternative to the change to
the accounting as proposed by the DP.
We have responded to certain of the questions as set out in the DP in the Appendix to this
letter.
Should you wish to discuss the contents of this letter with us, please contact Tony Clifford on
+44 (0)20 7951 2250.
Yours faithfully
4
Appendix 1 – Response to questions
Question 1—Need for an accounting approach for dynamic risk management
Do you think that there is a need for a specific accounting approach to represent dynamic risk
management in entities’ financial statements? Why or why not?
We believe that an accounting approach that better reflects the dynamic risk management
activities of banks and other preparers may be beneficial to users of financial statements if it
provides information that is more relevant than the information that is provided in the
current IAS 39 and IFRS 9 hedging models and IFRS 7 risk disclosures. It could also remove
the need for the EU ‘carve out’.
Question 2—Current difficulties in representing dynamic risk management in entities’
financial statements
(a)
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?
(b)
Do you think that the PRA would address the issues identified? Why or why not?
We believe that the DP identifies the main issues with respect to application of existing hedge
accounting solutions to banks’ risk management activities. However, as stated in our cover
letter, there is probably a more fundamental issue that risk management encompasses
objectives and a wider range of issues that are not necessarily capable of being fully reflected
in financial statements except, possibly, through disclosure. We are concerned that the DP
attempts to ‘stretch’ the conceptual framework and redefine the boundaries of financial
reporting in order to find a compromise solution, while still falling short of what banks believe
is needed to reflect fully their actual risk management activities.
By way of example, contrast the risk management objectives and activities of a commodity
trader and those of a manufacturing company that has to purchase commodities as an input
to its production processes. In the first case, risk management is likely to be capable of being
faithfully reflected in financial statements, as the trader’s objective of controlling its fair value
exposures is consistent with how these exposures might be reflected in the statement of
financial position. However, the price exposures related to future manufacturing inputs are
not reflected in the financial statements and any risk management activities (except to the
extent that there is hedging activity) would be better addressed through footnote disclosures.
Banks’ management of their future net interest rate margin is often closer to the second
example than the fair value-based model explored in the DP.
The challenges raised by the DP would be even more evident if the PRA were applied to
entities other than banks. The DP would need to consider matters such as whether an oil
company should measure changes in the fair value of its oil reserves in its statement of
financial position, or whether a manufacturing company should reflect its structural foreign
risk that arise because its future purchases and sales are denominated in different currencies,
5
just because they chose to manage their risks dynamically, but only mitigate part of these
risks.
Preparers will be best placed to provide feedback on whether the portfolio PRA results in a
faithful representation of their dynamic risk management and the views of users will be most
pertinent as to the usefulness of the information provided.
As a further observation, we would expect that the IFRS 9 cost of hedging concepts for cross
currency basis spreads (IFRS 9.6.2.4(b), B6.5.34-39) should be incorporated into any
solution for accounting for dynamic risk management. The rationale for the guidance in
IFRS 9 is equally relevant to dynamic risk management.
Question 3—Dynamic risk management
Do you think that the description of dynamic risk management in paragraphs 2.1.1–2.1.2 is
accurate and complete? Why or why not? If not, what changes do you suggest, and why?
We believe that the description of dynamic risk management in the DP captures banks’
dynamic risk management activities. We also concur with the need for a description to ensure
that any accounting solution for dynamic risk management is only applied to dynamic risk
management activities. However, as iIlustrated by the example in our response to Question 2,
dynamic risk management objectives and activities may vary significantly for different
entities, e.g. for a commodity trader compared to a manufacturing company. But even banks
do not necessarily carry on risk management in quite the same way. The level of accuracy and
completeness required of a description would depend on the scope of the PRA and whether
application of the PRA would be mandatory. Mandatory application would require a much
clearer definition of what constitutes dynamic risk management, which may be difficult to
agree, given the variety of practice.
Question 4—Pipeline transactions, EMB and behaviouralisation
Pipeline transactions
(a)
Do you think that pipeline transactions should be included in the PRA if they are
considered by an entity as part of its dynamic risk management? Why or why not?
Please explain your reasons, taking into consideration operational feasibility, usefulness
of the information provided in the financial statements and consistency with the
Conceptual Framework for Financial Reporting (the Conceptual Framework).
EMB
(b)
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? Please explain your reasons,
taking into consideration operational feasibility, usefulness of the information provided
in the financial statements and consistency with the Conceptual Framework.
6
Behaviouralisation
(c)
For the purposes of applying the PRA, should the cash flows be based on a
behaviouralised rather than on a contractual basis (for example, after considering
prepayment expectations), when the risk is managed on a behaviouralised basis? Please
explain your reasons, taking into consideration operational feasibility, usefulness of the
information provided in the financial statements and consistency with the Conceptual
Framework.
In the context of the preliminary concerns raised in our response to question 2, it is clear that
any solution that seeks to reflect fully the dynamic risk management activities of banks, in a
manner that accords with their objectives, will need to include exposures that are calculated
on a ‘behaviouralised’ basis. Critically, the approach will need to allow the revaluation of
demand deposits, otherwise, it will not successfully achieve the objectives of the project. For
many banks, exposures described as EMB and ‘pipeline transactions’ in the DP also form a
significant element of their dynamic risk management. 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. To do
otherwise would not fully represent the dynamic risk management of those banks as they see
it.
As we noted in response to question 2, risk management may be better communicated
through disclosures than accounting entries. If the Board decides not to allow demand
deposits and the EMB, etc. to be included in the accounting solution, then they will need to be
reflected in the disclosures that banks make about their risk management activities.
Question 5—Prepayment risk
When risk management instruments with optionality are used to manage prepayment risk as
part of dynamic risk management, how do you think the PRA should consider this dynamic
risk management activity? Please explain your reasons.
We believe that most banks apply a ‘bottom layer’ approach to dynamically manage
prepayment risk, rather than use instruments with optionality. We refer to our answer to
question 7.
Question 7—Bottom layers and proportions of managed exposures
If a bottom layer or a proportion approach is taken for dynamic risk management purposes,
do you think that it should be permitted or required within the PRA? Why or why not? If yes,
how would you suggest overcoming the conceptual and operational difficulties identified?
Please explain your reasons.
The role of ‘bottom layers’ within risk management strategies is a difficult area. We
understand that most banks assume that there is a bottom layer within prepayable portfolios
that will not be prepaid, and which is managed as if it were not prepayable, using nonoptional hedging instruments such as swaps. They tend to hedge less than the amount of
7
loans that are expected not to prepay, so as to create a buffer in case prepayment levels are
higher than expected. It would not be consistent with their objective of reflecting their risk
management activity, if profit or loss volatility from unexpected prepayments were to be
recognised if this buffer is not breached. It would also not be easy to audit prepayment
assumptions unless there is a reasonably wide buffer.
Unlike demand deposits, prepayable assets are not homogeneous, as they will have different
contractual due dates and rates. Hence, any solution would need to be applied to assets
grouped by tenor. We believe that an approach could be developed to introduce a bottom
layer that would result in information that better reflects the actual risk management
approach, but it would not be operationally simple to apply.
Question 9—Core demand deposits
(a)
Do you think that 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? Why or why not?
(b)
Do you think that guidance would be necessary for entities to determine the
behaviouralised profile of core demand deposits? Why or why not?
We believe that a PRA would need to allow the revaluation of demand deposits. Otherwise, it
will not successfully achieve the objectives of the project – see our response to question 4.
Question 15—Scope
(a)
Do you think that the PRA should be applied to all managed portfolios included in an
entity’s dynamic risk management (ie a scope focused on dynamic risk management) or
should it be restricted to circumstances in which an entity has undertaken risk
mitigation through hedging (ie a scope focused on risk mitigation)? Why or why not? If
you do not agree with either of these alternatives, what do you suggest, and why?
(b)
Please provide comments on the usefulness of the information that would result from
the application of the PRA under each scope alternative. Do you 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? Why or why not?
(c)
Please provide comments on the operational feasibility of applying the PRA for each of
the scope alternatives. In the case of a scope focused on risk mitigation, how could the
need for frequent changes to the identified hedged sub-portfolio and/or proportion be
accommodated?
(d)
Would the answers provided in questions (a)–(c) change when considering risks other
than interest rate risk (for example, commodity price risk, FX risk)? If yes, how would
those answers change, and why? If not, why not?
8
The DP discusses two scoping alternatives: one with a focus on dynamic risk management
and the other with a focus on risk mitigation. We appreciate that a focus on dynamic risk
management may make it easier to justify, conceptually, some key features of the PRA, such
as the inclusion of demand deposits. However, it assumes that the objective of risk
management is to manage exposures to changes in fair values. To record income volatility
from intentionally unhedged positions is inconsistent with how banks would describe their
objective of dynamic risk management. Accordingly, a focus on risk mitigation would
probably be more appropriate, as a possible compromise between financial reporting
principles, on the one hand, and the objectives of actual risk management on the other. A
second advantage of focusing on risk mitigation is that it places less demands on the quality
of the description of ‘dynamic risk management activities’ (see question 3).
The accounting would also be less sensitive to changes in subjective assumptions.
We expect that preparers will be able to provide constructive comments about how a focus on
risk mitigation could practically be applied. We recognise that this is likely to lead to a
stop/start approach that will require tracking and amortisation. Consequently, this will not
deliver the operational simplicity that was one of the Board’s initial objectives. However, we
understand that banks generally would support a more complex approach if it better reflects
their risk management objectives and activities.
Question 16—Mandatory or optional application of the PRA
(a)
Do you think that the application of the PRA should be mandatory if the scope of
application of the PRA were focused on dynamic risk management? Why or why not?
(b)
Do you think that the application of the PRA should be mandatory if the scope of the
application of the PRA were focused on risk mitigation? Why or why not?
We would not support mandatory application of the approach under either of the scopes set
out above. Also as outlined in our response to question 3, mandatory application would
require a very clear definition of what constitutes dynamic risk management, which may be
difficult to agree, given the variety of practice. Application of such a definition could also be
very difficult and judgemental, making it challenging to audit.
Question 18—Presentation alternatives
(a)
Which presentation alternative would you prefer in the statement of financial position,
and why?
(b)
Which presentation alternative would you prefer in the statement of comprehensive
income, and why?
9
(c)
Please provide details of any alternative presentation in the statement of financial
position and/or in the statement of comprehensive income that you think would result
in a better representation of dynamic risk management activities. Please explain why
you prefer this presentation taking into consideration the usefulness of the information
and operational feasibility.
We support an actual net interest income presentation for the statement of comprehensive
income. We believe that this provides transparent information on the before and after net
interest income position from dynamic risk management, and is likely to require only minimal
changes to existing procedures.
We would not support a line by line gross up presentation in the statement of financial
position. Such an approach is inconsistent with net dynamic risk management, and may not
be useful to users.
Further consideration is also required on the interaction of PRA with the expected credit
losses requirements under IFRS 9, i.e., how the loss allowance for expected credit losses for
managed exposures would be considered when revaluing those exposures.
Question 19—Presentation of internal derivatives
(a)
If an entity uses internal derivatives as part of its dynamic risk management, the DP
considers whether they should be eligible for inclusion in the application of the PRA.
This would lead to a gross presentation of internal derivatives in the statement of
comprehensive income. Do you think that a gross presentation enhances the usefulness
of information provided on an entity’s dynamic risk management and trading activities?
Why or why not?
(b)
Do you think that the described treatment of internal derivatives enhances the
operational feasibility of the PRA? Why or why not?
(c)
Do you think that additional conditions should be required in order for internal
derivatives to be included in the application of the PRA? If yes, which ones, and why?
We are generally supportive of the role of internal derivatives, as described in the DP. We
perceive internal derivatives to be the facilitator of the revaluation of the managed exposure
within dynamic risk management. We are also aware that the current requirement to find
external derivatives is operationally intensive and can often result in selections that are
somewhat arbitrary.
The presentation change to gross up the effect of internal derivatives in the income
statement would provide additional information on preparers’ separate activities of trading
and dynamic risk management, although we do have some concerns about adjusting net
interest income based solely on internal trades. This topic requires some further
consideration and it is possible that this information would be better shown in the notes to
the financial statements, rather than on the face of the statement of comprehensive income.
10
Question 20—Disclosures
(a)
Do you think that each of the four identified themes would provide useful information
on dynamic risk management? For each theme, please explain the reasons for your
views.
(b)
If you think that an identified theme would not provide useful information, please
identify that theme and explain why.
(c)
What additional disclosures, if any, do you think would result in useful information
about an entity’s dynamic risk management? Please explain why you think these
disclosures would be useful.
We believe that disclosures will be a very important aspect of this project. As explained in the
example in our answer to Question 2, dynamic risk management differs from entity to entity
and qualitative and quantitative disclosures will help understanding diversity in application of
the PRA.
As an alternative, we are aware of some preparers who have a preference for adjusting the
IFRS 9 hedge accounting model and providing additional transparent information on dynamic
risk management in their disclosures, rather than implementing a wholesale change to their
accounting. This would be an opportunity to develop non-trading market risk disclosures that
are more meaningful than those currently required by IFRS 7. Further consideration should
be given to the role of disclosures and whether there is a worthwhile alternative to the
wholesale change to the accounting as proposed by the DP.
In addition, as we mentioned in response to question 4, if the Board does not agree to allow
demand deposits, the EMB, etc., to be included in the accounting solution, then they will need
to be reflected in the disclosures that banks make about their risk management activities.
Question 21—Scope of disclosures
(a)
Do you think that the scope of the disclosures should be the same as the scope of the
application of the PRA? Why or why not?
(b)
If you do not think that the scope of the disclosures should be the same as the scope of
the application of the PRA, what do you think would be an appropriate scope for the
disclosures, and why?
This initiative should be designed to mesh the disclosures with the IFRS 7 requirements
rather than simply be additional to them. The objective should be to require enhanced
disclosures of the ‘banking book’ risks to which banks are exposed (or portfolios with similar
characteristics for non-banking entities), and how they are managed and mitigated. Such
disclosures might include the impact of dynamic risk management on future net interest
income.
11
Question 22—Date of inclusion of exposures in a managed portfolio
Do you think that the PRA should allow for the inclusion of exposures in the managed
portfolios after an entity first becomes a party to a contract? Why or why not?
(a)
If yes, under which circumstances do you think it would be appropriate, and why?
(b)
How would you propose to account for any non-zero Day 1 revaluations? Please explain
your reasons and comment on any operational implications.
If a focus on a risk mitigation scoping alternative is applied, which we believe it should, there
may well be cases in which a bank will choose to mitigate the risk of exposures included
within dynamic risk management sometime after it first becomes a party to a contract.
Therefore, it would be necessary for the PRA to allow for the inclusion of exposures in the
managed portfolios after an entity first becomes a party to a contract.
We recognise that this will result in non-zero Day 1 revaluations which, we believe, will need
to be dealt with through amortisations. This will increase operational complexity, but is
preferable to immediate recognition of Day 1 revaluations in the statement of comprehensive
income, as that would not represent faithfully the decision to mitigate risks only from that
point onwards.
Question 24—Dynamic risk management of foreign currency instruments
(a)
Do you think that it is possible to apply the PRA to the dynamic risk management of FX
risk in conjunction with interest rate risk that is being dynamically managed?
(b)
Please provide an overview of such a dynamic risk management approach and how the
PRA could be applied or the reasons why it could not.
We have not yet seen any interest in applying the PRA to foreign currency instruments.
However, as we mentioned in our response to question 2, we would expect that the IFRS 9
cost of hedging concepts for cross currency basis spreads (IFRS 9.6.2.4(b), B6.5.34-39)
should be incorporated into any solution for accounting for dynamic risk management. The
rationale for the guidance in IFRS 9 is equally relevant to dynamic risk management.
Question 25—Application of the PRA to other risks
(a)
Should the PRA be available for dynamic risk management other than banks’ dynamic
interest rate risk management? Why or why not? If yes, for which additional fact
patterns do you think it would be appropriate? Please explain your fact patterns.
(b)
For each fact pattern in (a), please explain whether and how the PRA could be applied
and whether it would provide useful information about dynamic risk management in
entities’ financial statements.
We agree that any approach should be open to other risks and other industries. However,
industries other than banks generally seem to be well served by the changes to hedge
12
accounting already introduced by IFRS 9 Thus, we recognise that additional analysis would be
required to better understand how the PRA could be applied to other risks and industries.
Question 26—PRA through OCI
Do you think that an approach incorporating the use of OCI in the manner described in
paragraphs 9.1–9.8 should be considered? Why or why not? If you think the use of OCI should
be incorporated in the PRA, how could the conceptual and practical difficulties identified with
this alternative approach be overcome?
We have not seen any interest in the use of OCI in this manner.