13 November 2012

ASCG's analysis of the IASB's review draft on hedge accounting

The ASCG commented on the IASB Review Draft "Hedge Accounting". In order to submit its findings early, the ASCG provided remarks on what it deems illustrate 'fatal' flaws, i.e. inconsistencies within the text, inappropriate wording, or imperfect structure.

The ASCG provided its findings on accounting for credit risk, accounting for sub-Libor-hedges, effectiveness when hedging basis risks, and co-existence of hedge accounting requirements in IFRS 9 and IAS 39.

1. Accounting for Credit Risk

The hedge accounting ED prohibited hedge accounting for credit risk. Respondents to the ED commented that hedging credit risk is a common risk management strategy and, therefore, a solution was needed. In the review draft, the IASB permits hedge accounting for credit risk using the fair value option.

Whilst it is acknowledged that the IASB wanted to address constituents’ concerns regarding hedging of credit risk, the ASCG does not believe that a robust case has been made as to why using the general fair value hedge accounting model would lead to less decision-useful information for users than the modified fair value option. On the contrary, the proposed method adds extra complexity, is inconsistent with the general requirements surrounding that option and does not lead to an answer that is conceptually superior. If the arguments above are agreed on, then there seems to be no valid reason why entities should not be allowed to rely on the general fair value hedge accounting model (perhaps with the same safeguards put in place for inflation risk) instead of tweaking the fair value option.

Hence, it is argued here that the IASB should discard its proposed alternative and make credit risk an eligible risk factor just as any other risk factor. This would also ensure that the accounting could keep in line with new developing credit markets and practices as they evolve. If, nonetheless, the Board were to keep the alternative treatment, the conditions for applying the fair value option in this context should be tightened such that requirements equivalent to those introduced for the general hedge accounting model (i.e. as regards necessary documentation, a proven rela-tionship to risk management practices, etc.) can be put in place.

2. Accounting for Sub-Libor-hedges

Hedge accounting is not permitted for sub-Libor risk, although this is a common risk management strategy applied by banks in practice. The ASCG does not believe that prohibiting hedge accounting for sub-Libor issues is consistent with the overall principle in the general hedge accounting model which is to better align hedge accounting with an entity’s risk management strategy. This is especially true in current times when enti-ties seek to invest more in less risky and high quality financial instruments, esp. AAA-rated government bonds.

Given that many entities are currently engaging in sub-Libor hedging, the EU has placed a carve-out on the respective requirements in IAS 39 which, should the prohibition survive in the final standard, is likely to be imposed on the relevant paragraph in IFRS 9, too. When the IASB started developing new requirements for hedge accounting, one of the expectations of the European constituents was that the IFRS 9 requirements would be capable of being applied without an EU carve-out. The sub-Libor issue could lead to an EU carve-out of IFRS 9 which would not be desirable and could result in delays to the endorsement process. The ASCG does not believe that such outcome would be necessary, if the IASB acknowledged that entities do hedge sub-Libor risk in order to eliminate the variability in interest rate risk stemming from fluctuations in Libor.

3. Effectiveness when hedging basis risks

The ASCG is aware of situations in which hedge accounting may lead to presenting ineffectiveness inappropriately because of "basis risk" included in economic FX hedges. This arises when cashflow hedge accounting is applied to an economic hedge on FX risk, e.g. a FX funding liability and a cross currency swap with actually exchanging currencies (sometimes called "funding swap"). Such swaps usually include a charge for the FX exchange. Therefore, a basis spread would be included when discounting the hedging instrument, but not the hedged item. This causes volatility during the life of the hedge. The hypothetical derivative method, when used for determining the effectiveness, does not allow for inclusion of such features like basis spread risk (see B6.5.5). This would lead to recognising ineffectiveness that is not considered as such from an economic perspective.

4. Co-existence of hedge accounting requirements in IFRS 9 and IAS 39

The ASCG sees major conflicts between the new hedge accounting requirements to become part of IFRS 9 and those hedge accounting requirements of IAS 39 that will not be replaced (yet). The ASCG is aware that selected requirements in IAS 39 need to remain in place as soon as IFRS 9 (hedge accounting section) is finalised, in order to maintain the accounting for portfolio fair value hedges of interest rate risk. This is the case for IAS 39.81A, 89A and AG114-132 – see reference in RD 6.1.3.

However, inconsistencies are caused by other references in the RD (e.g. 5.2.3, 5.3.2, 5.7.1(a)), referring to IAS 39.89-94. In addition, but not necessarily in line with this, the consequential amendments to IAS 39 (RD, App. C, C40) make evident that some hedge-related paragraphs in IAS 39 will be deleted, some will be amended, and some ought to remain unchanged. Apart from not being fully certain about how the amended IAS 39 will finally read, the ASCG wonders when and how those remaining paragraphs would apply. This is particularly unclear, since there are analogous but different new requirements, e.g. IAS 39.88 vs. RD 6.4.1 (qualifying criteria), or IAS 39.91 vs. RD 6.5.6 (discontinuation), or IAS 39.83 vs. RD 6.6.1 (groups as hedged item).

One issue arising from this is that it remains unclear whether "old" IAS 39 portfolio fair value hedges shall comply with the "old" hedge accounting criteria and "new" IFRS 9 hedges shall only comply with the "new" hedge accounting criteria, or whether "old" portfolio hedges shall instead comply with the "new" hedge accounting criteria (e.g. relaxed effectiveness test, rebalance but no voluntary discontinuation, etc.).

Another issue around this co-existence needs further reflection. The RD is meant also to cover some macro-hedging strategies, i.e. closed portfolio strategies. Even though, the portfolio fair value hedge accounting in IAS 39, once introduced to cover a broad range of macro-hedging strategies (i.e. closed as well as open portfolio strategies, however, restricted to the interest rate risk component), will remain in place. Given this, the ASCG sees two ways how to account for such closed portfolio hedges: macro-hedges of interest rate risk for closed portfolios may – at free choice – be accounted for either as a portfolio fair value hedge (under IAS 39) or as a fair value hedge with a net position as hedged item (under the RD) – both under different conditions for eligible items, effectiveness, rebalancing, discontinuation, etc. This seems arbitrary or, at least, raises some confusion as to how such economic hedges should be accounted for in the future. Another example is how to account for layer components. Whereas under IAS 39 the layer eligibility is restricted to a percentage layer, the RD is more relaxed for designating layer components. Again, there is a free choice between two ways how to designate, and account for, layer components.

As well as on major issues, the ASCG added as well as other findings on scope of IFRS 9 and hedge accounting requirements, synthetic positions (e.g. net positions, aggregated exposures) as hedged item, partial designation of options and forward contracts, hedge ratio and rebalancing and transition and early application.

Comment letter

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