Hedging and

IFRS – Global Reporting Revolution March 2003

IFRS – Global Reporting Revolution Hedging and Hedge Accounting

elcome to the fourth in a series of papers dedicated to discussing International elcome to the fourth in a series

ould like to discuss any of the issues addressed in more detail, please speak of the issues ould like to discuss any he impending requirement for EU listed companies to adopt IFRS, and in he impending requirement for inancial Reporting Standards and the impact on the banking industry. IFRS is the impact on the banking industry. inancial Reporting Standards and

UK Banking Leader John Hitchins

are most focused on. this paper, as this helps us to ensure that we are addressing the issues that you as this helps this paper, with your usual contact at PricewaterhouseCoopers or those listed at the end of usual contact at PricewaterhouseCoopers with your w I hope that you will find this paper thought-provoking and insightful. If you thought-provoking will find this paper I hope that you cannot be underestimated. deals with hedge accounting, will create a number of major challenges which will create a number of major challenges deals with hedge accounting, T – Recognition and Measurement which Instruments particular IAS 39 Financial

result in fundamental changes to the way in which the industry does business. which in the way to result in fundamental changes much more than just a technical issue and, based on the current proposals, will issue more than just a technical much F W The IFRS Revolution 2

Introduction

IAS 39 Financial Instruments – Recognition and Measurement will create a number of significant issues for banks. This paper deals with some of the more significant issues around hedging.

Most UK financial institutions which use derivatives extensively follow the high level principles set out in the British Bankers Association Statement of Recommended

IFRS – Global Reporting Revolution Practice (‘the BBA SORP’) on Derivatives. The BBA SORP gives in general terms, the principles which should be applied: ‘Non-trading transactions should be clearly identified and their purpose clearly documented at the outset and an on-going assessment should be undertaken to confirm that such transactions do in fact manage the risk to the degree sought.’

While the requirements of IAS 39 are not inconsistent with the BBA SORP’s principles, there are now specific and, importantly, much more onerous requirements, principally in the area of documentation and demonstration of effectiveness, to be met before hedge accounting can be applied. Hedging and Hedge Accounting Hedging and Hedge 3 Hedging and Hedge Accounting Cause for concern underlying hedged instrument substantial portfolios of hedging RevolutionIFRS – Global Reporting unless some very complex derivatives this would expose Why should this standard be a and restrictive rules for hedge their reported profitability to cause for significant concern for accounting are followed. significant volatility if hedge banks? The key factor is that IAS For organisations with accounting cannot be achieved. 39 requires that effectively all derivatives be held on the Trading at , with the changes in the fair value of those instruments being FAIL recognised through the profit Hedge and loss account. Where criteria Assess regularly – track institutions are using derivatives – monitor to hedge exposures accounted – designate – select for on an basis they PASS risk face the prospect of having to Hedging take changes in the fair value of the hedging instrument to the profit and loss account without – document being able to recognise the – effective test associated changes in the 4

Institutions need to consider the Experience with these Securities comparatives, will need to have challenges of IAS 39 now. While and Exchange Commission (SEC) complied with the hedging there are frequently goals that Registrants has shown that a large regulations from 1 January 2003, can be achieved easily for number of banks have not although the SEC may yet give a certain significant transactions attempted to apply the US rules dispensation of some form. within a retail financial and have accepted the resulting institution, they should not earnings volatility in their A Question of Guidance underestimate the challenges reported balances for US GAAP and complexities of considering reconciliation purposes (20-F). IAS 39 poses a number of the questions posed by IAS 39 in Most organisations do not,

IFRS – Global Reporting Revolution searching questions, but not the areas of hedging of pipeline however, consider this acceptable surprisingly, given the exposure and achieving hedge when it begins to impact complexity of the subject it does accounting for the derivatives reported results in their primary not always specify the level of used to manage interest rate GAAP, i.e. their primary detail and rigour that would be exposure on mortgage books. ‘reported profit measures’. acceptable for the adoption of It is certain that most, if not all, hedge accounting. This lack of institutions will have to accept A large number of institutions clarity is a key concern because some degree of volatility as a will therefore need to address the the consequences of not being result of their use of challenging issues within IAS 39 able to adopt hedge accounting instruments, however there are a if they are to avoid unpleasant could be considerable for number of actions which can be and unwanted earnings volatility. an organisation. taken that will enable much of Addressing such problems is far this volatility to be removed. from a straightforward matter. The potential consequences of Giventhe requirements under

Hedging and Hedge Accounting Hedging and Hedge not meeting the criteria go A number of institutions who IAS 39, it is important for banks beyond the issue of earnings have US GAAP as their to consider the impact of their volatility. The adoption in the secondary reporting framework hedging activities on their United States of FAS 133 saw have already been subject to the financial results as soon as the SEC requiring public requirements of US Financial possible. A bank wishing to restatement of the accounts of Accounting Standard 133 (‘FAS convert to IFRS for the year-end institutions which had not 133’) which has similar hedge 31 December 2005 which complied with the hedging accounting rules to IAS 39. requires two years of documentation requirements. 5 Hedging and Hedge Accounting Banks wishing to adopt hedge and what level of detail there documentation is whether it RevolutionIFRS – Global Reporting accounting need to get should be. would be sufficient to enable a compliance with the third party to re-perform the requirements right first time. IAS 39 sets out the areas that effectiveness testing. Therefore, It has always been important for hedge documentation should there must be robust review banks to comply with financial cover, but does not go as far as procedures in place to ensure reporting requirements, but in the giving specific examples of pro- ongoing compliance. It is also current climate the consequences forma documentation. Many important to recognise that the of non-compliance are much banks will consider developing establishment of documentation more severe. Accordingly, their own pro-forma is a prospective matter. The institutions are naturally documentation that can be used requisite documentation must be concerned as to how to address for all types of hedge. The put in place prior to the the questions of quality and advantage the pro-forma adoption of hedge accounting. sufficiency of documentation approach brings is that it ensures and the development of robust a consistent standard of A common misconception is that hedge effectiveness testing. documentation for all of an the failure to put hedge organisation’s hedges and that documentation in place at the the key information is captured date of execution of the hedging Documentation each time. However, it is item prevents the adoption of important to note that a high hedge accounting for a IAS 39 requires key information level of detail will be needed particular relationship at a later about the hedging relationships in the hedge documentation in date. However, Hedge to be formally documented prior areas such as describing how accounting can be adopted later to hedge accounting treatment effectiveness will be measured. but only from the date when the being applied, this may be at the A good test of the level of documentation was put in place. date of inception of the hedging instrument or a subsequent date. Failure to establish this Example 1: documentation will mean hedge If Bank A undertakes to hedge a fixed rate loan issued on 1 January 2003 accounting cannot be adopted with a fixed versus floating rate interest swap, also executed on 1 January regardless of how effective the 2003, but has not put the hedge documentation in place until 1 May 2003, then Bank A can begin to hedge account for the swap from 1 May 2003, hedge actually is in offsetting providing that it passes the effectiveness tests but must recognise in the risk. Organisations will need the fair value movements on the swap for the four month to consider how much period between January 1 and April 30 when the documentation was not documentation is required in place. 6

Hedge effectiveness Firstly, at inception of the hedge Hedge Effectiveness Tests testing the hedging relationship must be shown to be effective on a Guidance as to what is and In addition to the documentation prospective basis, i.e. that the is not an effective hedge does of the hedging relationship IAS hedge is indeed expected to be not, however, completely 39 requires organisations to effective. The level of address the question of what prove that their hedging effectiveness required for constitutes an acceptable hedge instruments are indeed ‘effective’ prospective effectiveness in IAS effectiveness test. in mitigating the hedged risk or 39 is that the risks are ‘almost variability in cashflows in the fully offset’. Whilst no numerical In practice there are a number of IFRS – Global Reporting Revolution underlying instrument. It is range has been formally given as general factors to consider when therefore very important that meeting the ‘almost fully offset’ looking at hedge effectiveness, banks are specific about the criteria, it is viewed in practice including which one of a range nature of the risk that they are that the changes in the value or of methods to use, from the hedging, as this will tie directly cashflows of the hedged item are intuitively straightforward, to the into the effectiveness testing. expected to be at least between mathematically sophisticated 95% and 105% of the changes proposed in the United States There is no specific method in value or in the cashflows of following the introduction of for testing hedge effectiveness the hedging instrument. FAS 133. prescribed by IAS 39 so organisations wishing to adopt Secondly, there is a requirement It is critical to consider carefully hedge accounting will need to to show that the hedge was the method of effectiveness design, build and implement actually ‘highly effective’ on a testing adopted, since the careful effectiveness tests. However, retrospective basis. Here the design of an effectiveness test Hedging and Hedge Accounting Hedging and Hedge IAS 39 discusses the need for definition of ‘highly effective’ can mean the difference two distinct types of testing. is slightly less strict than for between a hedging relationship prospective testing, the range passing and failing the test. being given within IAS 39 as Furthermore many of the 80%-125% effective. popular methods do not 7 Hedging and Hedge Accounting necessarily produce consistent item is affected by a small techniques are intuitively less RevolutionIFRS – Global Reporting results. Some hedge effectiveness change in value in a period, the obvious and more time tests will show a relationship to test often fails hedges even consuming to implement. be ineffective whereas other where the cashflows and terms methods may indicate a high are highly correlated. As an A further complication is that the degree of effectiveness. This is illustration consider the choice of hedge effectiveness highlighted by looking at the scenarios given below (see test cannot be made by looking most common method of testing Example 2). at each hedging relationship in effectiveness the so-called ‘dollar isolation. Banks will need to offset method’. In both scenarios there is an bear in mind that where a absolute difference of 1,000 in the method of assessing is adopted The dollar offset method has the change in fair value of the hedged for a particular hedging advantage of being easy to item and hedged instrument, but relationship there is the understand and to implement, in Scenario A because the requirement that the same providing the institution has the changes in fair value are small this method will be applied to all systems capability to generate leads to a failure of a test whereas similar hedges, groupwide. fair values for the instruments in Scenario B, the relationship concerned. In basic terms it appears highly effective. A final point to note on the compares the ratio of the changes methods of assessing in fair value of the hedged item This problem can be avoided by effectiveness is that IAS 39 does and the hedging derivative. The using more advanced techniques not permit the use of the ‘short- problem with this method is that such as a statistical regression cut method’ which is allowed by where the underlying hedged based test. However, such FAS 133, whereby if the critical contractual terms of individual Example 2: hedged item and hedging Scenario A Scenario B instrument match, then the Change in Fair Value hedge can be assumed to be 100% effective. Many UK Hedged Item due to Hedged Risk 1,000 99,000 organisations currently applying Hedging Instrument 2,000 100,000 hedge accounting for any US Dollar-Offset Effectiveness 50% 99% GAAP reporting will need to revisit their hedge IFRS – Global Reporting Revolution 8 Hedging and Hedge Accounting depending when itfails,thereis during any oneperiod,and frequently, ifthetestisfailed testing tobeundertakenmore costly forhedgeeffectiveness can be. Therefore, althoughitis longer you leave ittheworse it to earnings,soinessencethe during thatperiodmustbetaken on thehedginginstrument period thenallofthemovements effectiveness testfails fora benefit achieved. Ifthehedge frequent testingagainstthe effort requiredinconducting should balancethecostsand to beweighedupby banks,they T accounting standards? frequently thanrequiredby the effectiveness testing more Are therebenefitstoundertaking av often asthereleaseofpublicly effectiveness testing atleastas IFRS requirestheperformanceof T Fr effectiveness testing. lead totheneedcommence accounting underIFRS. This may cut methodwhen hedge they arenotrelyingontheshort- documentation toensurethat esting his isadecisionthatwillneed equency ofEffectiveness ailable financialreporting. incurring excessive costs. the economicsubstanceor without significantlychanging meet hedgeeffectiveness criteria alternative strategies which would perspective andto investigate hedging strategies fromanIFRS effectiveness oftheir current begun toanalysethepotential organisations have already purposes. A numberofUK will beeffective for accounting necessarily implythatthehedge economically effective doesnot recognised thatahedgebeing potentially behaviour, asitis a change inprocesses,and also have tobeaccompaniedby T earnings aredirectlyimpacted. a shortertimeframe over which exposures ofatypicalbank.Of thousands ofindividual institutions given thetensof economies ofscalethatitoffers o practice inthebankingindustry, macro level isacommon other risksataconsolidated T management rate risk ‘ Macro-hedging and osldtd interest Consolidated’ he hedgeaccountingruleswill he hedgingofinterestrate and wing principallytothe by portfolio canbeanalyseditem that althoughthemortgage Practical experiencehasshown mortgage basis. link theswap onamortgage-by- to thissituationitisnecessary application ofhedgeaccounting In ordertoconsiderthe number ofindividual mortgages. hedge theexposureonalarge derivative hasbeenusedto interest rate swap. Hereasingle portion ofitsportfoliousingan exposure onthefixedrate lender hedgestheinterest the situationwhere amortgage many-to-one basisforexample hedging relationshipsareona hedged item.Inpractice, many hedging instrumentandthe one-to-one linkagebetweenthe that thereshouldexistadirect T practice ofmacro-hedging. the rulessurroundingthis some ofthemostcontentiousare r the many challenges thatIAS39 Further, even ifthiscanbe current systemspecifications. advances tocustomers,given derivatives againsttheindividual being abletomatch thehedging practical difficulties,such as aises forthebankingindustry, he keyIAS39requirementis

item, thereareconsiderable 9 Hedging and Hedge Accounting achieved, the strictness of the RevolutionIFRS – Global Reporting Example 3 ‘almost fully offset’ requirement of the prospective test for A bank has a portfolio of interest rate bearing of 90, interest-rate effectiveness means that almost bearing liabilities of 100 and it wishes to hedge the net interest rate exposure via an interest rate swap with notional 10. Following the guidance any dissimilarity in the terms of of IGC 121-2, the bank would designate the swap as the hedge of a the individual item being hedged particular liability of 10, put in place appropriate documentation and and the derivative will lead to a commence effectiveness testing. failure in the effectiveness test. At a later date the profile of the bank has changed, such that it now Under IFRS it is possible to have has assets of 110, but liabilities of 100. If the bank wishes to hedge the net a single hedging instrument for a interest rate risk exposure and takes out a swap with notional 20 to gain the portfolio of identical assets, appropriate exposure (from hedging a net liability of 10 to an asset of 10), however a considerable degree it will need to designate the second swap as the hedge of an asset of 20. of analysis will be required to Experience in territories where IAS has been implemented has shown that identify assets which are this process of designation and testing of effectiveness is a complex one sufficiently similar to pass the requiring considerable investment in developing suitable systems. tests. Overall, the current methods typically used by retail effecting an accounting hedge portfolio to be the hedged item. and some wholesale banks are will become increasingly The intricacies of this process unlikely to enable effectiveness challenging. Those banks can be illustrated by means of to be proven on an instrument- hedging pools of assets which an example (see Example 3). by-instrument basis. redeem faster or slower than expected may need to take out a Another challenging problem for As a consequence many retail large number of smaller swaps to retail financial institutions has banks will be facing the match the maturity profile rather been, and will continue to be, possibility of the volatility on the than one large swap, which will the application of hedge fair value changes on their clearly be more costly. accounting for hedging current hedging instruments anticipated, or pipeline affecting their earnings. From a For banks that have portfolios of transactions. Current UK GAAP financial reporting perspective, assets and liabilities and are not allows the hedging of such many institutions will consider able to undertake micro hedging, transactions, provided there is a this to be an unacceptable IAS 39 in its Implementation reasonable expectation that the situation and they will need to Guidance Question and Answers anticipated transaction will be re-evaluate their hedging 121-2 (‘IGC 121-2’) gives a undertaken. IAS imposes more strategies in light of the new method whereby entities stringent criteria over the standard. With new and designate a single asset or expectation beyond just a complex products being liability with the same reasonable anticipation. developed in the industry, characteristics as the whole net Accordingly, how a bank 10 IFRS – Global Reporting Revolution Hedging and Hedge Accounting allow thedesignationand unlikely tobeconfigured transactional level systemsare considerable. Existing effectiveness testing canbe and hedgingitemsconduct identify andmonitorthehedged maintain documentation, required toestablishand transactions thenthemanpower significant volume ofhedging organisation undertakesa an resources. Where areas ofbothsystemsand impact forinstitutionsinthe hedging willhave amajor T Systems andresources associated additionalcosts. smaller tranches forthe may needtobeundertakenin consideration, andfuturehedges will needtobegiven careful c hooses tohedgeitspipelinerisk he above issueshighlightthat or choose tobuilddedicated Some organisationswillneed modifications. flexible withoutextensive find thepackages insufficiently offset orregressionmethodsmay testing beyond thesimpledollar undertaking hedgeeffectiveness strategies ofIGC121-2or designation andre-designation at undertakingsomeofthe strategies. Organisationslooking straightforward hedging and implementing numbers ofhedgingtransactions banks undertakingsmall meeting therequirementsof solutions willprimarilybe by are beginningtobedeveloped solutions addressingtheseissues Commercially available IT effectiveness testing. perform theassociatedhedge documentation ofhedgesandto

software providers. Such needed tomaintainthem. the groundsofsystemscosts be simplifiedgreatly, purelyon Hedging strategies may have to implementing hedgeaccounting. earnings volatility arisingby not consequences ofthepotential accounting againstthe requirements forhedge the costsofmeeting institutions willbetoweigh perform. A challenge for nature ofthetaskthatitwill systems given thecomplex time willbespentintestingthe development phaseconsiderable w Experience hasshown thateven employing suitableITresources. c designed andbuilteasilyor complex andcannotbe Such systemsby theirnatureare effectiveness testing. automatically conduct underlying dataand systems thatmaintainthe heaply given thecostof hen such systemsarepastthe 11 Hedging and Hedge Accounting Conclusion With the potential difficulties RevolutionIFRS – Global Reporting inherent in achieving hedge The introduction of IAS 39 will accounting, putting in the radically change the ability of processes which will ensure UK financial institutions to compliance may involve achieve hedge accounting, substantial effort and resources resulting in increased earnings and involve a timescale volatility. Many will feel this denominated in months and effect to be sufficiently severe years rather than days. Given the or misleading of the ‘true’ timetable for the introduction of (or economic) performance IFRS, institutions need to be that it justifies incurring the deciding on their strategy now. additional costs needed to achieve hedge accounting treatment. Management of institutions are advised to consider the matter of hedge accounting thoroughly and as soon as possible to ensure that they are making an informed decision and putting in place the most appropriate course of action. 12

PricewaterhouseCoopers

If you would like to discuss any of the issues raised in this paper, please speak with your usual contact at PricewaterhouseCoopers. Contacts This paper was prepared by:

John Hitchins Ed Jenkins UK Banking Leader Senior Manager, UK Banking Group Tel: 44 207 804 2497 Tel: 44 20 7804 8043 E-mail: [email protected] E-mail: [email protected] IFRS – Global Reporting Revolution

Global IFRS contacts

Etienne Boris Karen Loon Tel: 33 1 5657 1029 Tel: 65 6236 3021 E-mail: [email protected] E-mail: [email protected]

Michael Codling Johan Månsson Tel: 61 2 8266 3034 Tel: 46 8 555 33044 E-mail: [email protected] E-mail: [email protected]

Burkhard Eckes John McDonnell Tel: 49 30 2636 2222 Tel: 35 3 1 704 8559 E-mail: [email protected] E-mail: [email protected]

Jeremy Foster Lorenzo Pini Prato

Hedging and Hedge Accounting Hedging and Hedge Tel: 44 20 7212 5249 Tel: 390 6 57025 2480 E-mail: [email protected] E-mail: [email protected]

Bernard Heinemann Arno Pouw Tel: 41 1 630 25 77 Tel: 31 20 568 7146 E-mail: [email protected] E-mail: [email protected]

Edmund Hodgeon Tel: 34 91 568 5180 E-mail: [email protected]

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