The IASB's Discussion Paper on Accounting for Dynamic Risk Management - Evaluation of Comment Letters

Transcription

1 The IASB's Discussion Paper on Accounting for Dynamic Risk Management - Evaluation of Comment Letters Working Paper16/01 Edgar Löw/Sebastian Mauler 1 Frankfurt School of Finance and Management 1 Please send comments to e.loew@fs.de or edgar@eloew.de

2 TABLE OF CONTENTS 1. Introduction Overview: Discussion Paper on Accounting for Dynamic Risk Management Approach to Comment Letter Evaluation Evaluation of Comment Letters Difficulties with Current Standard and Need for a New Approach Question 1: Need for a Specific Accounting Approach Question 2a: Difficulties with Current Standard Critical Appraisal Scope of the PRA and Discussion About Obligatory Application Question 15: Scope of the PRA Question 16: Mandatory or Optional Application Critical Appraisal Behaviouralisation within the PRA Question 4: Elements of Behaviouralisation Question 9: Core Demand Deposits Critical Appraisal Presentation of the PRA within Financial Statements Question 18: Presentation Alternatives Critical Appraisal Overall Evaluation of the PRA Question 2b: PRA as Potential New Accounting Concept Critical Appraisal Summary of Evaluation Results Outlook on Next Steps IASB s Evaluation of the Comment Period Considered Approaches Project Plan: Disclosures First Conclusion REFERENCE LIST

3 TABLE OF FIGURES Figure 1: Dynamic risk management within banks Figure 2: The Portfolio Revaluation Approach Figure 3: Comment letters by group Figure 4: Group composition of users and preparers of financial statements Figure 5: Questions answered by frequency Figure 6: Evaluation of Question Figure 7: Evaluation of Question 2a Figure 8: Scope alternatives of the PRA Figure 9: Evaluation of Question 15a Figure 10: Evaluation of Question 15b Combination of risk mitigation scope and IFRS Figure 11: Evaluation of Question 15d Figure 12: Evaluation of Question 16a Figure 13: Evaluation of Question 16b Figure 14: Pipeline transactions Figure 15: Core demand deposits Figure 16: Evaluation of Question 4a Figure 17: Evaluation of Question 4b Figure 18: Evaluation of Question 4c Figure 19: Evaluation of Question 9a Figure 20: Evaluation of Question 9b Figure 21: Presentation alternatives in the statement of financial position Figure 22: Actual net interest income presentation Figure 23: Stable net interest income presentation Figure 24: Evaluation of Question 18a Figure 25: Evaluation of Question 18b Figure 26: Evaluation of Question 2b Figure 27: Predominant views on analyzed questions Figure 28: Proposed project plan

4 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

5 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 redesignations, 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 17 th 2014 the public was invited to submit comment letters and thereby answer up to 26 questions posted by the IASB. During this period 123 letters 4 were submitted which are publicly available at the IASB s website. 2 Cf. IFRS Foundation (ed.) (2010), p 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

6 Despite some publications summarizing commentators aggregated views as well as brief descriptions of reasoning regarding the important topics 5, 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 IFRS Foundation (ed.) (2014b), p

7 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 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 Cf. IFRS Foundation (ed.) (2014b), p

8 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

9 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

10 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. Financial markets associations (users of financial statements) 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 Aggregate banking industry (preparers of financial statements) Banks: 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: 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 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 - 6 -

11 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 subquestions (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 - 7 -

12 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 Cf. IFRS Foundation (ed.) (2014b), p. 105 ff

13 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 1 st 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 See IAS to IAS , IFRS. 18 Cf. Löw, E. (2015), p. 590 ff. 19 Cf. IFRS Foundation (ed.) (2014b), p. 11 f

14 replace IAS 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 oneto-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 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 Cf. IFRS Foundation (ed.) (2014b), p. 20 f

15 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 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

16 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 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 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 Flores, F. (2014), p Bradbery, D./Corbi, A. (2014), p

17 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 Cf. IFRS Foundation (ed.) (2014b), p IFRS Foundation (ed.) (2014b), p Reback, L. (2014), p

18 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 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 Cf. Hirao, Y. (2014), p. 1 ff

19 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

20 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 Cf. IFRS Foundation (ed.) (2014b), p. 58 f. 38 Cf. IFRS Foundation (ed.) (2014c), p Cf. Garz, C./Wiese, R. (2014), p

21 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 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 subquestion, 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 IFRS Foundation (ed.) (2014b), p

22 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 Lee, P./Miemietz, M./Goodhart, W. (2014), p On this see for example Wehling, A./Saeglitz, H.J. (2014), p. 6 f. 45 Cf. Ernst & Young (ed.) (2011), p

23 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 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 On this see for example Mulch, S. (2014), p. 22 f. 47 Cf. Hannah, D. (2014), p Cf. Bancaria, A. (2014), p Adams, M. (2014), p Cf. Mulch, S. (2014), p Mezon, L. (2014), p

24 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 abovementioned 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 Cf. Gallagher, S. (2014), p

25 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 subportfolio 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 Cf. Termer, T. (2014), p Fuchs, E. (2014), p On this see for example PricewaterhouseCoopers International Limited (ed.). (2014), p Cf. IFRS Foundation (ed.) (2014b), p On this see for example Schroeder, N. (2014), p Cf. Rave, H./Kehm, P. (2014), p

26 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 Cf. IFRS Foundation (ed.) (2014b), p Cf. Viandier, M. (2014), p On this see for example Patrigot, N. (2014), p

27 respondent even notes that including other types of risk might result in a considerable delay of the project 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 Cf. IFRS Foundation (ed.) (2014b), p

28 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 Joyce, D. (2014), p Maijoor, S. (2014), p Huthmann, A. (2014), p

29 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 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 On this see for example Clifford, T. (2014), p Cf. Peters, D. (2014), p On this see for example Schneiß, U./Fieseler, U. (2014), p

30 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 subportfolios 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 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

31 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 Cf. IFRS Foundation (ed.) (2014b), p

32 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 Cf. Spall, C./Tejerina, E./Harding, T. (2014), p Cf. IFRS Foundation (ed.) (2014b), p

33 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 Cf. IFRS Foundation (ed.) (2015a), p Cf. IFRS Foundation (ed.) (2014b), p

34 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 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 Cf. Spall, C./Tejerina, E./Harding, T. (2014), p Cf. IFRS Foundation (ed.) (2014b), p

35 usefulness of information and consistency with the conceptual framework should be taken into consideration 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 Cf. Poole, V. (2014), p IFRS Foundation (ed.) (2015a), p

36 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 Cf. Chng, S. (2014), p Clifford, T. (2014), p On this see for example Buggle, S. (2014), p Cf. Schneiß, U./Fieseler, U. (2014), p On this see for example Wong, E. (2014), p IFRS Foundation (ed.) (2014b), p

37 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 IFRS Foundation (ed.) (2015a), p Cf. Ingves, S. (2014), p On this see for example Jang, J. (2014), p Cf. Maijoor, S. (2014), p

38 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 On this see for example Patrigot, N. (2014), p Tovey, M./Lasik, M. (2014), p Cf. IFRS Foundation (ed.) (2014b), p

39 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 Cf. Chua, K. (2014), p Cf. Chng, S. (2014), p Cf. Scutt, S. (2014), p Cf. Maijoor, S. (2014), p Cf. Innes-Wilson, C. (2014), p

40 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 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 subquestion 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 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 On this see for example Kilesse, A./Boutellis-Taft, O. (2014), p IFRS Foundation (ed.) (2014b), p

41 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 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 Cf. Chng, S. (2014), p Cf. Kvaal, E. (2014), p On this see for example Chien, L. (2014), p Cf. Vaessen, M. (2014), p Hannah, D. (2014), p Rave, H./Kehm, P. (2014), p Cf. PricewaterhouseCoopers International Limited (ed.) (2014), p

42 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 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 Cf. IFRS Foundation (ed.) (2014b), p Kilesse, A./Boutellis-Taft, O. (2014), p Cf. Poole, V. (2014), p

43 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 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 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

44 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

45 (aggregate adjustment alternative) and single net line item. The example of the DP is used to illustrate the differences among those alternatives: DR/(CR) Assets Amortized cost Revaluation adjustment Fair value Presentation alternatives in the statement of financial position Line-by-line gross up Aggregate adjustment Retail loans Commercial Loans Debt securities 500 (20) Dynamic risk management revaluation 21 Single net line item Derivatives 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 Profit or loss from dynamic risk management activities 4 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

46 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 in CU 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 Jun 20X1 31 Dec 20X1 30 Jun 20X2 31 Dec 20X2 Interest revenue 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 Revaluation effect from dynamik risk management (0.67) (0.52) Total profit/loss for the 6 month period (0.12) (0.04) 130 Cf. IFRS Foundation (ed.) (2014b), p. 69 f. 131 Cf. IFRS Foundation (ed.) (2014c), p

47 in CU 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. 30 Jun 20X1 31 Dec 20X1 30 Jun 20X2 31 Dec 20X2 Interest revenue Interest expense (1.49) (1.37) (1.24) (1.61) Net interest income Revaluation effect from dynamik risk management (0.62) (0.54) Total profit/loss for the 6 month period (0.12) (0.04) 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 IFRS Foundation (ed.) (2014b), p

48 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 Cf. Peach, K. (2014), p Cf. Joyce, D. (2014), p Cf. Poole, V. (2014), p

49 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 Vaessen, M. (2014), p On this see for example Peters, D. (2014), p On this see for example Ludolph, S. (2014), p Cf. Rave, H./Kehm, P. (2014), p Maijoor, S. (2014), p Faull, M. (2014), p

50 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 On this see for example Schneiß, U./Fieseler, U. (2014), p On this see for example Bertl, R. (2014), p

51 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 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 Vaessen, M. (2014), p Menk, M./Rissi, R./Spillmann, M. (2014), p

52 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 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

53 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 Cf. Dignam, S./Ward, R. (2014), p. 1 f

54 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 Kenny, M. (2014), p Cf. Chien, L. (2014), p Cf. Tovey, M./Lasik, M. (2014), p. 3 f. 157 On this see for example Kvaal, E. (2014), p

55 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 On this see for example Innes-Wilson, C. (2014), p Cf. Patrigot, N. (2014), p Cf. Barbett-Massin, M. (2014), p Croteau, L. (2014), p

56 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 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

57 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 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

58 Section 4.1 Section 4.2 Section 4.3 Section 4.4 Question Subject Predominant view % of answers that share predominant view 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% 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

59 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 20 th 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

60 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 Cf. Yamashita, Y./Dasgupta, K. (2015), p Cf. Yamashita, Y./Dasgupta, K. (2015), p. 6 ff. 167 Cf. Yamashita, Y./Dasgupta, K. (2015), p. 9 f

61 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 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