Comment on the Discussion Paper:

Transcription

1 1 IFRS Foundation 30 Cannon Street London EC4M 6XH United Kingdom Comment on the Discussion Paper: Accounting for Dynamic Risk Management: A Portfolio Revaluation Approach to Macro Hedging Authors: Dr Michael Torben Menk, University of Siegen/Germany Contact: michael.menk@uni-siegen.de Dr Roger Rissi, Lucerne University of Applied Sciences and Arts/Switzerland Contact: roger.rissi@hslu.ch Dr Martin Spillmann, Lucerne University of Applied Sciences and Arts/Switzerland Contact: martin.spillmann@hslu.ch Abstract Before we deal with and comment critically on the following questions, we would like to give a brief summary of the key points of criticism regarding the proposed PRA and touch on an alternative concept, which, in our opinion, is superior to the PRA - using the example of question 18 presentation alternatives we will demonstrate the advantages of ALM-compliant Accrual Hedge Accounting (AHA), (cf. Appendix A). It is completely indisputable that there is an urgent need to bring external accounting of banks in line with internal risk management practices - here in particular the interest rate risk intensive ALM. First of all, the question arises whether and to what extent this is possible with the current hedge accounting rules and if there is an additional need to revise IFRS 9 finally published just recently. In our view, neither too rigid and detailed rules for external accounting should dominate, in an extreme case even "take over" internal risk management, nor should a too lax and liberal attitude open the way to improper balancing which might be too strongly aimed at internal motives: e.g. regulators credulity in banks own risk management models and techniques

2 2 within the Basel framework have lead to disastrous results. Theory and practice must be equally taken into account and assessed in a balanced way. In view of this targeted consonance, we doubt that the PRA is capable of achieving this. The revaluation in terms of a fairvalue-assessment of portfolios always leaves unpleasant marks by drastically increasing the volatility of values and value changes. The partially artificial and therefore completely unrealistic volatility in key ratios of financial statements due to the application of the PRA thus inevitably collide with the primary aim of ALM, namely to keep the net interest result stable over time. In our opinion, the investor would be more confused and maybe even mislead than provided with more transparent and objective financial statements. We consider it very important to include the observed and assumed behaviour of clients, when they deposit or withdraw funds. We also advocate for inclusion of anticipated decisions of bank managements, when they attempt to attract or defend customer deposits. Both lead to the concept of replication. Replicated portfolios of core deposits are a largely accepted risk management concept, and they may not be neglected. Also the replication of equity is a wide-spread practice in ALM. It therefore shall be included into accounting on risk positions as well. However, we are sceptical towards the inclusion of risk limits. In ALM, transfer prices are determined via FTP and should therefore also be included in balancing. In the interests of good risk governance, the replication parameters are defined by the bank management and audited and monitored by independent, internal and external institutions. The heart and at the same time weak spot of this discussion paper is the example of the presentation in the annual accounts (question 18). Based on incorrect data and on a flawed model, it reports extremely volatile results. It demonstrates that a PRA is not suitable for risk management accounting. An alternative reporting approach is presented in appendix A: Accrual Hedge Accounting (AHA), following a cash flow hedge approach, provides profits and losses in line with practical risk management. AHA further aligns with the overarching aim of ALM, namely to achieve and defend a stable net interest margin. We welcome the disclosure requirements in the appendix complementing the balance sheet and the profit and loss account and explaining the aims and strategies of ALM to the annual accounts recipient. However, the disclosure should not go as far as disclosing sensitive, bank-internal parameters and procedures. In this respect, disclosure matters should be differentiated very carefully. Internal hedging derivatives play an important but not a fundamental role for ALM. It should be made sure that the trading department passes the hedging derivatives on to external contract partners, i.e. externalise them 1:1. Under this condition, an entry of the value changes (which we do not approve though) would be imaginable in OCI, whereas we are generally in favour of a straightforward and transparent entry of value changes in the profit and loss account. Entries in OCI cause a greater obfuscation than they provide information useful for decision making. All in all, we take the view that the current, already very complex hedge accounting rules provide a solid basis for presenting net positions in ALM. Primarily, though, cash flow hedge must be borne in mind. Merely some adjustments, easing or expansions respectively should be addressed. A portfolio revaluation model promoting the volatility of the net interest result then becomes superfluous.

3 3 Question 1 Need for an accounting approach for dynamic risk management Do you think that there is a need for a specific accounting approach to represent dynamic risk management in entities financial statements? Why or why not? To achieve the overall aim of financial statements, namely to provide decision usefulness for current and potential investors, internal methods and techniques of risk management should be presented faithfully in the financial accounting. There is no way round it. Macro Hedge Accounting is one of the core elements within the overall concept of banking triad, which works out solutions concerning the reconciliation of external accounting, risk management and supervision. Specifically for banks, the financial reporting of its portfolio management in the nature of a group-wide assetliability-management (ALM) supports investors to evaluate the quality and complexity of banks risk management and helps to compare it with peer group banks. However, in our opinion, the best presentation of quantitative and qualitative risk management in financial reporting of banks is only able to close the large gap between the internal and external information rudimentarily. That is why we are convinced that hedge accounting rules are very important, but such rules should be designed in a practical way, with no artificial complication and intelligibly. Thus the decisive question, whether this important role of ALM justifies an additional accounting model Portfolio Revaluation Approach (PRA) besides a couple of current hedge accounting requirements and therefore an increased complexity, has to be answered differentiatedly and depends on the factual design. Without a doubt, the fundamental problem that hedge accounting is still necessary has its roots in the mixed measurement model fair value on the one hand and cost/accrual accounting on the other hand. The goal of ALM is primarily to stabilize the net interest margin in profit or loss and to reduce the volatility of interest income over time. The management of (fair) values of assets and liabilities plays a subordinate role here. Hence, in our opinion the financial reporting of hedging activities in ALM should follow comprehensive accrual accounting rules because the management of interest net income is generally not in alignment with (fair) value-based accounting, but cash-flow-oriented accounting. Finally, the proposed PRA might be a second best approach if the IASB adhere to the fair value accounting of derivate hedging instruments. In some circumstances, for example by measuring trading instruments, fair-value-accounting could make sense. But for the long-term oriented ALM, accrual accounting of derivatives appears imperative. So, in accordance with ALM-purposes, we suggest a comparable easy and less- P&L-volatile way, say accrual accounting for both hedged item and hedging instrument. We define it as Accrual Hedge Accounting (AHA) without any changes and adjustments in fair values. The current requirements of hedge accounting (see Appendix A) have also been revised among this proposition (partially). It is certainly not our intention to abolish hedge accounting rules completely by proposing an AHA, but we would prefer to use existing procedures and transmit them to reflect economic reality.

4 4 Against this critical backdrop with respect to PRA, some questions in the discussion paper will only be commented superficially or not at all; others only illustrate an overriding, systemic character to which we want to point out our opinion (e.g. EMB, core demand deposits and so on). We only take banks into consideration. Question 2 Current difficulties in representing dynamic risk management in entities financial statements a) Do you think that this DP has correctly identified the main issues that entities currently face when applying the current hedge accounting requirements to dynamic risk management? Why or why not? If not, what additional issues would the IASB need to consider when developing an accounting approach for dynamic risk management? In our view, the identified issues that entities (banks) currently face when applying the current hedge accounting requirements to dynamic risk management are largely correct, but in some cases ambiguous and overestimated. Banks naturally manage open portfolios which usually change over time, as new loans/deposits are added and existing loans/deposits mature; a one-to-one designation between hedged item and hedging instrument is regularly not given. One of the main shortcomings of the current requirements is the non-hedge-accounting of core demand deposits. Indeed, ALM managers handle the deemed interest risk of core demand deposits on the expected behaviour of depositors. By contrast, the non-designation of pipeline transactions is much less dramatic, because pipeline transactions can be considered as low in terms of volume and relevance. Furthermore, as mentioned below, the equity model book shows exactly the internal risk management of ALM, that there is no distinction between the replication portfolio of liabilities (deposits) and equity. Thus a base return on equity should qualify for a hedged item (IFRS 9.6.3) similar to a fixed interest rate of deposits. That is why the problem of equity models is much more significant compared to pipeline transactions. To summarize, replication of the equity model book as well as core demand deposits are the most important issues banks are faced when preparing the financial statement and try to harmonize management accounting and financial accounting. b) Do you think that the PRA would address the issues identified? Why or why not? The proposed Portfolio Revaluation Approach (PRA) is one possibility to account dynamic portfolio management (ALM). However, it is more than questionable whether this approach demonstrates the economic reality of banks optimally and therefore supports investors in their decisions to invest or not invest. The fact that derivatives (hedging instruments) are measured at fair value, while loans and deposits (hedged items) are measured at cost, therefore results in an undesired accounting mismatch. When applying the PRA, hedged items usually would be designated at fair value. Consequently in terms of revaluation, banks are encouraged to compare the changes of fair values (due to changes in the market interest risk) of the managed portfolio with the changes in fair value of derivatives. In the end, only for accounting purposes, banks compare the more or less great volatility of hedging instruments with the more or less great volatility of hedged items that is not a practical and economically valid procedure. The overall objective for treasury is to stabilize and cement the net interest

5 5 income in profit or loss in the medium and long term, so banks do not emphasise the composition of portfolios value-driven, but instead performance-driven. Hence, we propose to reconsider the mixed measurement model in conjunction with an overall AHA for portfolio management ALM. In our understanding, a revaluation of portfolios produces artificial volatilities which are directly in conflict with internal risk management. We are convinced that the application of cash flow hedge accounting as described in IFRS comes closest to the goal of stabilizing the net interest income of banks. Anyway, the general requirements of hedge accounting should remain unaffected respectively almost fully unaffected. Obviously the criteria of qualifying hedged items and the fair value measurement-model of qualifying hedging instruments need to be reconsidered. Question 3 Dynamic risk management Do you think that the description of dynamic risk management in paragraphs is accurate and complete? Why or why not? If not, what changes do you suggest, and why? Yes, we agree for the most part. The description of dynamic risk management seems to be accurate: The composition of portfolios varies frequently, treasury managers replicate and adjust portfolios on a timely basis (e.g. weekly), open portfolios include exposures based on estimates (in particular core demand deposits, embedded prepayment options, EMB) and risks arising only from external exposures. As has rightly been pointed out, too, the objective of ALM is to keep the net interest income from the open portfolio within a targeted sensitivity to changes in market rates. Exactly this latter point speaks against the application of the suggested PRA, because the PRA aims at a possible strong volatile (fair-)value-based accounting, whereas ALM proposes to level net interest income over time. The PRA reflects ALM only partially without capturing the heart of the problem: In our view, the shortcomings of current accounting rules are not primarily a result of either the dynamic component of risk management or the closing of the net position of asset and liabilities. Rather the mixed measurement model for hedging derivatives and hedged items should have been reformed and adjusted in favor of practical ALM. Side note: Would it make sense to specify (define) the term risk in contrast to exposure? Such clarification might be helpful because exposure and risk are blurred. Question 4 Pipeline transactions, EMB and behaviouralisation Pipeline transactions a) Do you think that pipeline transactions should be included in the PRA if they are considered by an entity as part of its dynamic risk management? Why or why not? Please explain your reasons, taking into consideration operational feasibility, usefulness of the information provided in the financial statements and consistency with the Conceptual Framework for Financial Reporting (the Conceptual Framework). No, Pipeline transactions should not be included in the PRA or rather in our opinion in any other approach to harmonize risk management and financial accounting. The

6 6 description of pipeline transactions is right and banks definitely manage forecast volumes of drawdowns on fixed interest rate products at advertised rates (operational feasibility), but we are nonetheless convinced that the volume of pipeline transactions is comparatively low and the additional benefit of information about those pipeline instruments provided in the financial statements tends to be small. Principally, we welcome behaviouralisation in financial statements (extension of the term hedged item, IFRS ), see below), but the basic qualitative criteria relevance allows to omit such information about pipeline transactions we are sure that additional information about pipeline transactions will probably not influence investors decisions. EMB b) Do you think that EMB should be included in the PRA if it is considered by an entity as part of its dynamic risk management? Why or why not? Please explain your reasons, taking into consideration operational feasibility, usefulness of the information provided in the financial statements and consistency with the Conceptual Framework. Yes, absolutely. That is one key driver to reconsider hedged items. From the perspective of ALM it is not reasonable why EMB should be excluded from financial statements. As described in the DP properly, banks manage a base return on equity similar to interest. In this case, they typically do not distinguish between deposits and equity. Indeed, the targeted base return is interpreted as an interest risk profile and modelling by a replication portfolio. Finally, the return to shareholders is sensitive to changes in interest rates, so equity should be involved in ALM through transfer pricing, too. Operational feasibility is given. But in our opinion, there is no need for an additional PRA to include EMB in financial statements, because the cash flow hedging on the variable interest rate assets is the economically right way. However, in the DP, managing EMB in this way is called indirect way with two negative implications. In our understanding in practical ALM, cash flow hedging is surely not an indirect way, because cash flow hedging reflects the overall aim of ALM to stabilize the net interest income. The DP obviously misunderstands the fact that banks first of all favour managing components of the P&L rather than positions or portfolios of the balance sheet. There is a fundamental divergence of what principle-based risk management is. Furthermore, not the definitions of assets and liabilities in general (framework) have to be extended, but probably the individual definition of hedged item ( equity ). For us, the presentation of the replication portfolio EMB in financial statements of banks in connection with the cash flow hedge accounting build up the economic reality much better than the proposed revaluation of portfolios. Behaviouralisation c) For the purposes of applying the PRA, should the cash flows be based on a behaviouralisation rather than on a contractual basis (for example, after considering prepayment expectations), when the risk is managed on a behaviouralisation basis? Please explain your reasons, taking into consideration operational feasibility, usefulness of the information provided in the financial statements and consistency with the Conceptual Framework.

7 7 Yes, we think so. Behaviouralisation is really important for banks risk management and thus is has to be included in external financial accounting. Instead of contractual terms banks work with expected prepayments (loans) or stable fixed interest rates regarding core demand deposits. It is incomprehensible why investors by analysing the financial report should consider that banks would manage assets and liabilities on a contractual basis; that is not the case. Instead, as described below (question 3.9), demand deposits (round 80% of banks liabilities) are managed by overlapping tranches of fixed term deposits and these tranches constitute a replication portfolio. The so called core demand deposits are completely integrated into the overall managed portfolio. For investors, the use of information about the management of core demand deposits is very high and relevant. Then faithful presentation has occurred. In our understanding, in order to transfer behaviouralisation into external reporting, the term hedged item has to be extended maybe to expected transactions. The consistency with the framework ( asset, liability ) is not disturbed. It is generally more appropriate to adjust terms or practical approaches on a specific level (hedge accounting) than on a highly abstract level (framework). Question 5 Prepayment Risk When risk management instruments with optionality are used to manage prepayment risk as part of dynamic risk management, how do you think the PRA should consider this dynamic risk management activity? Please explain your reasons. As indicated in DP 3.5. Introductory, we agree that nearly all banks manage (loan) portfolios not based on the contractual lives of the exposure but on behaviouralisation through prepayments. However, from the perspective of treasury management, it is doubtful that hedging prepayment risk with interest rate options (swaptions) takes place on a large scale. As already explained above, the key for managing asset and liabilities successfully to stabilize the net interest income in P&L is to build a replication portfolio transferring fixed to variable interest rate positions (and vice versa) with various maturities and volumes. We are convinced that on a case-to-case basis, the use of options (swaptions) to manage prepayment risk makes sense, but it is not reasonable to raise complexity of hedge accounting for only individual facts which in terms of qualitative requirements (framework) are rarely relevant to influence the decision of shareholders or lenders. Instead of emphasising the dynamic component of ALM (that is true but not primarily the difficulty) the main focus of treasury is on accounting replication portfolios in financial statements. So we argue that the volume of loans with prepayment risk should be included in the managed portfolio as hedged item, but in conjunction with PRA rather by applying cash flow hedge accounting. Nevertheless, the relevance of prepayment risk is significantly lower than core demand deposits, because the replication portfolio is managed seemingly with shortterm instruments concerning liabilities (and not assets). Accordingly, the usefulness of such information is comparably low to core demand deposits. To summarize this point in question (behaviouralisation), estimation of core demand deposits get the greatest weight for harmonizing ALM and financial accounting. As mentioned above, the term hedged item in turn has to be extended to expected transactions.

8 8 Question 6 Recognition of changes in customer behaviour Do you think that the impact of changes in past assumptions of customer behaviour captured in the cash flow profile of behaviouralisation portfolios should be recognized in profit or loss through the application of the PRA when and to the extent they occur? Why or why not? Irrespective of the approach to solve the shortcomings arising from ALM-compliant hedge accounting proposed PRA versus own favoured macro cash flow hedge accounting impacts of the changes in past assumptions of customer behaviour should be recognized in P&L. In this regard, the measurement of hedge effectiveness (IFRS 9.4.1(b) can be discussed: Is there a need for measurement hedge effectiveness? In our opinion, if ALM hedges do not open positions perfectly or in an optimal way whether consciously or not any resulting effects should be presented in profit or loss. When applying an overall AHA without of the need for a remeasurement of several fair values, the possible ineffectiveness becomes clear in the P&L automatically. However, by considering the background of stabilizing the net interest income, bank directors and treasurer further have an intrinsic motivation to avoid losses. As we understand it, an AHA would bring an unhedged net position to light in gains and losses. Thus, the investor gets useful information about the hedging strategy of the ALM complemented by additional risk disclosure requirements (questions 20). Changes in customer behaviour (prepayment risk) are managed by adjusting the replication portfolio. Finally, accounting rules for ALM should ensure that the measurement of the replication portfolio is recognized in the financial statement therefore we would establish a cashflow- and performance-oriented AHA. In accordance with the qualifying criteria for hedge accounting (IFRS ), the ALM strategy has to be initiated and developed by the group executive board. While corporate governance forms the internal framework for management and monitoring, Risk Governance represents the internal framework of risk-based management. Combined with international accounting standards, the group executive board determines the hedging and hedge accounting policy. Documenting the hedge accounting strategy is of great importance. Question 7 Bottom Layers and proportions of managed exposures If a bottom layer or a proportion approach is taken for dynamic risk management purposes, do you think that it should be permitted or required within the PRA? Why or why not? If yes, how would you suggest overcoming the conceptual and operational difficulties identified? Please explain your reasons. Yes, we think that a bottom layer of loans or a proportion approach generally should be permitted within the chosen hedge accounting approach, either PRA or better within our proposal AHA. As rightly said, if anything, only for homogenous portfolios, the PRA would be able to include prepayment risk within the managed portfolio, but this homogeneity is usually not applicable for open portfolios (ALM). The critical issue is the revaluation and the consequences arising from that. If Accrual Hedge Accounting was applied, first of all, there would be no necessity to revaluate (fair value) neither the hedging instrument nor the hedged item. In practical terms, the management of prepayment risk or bottom layer is solved by the replication portfolio. With respect

9 9 to the expectation and estimation of ALM that a certain proportion of loans or mortgages (bottom layer) will have been prepaid before the end of the contractual term, the replication can be handled by a payer swap and/or by additional short term (overnight) funding. It is crucial that without revaluation but instead by application of AHA, only the interest cashflow is presented in P&L (interest income and interest expenses). This helps to stabilize the net interest margin. Among other reasons, the management of prepayment risk and bottom layer definitely argues against the revaluation and fair value measurement of asset and liabilities. Question 8 Risk limits Do you think that risk limits should be reflected in the application of the PRA? Why or why not? No. As described, the aim of ALM is to avoid volatility in profit or loss. It is correct that the wider the risk limits are, the less volatility the profit or loss would show. But in our view it should be taken into account that risk limits are usually less rigid than assumed in DP. At the end of the day, the treasurer is normally authorized to override risk limits if it is useful for keeping the overall aim of ALM. One should not lose sight that risk limits are formal tools, not more and not less. For us, risk limits should be involved in hedge accounting under all circumstances. Question 9 Core demand deposits a) Do you think that core demand deposits should be included in the managed portfolio on a behaviouralised basis when applying the PRA if that is how an entity would consider them for dynamic risk management purposes? Why or why not? Yes, in our estimation, a solution for core demand deposits is obviously long overdue, because a divergence between the management of core demand deposits in ALM and hedge accounting is not acceptable. Without repeating any sections correctly addressed in 3.9., the key message is that banks form a replication portfolio to manage core demand deposits. But in contrast to the DP, we do not support the inclusion of this replication portfolio in the managed portfolio on application of the PRA. In , the author indicates that on the one hand, including core demand deposits in hedge accounting (PRA) would contribute to a better representation of dynamic risk management, but on the other hand, it generates some significant issues concerning the recognition of revaluation gains and losses in the financial statements arising from the application of the PRA. The difficulty is to assess whether changes in core demand deposits are the result of the changes in customer behaviour or not, which could be sidestepped when applying the practical, less complex and transparent AHA. Changes in fair values are already full of uncertainty and movements which directly contradicts the overall aim of ALM. Thus it is beneficial to form a replication portfolio for core demand deposits and present that in AHA only in P&L, say in net interest income (see Appendix A).

10 10 b) Do you think that guidance would be necessary for entities to determine the behaviouralised profile of core demand deposits? Why or why not? If guidance means guidance from an external institution: then no. Forming a replication portfolio of core demand deposits is not a huge challenge with respect to treasury managers. For other entities (industrial companies), this question would likely not be posed. If guidance means guidance from the group executive board: then yes. As described in answer 3.6., personnel in key positions define and document a risk accounting strategy by which ALM-managers are bound and observed. This strategy sets the guiding principles of managing the replication portfolio, of designating the hedged item and the hedging instruments and of providing a faithful presentation in the financial statements. Question 10 Sub-benchmark rate managed risk instruments a) Do you think that sub-benchmark instruments should be included within the managed portfolio as benchmark instruments if it is consistent with an entity s dynamic risk management approach (ie Approach 3 in Section 3.10)? Why or why not? If not, do you think that the alternatives presented in the DP (ie Approaches 1 and 2 in Section 3.10) for calculating the revaluation adjustment for sub-benchmark instruments provide an appropriate reflection of the risk attached to sub-benchmark instruments? Why or why not? Yes, we agree that sub-benchmark instruments should be included within the managed portfolio. That is common practice. For example, on the liabilities side, a couple of funding instruments are available for ALM, and all these instruments vary in their counterparty-specific pricing (e.g. in range from LIBOR (bonds) till LIBOR -50 (overnight)). ALM builds an internal transfer price and provides capital to the decentralized business units. The transfer price can be LIBOR, it can also be LIBOR plus x or LIBOR less x. Insofar we favor Approach 3 (note ), which gets to the heart of ALM. The benchmark pricing cash flows form the internal transfer price with regard to the business units, and the initial and current benchmark index is usually the LI- BOR respectively the swap rate. Assuming that the transfer price is LIBOR less/plus 20, 20 is part of the margin and not part of the hedging activity, so nevertheless hedging liabilities against changes in market interest will also be based on LIBOR. The margin is distributed among a) business units liabilities, b) business units assets and c) ALM. In our understanding, transfer prices usually represent the market price (LI- BOR) plus a margin. So, transfer pricing as a main task of ALM is to be seen detached from hedging and therefore from hedge accounting, too. Additionally, it should be guaranteed that risk governance (executive board, internal audit, supervisory board) sets and monitors the parameters of the replication portfolio and supports it by a back-testing-system..

11 11 b) If sub-benchmark variable interest rate financial instruments have an embedded floor that is not included in dynamic risk management because it remains with the business unit, do you think that it is appropriate not to reflect the floor within the managed portfolio? Why or why not? Yes. We think that it is absolutely acceptable if embedded floors within a subbenchmark instrument should be credited to the business units. Possible embedded floors are part of the margin and not part of the net open position arising from changes in market interests. We think that question 10 is a question tailored primarily to internal ALM but not for external hedge accounting. Question 11 Revaluation of the managed exposures a) Do you think that the revaluation calculations outlined in this Section provide a faithful representation of dynamic risk management? Why or why not? Yes, we think so. That is classical FTP. But as illustrated before we are nonetheless convinced that accrual accounting for derivatives is the first best solution. However, if revaluation was required, the principal procedures of ALM would be described correctly and largely accurately. Partly, the examples are really simple, for example, the assumption of a flat interest rate curve is obviously an unrealistic scenario. But in essence, we have no objections. b) When the dynamic risk management objective is to manage net interest income with respect to the funding curve of a bank, do you think that it is appropriate for the managed risk to be the funding rate? Why or why not? If not, what changes do you suggest, and why? No. The respective funding curve is obviously inappropriate to reflect ALM and FTP insofar as in our interpretation the funding rate does not include expressive risks arising from changes in market interest rate, rather than credit or default risks. We are not sure if the wording used by the IASB has another meaning. So, the funding curve comprised at least two types of risk, namely interest rate risk and a spread due to credit defaults. ALM and FTP do not take credit risk spreads into account. For us, the transfer rate (e.g. LIBOR or swap rate) is appropriate for hedging and stabilizing the net interest income. Question 12 Transfer pricing transactions a) Do you think that transfer pricing transactions would provide a good representation of the managed risk in the managed portfolio for the purposes of applying the PRA? To what extent do you think that the risk transferred to ALM via transfer pricing is representative of the risk that exists in the managed portfolio (see paragraphs )? We do not want to comment on this question with respect to the PRA, because we reject this approach. But in general, as already pointed out repeatedly, we are con-

12 12 vinced that well designed replication (FTP) is the best solution for banks to stabilize their net interest income. Apart from external, extraordinary shocks, transfer pricing is a good proxy for the managed risk in the managed portfolio over time (see note 4.3.1). Then, ongoing linkage is no longer a problem. Risk transferred to ALM via transfer pricing should be taken into account to its full extent in this respect independent of PRA. By applying a desired and practical AHA a lot of questions not least this one are not raised. Transfer pricing serves to coordinate and match cash inflows (interest earnings) and cash outflows (interest expenses) and determine the price to which these cash flows should be valued and transferred. The aim is to anticipate (as possible) and react to changes in market interest rates with flexible instruments. AHA automatically shed light on the hedged and (maybe) unhedged positions. Transfer pricing and hedge accounting can be brought into conformity very well. They are only two sides of one coin. b) If the managed risk is a funding rate and it represented via transfer pricing transactions, which of the approaches discussed in do you think provides the most faithful representation of dynamic risk management? If you consider none of the approaches to be appropriate, what alternatives do you suggest? In your answer please consider both representational faithfulness and operational feasibility. To answer this question we would like to refer to the applicable description in note This distinction between the managed interest rate risk (funding rate, e.g. LI- BOR minus 20) and the representation via transfer pricing (e.g. LIBOR) reflects the practical ALM and that is why transfer pricing should be used as an approximation for the risk resulting from the managed exposure. Transfer pricing is the expedient practice. Any other components except for the hedged transfer price (e.g. LIBOR), say first the margin of ALM, secondly the margin (+/-) earned by customer deposits and thirdly the margin by the customer-specific loan (+/-), represent the bank s profitability of interest income in the P&L. But we believe that the discussion advantages, disadvantages and so on concerning transfer pricing is probably an important issue for the PRA with respect to discounting, but not for practical hedge accounting. When applying the current hedge accounting method cash flow hedge, the net open position (fixed interest rate overhang on loans) is closed by a payer swap which turns the fixed interest income into variable interest income. Interest earnings and interest expenses with respect to the proxy managed risk (e.g. LIBOR) offset each other. The financial statement, in particular the income statement, gives a faithful presentation of banks hedging und non-hedging transactions without volatility over time, which is hardly explainable to the shareholder. c) Do you think restrictions are required on the eligibility of the indexes and spread that can be used in transfer pricing as a basis for applying the PRA? Why or why not? If not, what changes do you recommend, and why? We propose that personnel in key positions are responsible to set and monitor the parameter of the replication portfolio including the transfer pricing. We are also convinced that restrictions imposed on an external institution are less useful. External standard setters are strictly necessary only for defining the framework of AHA like the current rules.

13 13. d) If transfer pricing were to be used as a practical expedient, how would you resolve the issues identified in paragraphs concerning ongoing linkage? We believe, from a treasurer s point of view, the problems identified in paragraphs concerning ongoing linkage do not constitute true problems the bank faces regarding ALM. As described in paragraph (b), one possibility to react to an unexpected prepayment is to enter into an additional offsetting transfer pricing transaction. Indeed, this could have an effect on the net margin over time. To our knowledge those scenarios regarding unexpected prepayments are rare and low in volume, because a well designed replication portfolio will anticipate and compensate them. Furthermore, a small change in the average interest rate has nevertheless to be calculated. We ask ourselves what is the lesser evil a small volatility in interest income due to an unexpected customer behaviour or a great volatility due to the revaluation measurement? Question 13 Selection of funding index a) Do you think that it is acceptable to identify a single funding index for all managed portfolios if funding is based on more than one funding index? Why or why not? If yes, please explain the circumstances under which this would be appropriate. As argued before, a lot of funding instruments are available for ALM, and all these instruments vary in their counterparty-specific pricing (e.g. in range from LIBOR (bonds) till LIBOR -50 (overnight)). The transfer price can be LIBOR, it can also be LIBOR plus x or LIBOR less x. Also, we propose to identify the transfer price / transfer rate in terms of internal LIBOR for all managed portfolios. b) Do you think that criteria for selecting a suitable funding index or indexes are necessary? Why or why not? If yes, what would those criteria be, and why? Yes, of course. This is the responsibility of the treasurer in combination with the risk governance of the executive board. These criteria should be determined in an easy and practical way without external requirements. Question 14 Pricing index a) Please provide one or more example(s) of dynamic risk management undertaken for portfolios with respect to a pricing index. Replication Portfolio is the common standard to determine the transfer price in the nature of the internal LIBOR. b) How is the pricing index determined for these portfolios? Do you think that this pricing index would be an appropriate basis for applying the PRA if used in dynamic risk

14 14 management? Why or why not? If not, what criteria should be required? Please explain your reasons. See a). c) Do you think that the application of the PRA would provide useful information about these dynamic risk management activities when the pricing index is used in dynamic risk management? Why or why not? On the one hand, we generally believe that PRA would not provide useful information about dynamic risk management. On the other hand, transfer pricing and replication portfolio in relation to an Accrual Hedge Accounting bring ALM and accounting close together and offer useful information for investors decision-making. Question 15 Scope a) Do you think that the PRA should be applied to all managed portfolios included in an entity s dynamic risk management (ie a scope focused on dynamic risk management) or should it be restricted to circumstances in which an entity has undertaken risk mitigation through hedging (ie a scope focused on risk mitigation)? Why or why not? If you do not agree with either of these alternatives, what do you suggest, and why? First of all, as mentioned above, we think that the PRA is only a second best approach because continuous fair value accounting creates more volatility than accrual accounting and the measurement of fair values is often uncertain and difficult to compare. Nevertheless, this question maybe concerns the scope of ALM-accounting in general. The example under point shows that the revaluation of the hedged item (composition of assets and liabilities) and the hedging instrument (swap) is a precondition for reducing the volatility in profit or loss. When banks decide not to hedge a certain (sub)portfolio of their ALM, this decision is economically reasonable. Not unhedged portfolios are responsible for unwanted volatility, but it is rather the fair value accounting that creates it. Hence, by applying an AHA, scope alternatives such as focus on dynamic management or focus on mitigation do not even occur. Either hedging activities or non-hedging activities of ALM have a direct influence on the net interest income, so we think that hedge accounting rules which restrict banks in building portfolios only for accounting purposes cannot contribute to bringing together risk management and accounting. b) Please provide comments on the usefulness of the information that would result from the application of the PRA under each scope alternative. Do you think that a combination of the PRA limited to risk mitigation and the hedge accounting requirements in IFRS 9 would provide a faithful representation of dynamic risk management? Why or why not?

15 15 For each scope alternative, we think that the usefulness of the information is low. PRA should not combine with general hedge accounting requirements in IFRS 9. Under the condition that fair value accounting of ALM-derivatives would be loosened, banks are capable of stabilizing the net interest income and present their true performance in profit or loss. c) Please provide comments on the operational feasibility of applying the PRA for each of the scope alternatives. In the case of a scope focused in risk mitigation, how would the need for frequent changes to the identified hedged sub-portfolio and/or proportion be accommodated? By applying AHA, the question of operational feasibility does not arise. d) Would the answers provided in questions (a)-(c) change when considering risks other than interest rate risk (for example, commodity price risk, FX risk)? If yes, how would those answers change, and why? If not, why not? No. Question 16 Mandatory or optional application of the PRA a) Do you think that the application of the PRA should be mandatory if the scope of application of the PRA were focused on dynamic risk management? Why or why not? No. When studying the DP it remains unclear whether the IASB assumes or realizes that the volatility in profit or loss can be respectively will be decreased by applying the PRA. To circumvent an undesired accounting mismatch there are two solutions (in principle): consonance in terms of accrual accounting or consonance in terms of fair value accounting. However, the classification and measurement criteria of financial instruments/assets, first business model and second cash flow-requirement (IFRS 9.4.1) interfere with this harmonization. That means, if banks simply followed the classification and measurement requirements, they would not be able to stabilize the net interest income because loans and deposits are accounted at costs and derivatives are accounted at fair value. Therefore, alternative one without any hedge accounting rules does not work, unless derivatives especially for ALM-purposes could be recognized at cost. For us, under certain circumstances, alternative two is the best, because it is a compromise between simple but unrealistic without hedge accounting and a complicated and unrealistic hedge accounting plus PRA, too. The most practical and smooth solution is to separate derivatives in trading and nontrading. Derivatives held for trading should be measured by fair value, derivatives held for ALM should be recognized by accrual accounting (cost). On the whole, the current requirements of hedge accounting should be maintained the structuring of hedge effectiveness (qualitative/quantitative) has to be discussed. Alternative three (apply only PRA) and alternative four (hedge accounting plus PRA) are shortlisted.

16 16 b) Do you think that the application of the PRA should be mandatory if the scope of the application of the PRA were focused on risk mitigation? Why or why not? As we do not distinguish between focus on dynamic risk management and focus risk mitigation, answer a) can be transmitted to b). Question 17 Other eligibility criteria a) Do you think that if the scope of the application of the PRA were focused on dynamic risk management, then no additional criterion would be required to qualify for applying the PRA? Why or why not? Generally, we do not support the PRA. As noted in paragraph 5.4.1, however, the discussion paper does not make a statement about hedge effectiveness. This topic is too complex and controversial, so, to comment on testing hedge effectiveness at this point would be beyond the scope. a. Would your answer change depending on whether the application of the PRA was mandatory or not? Please explain your reasons. No. b. If the application of the PRA were optional, but with a focus on dynamic risk management, what criteria regarding starting and stopping the application of the PRA would you propose? Please explain your reasons. Not applicable PRA should not be optional. b) Do you think that if the scope of the application of the PRA were to be focused on risk mitigation, additional eligibility criteria would be needed regarding what is considered at risk mitigation through hedging under dynamic risk management? Why or why not? If your answer is yes, please explain what eligibility criteria you would suggest and, why. See a). a. Would your answer change depending on whether the application of the PRA was mandatory or not? Please explain your reasons. See a).

17 17 b. If the application of the PRA were optional, but with a focus on risk mitigation, what criteria regarding starting and stopping the application of the PRA would you propose? Please explain your reasons. See a). Question 18 Presentation alternatives First we want to say that 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. Because this question implies applying the PRA, we do not want to comment on the question in detail, but rather give some higher-level arguments on how to present ALM in the financial statement. Furthermore, we want to point out that in our understanding of ALM, there are a couple of errors and inadequacies regarding the underlying database (page 70) and in particular concerning the calculations of net interest income (pages 71 and 72). Hence, it is more or less impossible to evaluate it anyway. In point c) in conjunction with Appendix A we present our version of calculation by applying AHA with the result of stabilizing the net interest income optimally. a) Which presentation alternative would you prefer in the statement of financial position, and why? Neither nor. Without commenting on the alternatives in detail we ask ourselves one essential question: How was the revaluation of deposits made with an effect of 5? Which calculation method was applied? b) Which presentation alternative would you prefer in the statement of comprehensive income, and why? Neither nor. Initially, in tables and , page 70, the database involves some confusion with respect to the maturity or LIBOR-curve of the loan and the IRS. At various points instead of 6-month it says 6-year as described in paragraph verbally ( a 6-year IRS ). Besides this, the tables in and consistently show an error in the calculation of revenue expenses, because for 6 months the expenses only amount to 1.49/2 or 0.75 in the first half-year 20X1 and so on. We think that the line Interest expenses is totally flawed. Also the accurate calculation of the IRS, say receive floating (6m L) and pay fix (6y fix) for only 80% already missing.

18 18 c) Please provide details of any alternative presentation in the statement of financial position and/or in the statement of comprehensive income that you think would result in a better representation of dynamic risk management activities. Please explain why you prefer this presentation taking into consideration the usefulness of the information and operational feasibility. Given the database, a treasurer will hedge the net open with the following result: NII The ALM-treasurer enables hedging of the net open position arising from changes in the market interest rate nearly perfectly. The net interest income (NII) is stable over time. For more details (calculation and so on) see Appendix A. Question 19 Presentation of internal derivatives a) If an entity uses internal derivatives as part of its dynamic risk management, the DP considers whether they should be eligible for inclusion in the application of the PRA. This would lead to a gross presentation of internal derivatives in the statement of comprehensive income. Do you think that a gross presentation enhances the usefulness of information provided on an entity s dynamic risk management and trading activities? Why or why not? In our view it is only one alternative for ALM to manage interest rate risk positions from open portfolios (banking book) by transferring risk to the trading book, but internal derivatives are not necessarily common standard. It is also not unusual that treasurers go directly to the market without a detour through the trading department. However, if treasurers conclude an internal contract with the trader, the internal swap should be passed on the market (externalized) one-to-one with a written confirmation of the trader. The proposal of an AHA makes a clear separation between derivatives exclusively held for ALM-/hedging-purposes (long-term) and derivatives held for trading (HfT) to generate short-term profits: accrual accounting for long-term derivatives and fair value accounting for HfT-derivatives. This resulted in the net interest income independent from trading book being stabilized. An undesirable accounting mismatch belongs to the past. Also, an AHA in combination with passing ALM-derivatives directly to external counterparties does not influence the (consolidated) statement of comprehensive income the net profit or loss effect will be zero. Furthermore, if internal derivatives are permitted, a one-to-one externalization should be guaranteed. Trading book acts as a transit point changes in fair value of all other trading instruments would not be affected.