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IAS 39 and Macro Hedging – a significant win for the banking industry? Back  
The recent proposal by IASB in relation to IAS 39, and the use of macro hedging, should allow banks to apply macro hedging to their loan and deposit book, something the banking industry has long been calling for writes Glenn Gillard.
WWith the requirement for EU listed companies to prepare consolidated financial statements under International Financial Reporting Standards (IFRS) fast approaching, the International Accounting Standards Board (IASB) is continually revising the current standards to allow for a smoother transition from existing accounting rules to IFRS. The most recent development has seen the IASB revisit its controversial standard on financial instruments, IAS 39. This is not the first time in recent history that the IASB has addressed this standard. However, the previous amendments did not address one of the key issues - macro hedging. On 21 August 2003, the IASB published its proposal in relation to the use of macro hedging (sometimes referred to as ‘portfolio hedging’). The proposal looks solely at the use of macro hedging in respect of interest rate risk.

What is macro hedging
Hedging is the use of financial instruments, typically derivatives, to mitigate financial risks of another financial instrument. Macro hedging is a technique whereby financial instruments with similar risks are grouped together and the risks of the grouping or portfolio are hedged together. Often this is done on a net basis with assets and liabilities included in the one portfolio. For example, banks, instead of using interest rate swaps to hedge interest rate exposure on a loan-by-loan basis, hedge the risk of their entire loan book or specific portions of the loan book.

Current status of macro hedging
Macro hedging is widely used as a risk management tool. The current requirements within IAS 39, which allow an entity to avail of hedge accounting on a portfolio basis, are very onerous and have been branded as unworkable by the banking industry. The industry maintains that even when macro-hedging treatment can be achieved the cost and effort required to document, monitor and measure the effectiveness of a hedge outweighs any benefit.

However, if an entity cannot avail of hedge accounting all derivatives held by the entity have to be marked to market with all movements going through the profit and loss account. As the opposite side of the hedge, the loans or deposits, are held at amortised cost and not marked to market, the result is greater volatility in the profit and loss account. The banking industry has argued that this volatility does not reflect the actual economics of the portfolio hedges and penalises banks that have a good and active risk management process.

Proposed changes
The proposed changes are aimed directly at addressing the concerns of the banking industry by focusing on fair value macro hedging for interest rate risk. The exposure draft provides a simpler mechanism, which should allow banks to apply macro hedging to their loan and deposit book. A summary of the approach outlined in the exposure draft is as follows:

1. An entity identifies a portfolio of items whose interest rate risk it wishes to hedge. The portfolio may include both assets and liabilities.
2. The entity analyses the portfolio into time periods based on expected repricing dates
3. The entity can designate a percentage of assets (or liabilities) from the time periods as the item to hedge. The individual assets in the time period must be items whose fair value changes in response to the risk being hedged and which could have qualified for hedge accounting on an individual basis. The time periods must be sufficiently narrow so that the fair value of each item moves proportionately to changes in the interest rate risk hedged
4. The entity designates what interest rate risk is being hedged. This risk can be a portion of the interest rate risk in each of the items in the portfolio, such as a benchmark interest rate like LIBOR.
5. The entity designates a hedging instrument for each time period. The hedging instrument may be a portfolio of derivatives (for instance, interest rate swaps) containing offsetting risk positions
6. The entity measures the change in the fair value of the hedged item (from step 3) that is attributable to the hedged risk (from step 4). The result is recognised in the profit and loss account and as a separate asset (or liability) on the balance sheet adjacent to the relate asset (e.g the loans book).
7. The entity measures the change in the fair value of the hedging instrument and recognises it in the profit and loss and as an asset or liability in the balance sheet (this is in accordance with the general requirement for accounting for derivatives).
8. In the scenario, where the hedge is one hundred percent effective the net effect on the profit and loss is zero thus eliminating the volatility concerns noted above. However any ineffectiveness in the hedging relationship will be recognised in the profit and loss as it occurs (effectively the difference in the amounts determined under steps 6 and 7).

One key limitation is that demand deposits and similar items with a demand feature cannot be designated as a hedge item for any period beyond the shortest period in which the counterparty can demand repayment. Thus this effectively excludes deposits which are payable on demand from hedge accounting.

By introducing the ability to select a percentage of assets in each time period from a portfolio as the hedged item, the proposal seeks to eliminate one of the key difficulties under the current rules for portfolio hedging interest rate risk, that is, the changing composition of the hedged items due to considerations such as prepayment of loans. This change should allow banks to achieve hedge accounting using their current portfolio hedging strategies. The proposals still require a significant amount of documentation and monitoring especially around the identification of the portfolio, the division into time periods and the subsequent measuring of the effectiveness of the hedging relationship. These requirements may put a significant strain on systems and resources but should provide a better fit with existing risk management systems.

Although the IASB has requested public comment on the exposure draft they have emphasised that the proposals were the result of extensive consultation with all interested parties and especially with banking representatives. While further comment is welcomed, significant changes should not be expected. It will be interesting to see how the banking industry reacts to the exposure draft in the coming weeks and months. Public comment to date has been mixed and there may still be some way to go before the international banking industry is satisfied that IAS 39 and the provisions around hedging will be workable in practice.

Glenn Gillard is a financial services manager in the Audit & Assurance practice of Deloitte & Touche

1. Exposure Draft of Proposed Amendements to IAS 39 Financial Instruments Recognition and Measurement: Fair Value Hedging for a Portfolio Hedge of Interest Rate Risk

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