First in a series of articles by Zanders introducing the Dynamic Risk Management model proposed by the IASB to revolutionize hedge accounting for dynamic portfolios
The current standards for hedge accounting present significant challenges for financial institutions engaged in dynamically hedging their portfolios. The corresponding type of hedging accounting, known as “macro fair value hedge accounting”, is covered under IAS 39; however, the regulations fall short as they are unable to accurately reflect an organization’s risk management strategies in its financial reporting. In some instances, companies cannot apply hedge accounting as their hedge is deemed to be ineligible unless they perform some form of proxy hedging strategies. To address these issues, the international Accounting Standards Board (“IASB”) have introduced the Dynamic Risk Management (“DRM”) approach, which is intended to offer a more effective method for entities to apply macro hedging.
The current timeline by the IASB is for a first draft to be released in 2025. This article forms the first in a series of three that will delve into the DRM model, explore its improvements over the current regulations and provide a demonstration of a practical implementation of the current proposal. The insights provided within this series, are Zanders’ understanding drawn from the discussion papers that the IASB has released and so the information is subject to change before the publication of the draft in 2025.
The IASB is aiming for the DRM model to allow readers of the financial statement to gain the following insights:
The entity’s interest rate risk management strategy and how it is applied to manage interest rate risk.
How the entity’s interest rate risk management activities may affect the amount, timing and uncertainty of future cash flows.
The effect of the DRM model on the entity’s financial position and financial performance.
Within the May 2022 Staff Paper1, the IASB staff have identified a list of deficiencies of the current IAS 39 and IFRS 9 standards. The main limitations identified were:
Number
Area
Description of limitation
1
Closed Portfolios
The current regulations are designed for “closed portfolios” and requires the direct linkage of hedged items with a hedge. This causes problems as currently an “open portfolio” would be viewed as a set of multiple “closed portfolios”, each with short periodic lifespans. This leads to challenges, as any “open portfolio” hedge relationships need to be tracked individually and its hedge adjustments amortized accordingly.
2
Risk Management on a net basis
Generally, entities will manage their exposures to interest rate risk on a net basis. However, currently hedges need to be managed on a gross basis. This means that interest rate risk management can be incorrectly represented to achieve the accounting requirements.
3
Dual character of net interest rate risk position
The repricing risk of the net interest rate risk position arises from a combination of variable and fixed-rate exposures. The economic mismatch has both fair value and cash flow variability when interest rates change, and entities try to mitigate both aspects economically. However, the current hedge accounting requirements state that the hedging relationship must be designated as either a fair value hedge with the fixed rate item or as a cash flow hedge with the variable item.
4
Demand deposits
Under the current regulations demand deposits cannot be hedged by banks as, from an accounting perspective, the fair value is constant. Since banks are unable to apply hedge accounting to demand deposits, they cannot accurately portray their risk management within the financial statements.
Table 1: Limitations of Current Standards
The next two articles in this series will provide a comprehensive exploration of the DRM model and introduce the new concepts that the IASB has proposed. The next article offers a breakdown of the Risk Management Strategy (“RMS”) within the DRM model, how it factors into a company’s overarching strategy for managing their interest rate risk. It will cover the new concepts that the IASB have established. The third and final article in this series will provide an overview of the DRM cycle as well as an example taken from the IASB of how the DRM model would be applied in practice for a singular accounting period. Stay tuned!
What can Zanders offer?
Transitioning to the new DRM model can be difficult due to the dynamic nature of the model, especially with a more complex balance sheet. Zanders can provide a wide range of expertise to support in the onboarding of the DRM model into your company’s hedging and accounting. We have supported various clients with hedge accounting– including impact analyses, derivative pricing and model validation, and are familiar with the underlying challenges. Zanders can manage the whole project lifecycle from strategizing the implementation, alignment with key stakeholders and then helping design and implement the required models to successfully carry out the hedge accounting at every valuation period.
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