Hedging and Hedge Accounting

IFRS – Global Reporting RevolutionMarch 2003

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The IFRS Revolution

Welcome to the fourth in a series of papers dedicated to discussing InternationalFinancial Reporting Standards and the impact on the banking industry. IFRS ismuch more than just a technical issue and, based on the current proposals, willresult in fundamental changes to the way in which the industry does business.

The impending requirement for EU listed companies to adopt IFRS, and inparticular IAS 39 Financial Instruments – Recognition and Measurement whichdeals with hedge accounting, will create a number of major challenges whichcannot be underestimated.

I hope that you will find this paper thought-provoking and insightful. If youwould like to discuss any of the issues addressed in more detail, please speakwith your usual contact at PricewaterhouseCoopers or those listed at the end ofthis paper, as this helps us to ensure that we are addressing the issues that youare most focused on.

John HitchinsUK Banking Leader

Introduction

IAS 39 Financial Instruments – Recognition and Measurement will create a number of

significant issues for banks. This paper deals with some of the more significant issues

around hedging.

Most UK financial institutions which use derivatives extensively follow the high

level principles set out in the British Bankers Association Statement of Recommended

Practice (‘the BBA SORP’) on Derivatives. The BBA SORP gives in general terms, the

principles which should be applied: ‘Non-trading transactions should be clearly

identified and their purpose clearly documented at the outset and an on-going

assessment should be undertaken to confirm that such transactions do in fact manage

the risk to the degree sought.’

While the requirements of IAS 39 are not inconsistent with the BBA SORP’s principles,

there are now specific and, importantly, much more onerous requirements, principally

in the area of documentation and demonstration of effectiveness, to be met before

hedge accounting can be applied.

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Cause for concern

Why should this standard be acause for significant concern forbanks? The key factor is that IAS39 requires that effectively allderivatives be held on thebalance sheet at fair value, withthe changes in the fair value ofthose instruments beingrecognised through the profitand loss account. Whereinstitutions are using derivativesto hedge exposures accountedfor on an accruals basis theyface the prospect of having totake changes in the fair value ofthe hedging instrument to theprofit and loss account withoutbeing able to recognise theassociated changes in the

underlying hedged instrumentunless some very complex and restrictive rules for hedgeaccounting are followed. For organisations with

substantial portfolios of hedgingderivatives this would exposetheir reported profitability tosignificant volatility if hedgeaccounting cannot be achieved.

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– designate– select risk

– track – monitor

– document– effective test

Hedging

Trading

Assess regularlyHedgecriteria

PASS

FAIL

Institutions need to consider thechallenges of IAS 39 now. Whilethere are frequently goals thatcan be achieved easily forcertain significant transactionswithin a retail financialinstitution, they should notunderestimate the challengesand complexities of consideringthe questions posed by IAS 39 inthe areas of hedging of pipelineexposure and achieving hedgeaccounting for the derivativesused to manage interest rateexposure on mortgage books. It is certain that most, if not all,institutions will have to acceptsome degree of volatility as aresult of their use of derivativeinstruments, however there are anumber of actions which can betaken that will enable much ofthis volatility to be removed.

A number of institutions whohave US GAAP as theirsecondary reporting frameworkhave already been subject to therequirements of US FinancialAccounting Standard 133 (‘FAS133’) which has similar hedgeaccounting rules to IAS 39.

Experience with these Securitiesand Exchange Commission (SEC)Registrants has shown that a largenumber of banks have notattempted to apply the US rulesand have accepted the resultingearnings volatility in theirreported balances for US GAAPreconciliation purposes (20-F).Most organisations do not,however, consider this acceptablewhen it begins to impactreported results in their primaryGAAP, i.e. their primary‘reported profit measures’.

A large number of institutionswill therefore need to address thechallenging issues within IAS 39if they are to avoid unpleasantand unwanted earnings volatility.Addressing such problems is farfrom a straightforward matter.Given the requirements underIAS 39, it is important for banksto consider the impact of theirhedging activities on theirfinancial results as soon aspossible. A bank wishing toconvert to IFRS for the year-end31 December 2005 whichrequires two years of

comparatives, will need to havecomplied with the hedgingregulations from 1 January 2003,although the SEC may yet give adispensation of some form.

A Question of Guidance

IAS 39 poses a number ofsearching questions, but notsurprisingly, given thecomplexity of the subject it doesnot always specify the level ofdetail and rigour that would beacceptable for the adoption ofhedge accounting. This lack ofclarity is a key concern becausethe consequences of not beingable to adopt hedge accountingcould be considerable for an organisation.

The potential consequences ofnot meeting the criteria gobeyond the issue of earningsvolatility. The adoption in theUnited States of FAS 133 saw the SEC requiring publicrestatement of the accounts ofinstitutions which had notcomplied with the hedgingdocumentation requirements.

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Banks wishing to adopt hedgeaccounting need to getcompliance with therequirements right first time. It has always been important forbanks to comply with financialreporting requirements, but in thecurrent climate the consequencesof non-compliance are muchmore severe. Accordingly,institutions are naturallyconcerned as to how to addressthe questions of quality andsufficiency of documentationand the development of robusthedge effectiveness testing.

Documentation

IAS 39 requires key informationabout the hedging relationshipsto be formally documented priorto hedge accounting treatmentbeing applied, this may be at thedate of inception of the hedginginstrument or a subsequent date.Failure to establish thisdocumentation will mean hedgeaccounting cannot be adoptedregardless of how effective thehedge actually is in offsettingrisk. Organisations will need to consider how muchdocumentation is required

and what level of detail thereshould be.

IAS 39 sets out the areas thathedge documentation shouldcover, but does not go as far asgiving specific examples of pro-forma documentation. Manybanks will consider developingtheir own pro-formadocumentation that can be usedfor all types of hedge. Theadvantage the pro-formaapproach brings is that it ensuresa consistent standard ofdocumentation for all of anorganisation’s hedges and thatthe key information is capturedeach time. However, it isimportant to note that a highlevel of detail will be needed in the hedge documentation inareas such as describing howeffectiveness will be measured. A good test of the level of

documentation is whether itwould be sufficient to enable athird party to re-perform theeffectiveness testing. Therefore,there must be robust reviewprocedures in place to ensureongoing compliance. It is alsoimportant to recognise that theestablishment of documentationis a prospective matter. Therequisite documentation must beput in place prior to theadoption of hedge accounting.

A common misconception is thatthe failure to put hedgedocumentation in place at thedate of execution of the hedgingitem prevents the adoption ofhedge accounting for aparticular relationship at a laterdate. However, Hedgeaccounting can be adopted laterbut only from the date when thedocumentation was put in place.

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Example 1:

If Bank A undertakes to hedge a fixed rate loan issued on 1 January 2003with a fixed versus floating rate interest swap, also executed on 1 January2003, but has not put the hedge documentation in place until 1 May 2003,then Bank A can begin to hedge account for the swap from 1 May 2003,providing that it passes the effectiveness tests but must recognise in theincome statement the fair value movements on the swap for the four monthperiod between January 1 and April 30 when the documentation was not in place.

Hedge effectivenesstesting

In addition to the documentationof the hedging relationship IAS39 requires organisations toprove that their hedginginstruments are indeed ‘effective’in mitigating the hedged risk orvariability in cashflows in theunderlying instrument. It istherefore very important thatbanks are specific about thenature of the risk that they arehedging, as this will tie directlyinto the effectiveness testing.

There is no specific method for testing hedge effectivenessprescribed by IAS 39 soorganisations wishing to adopthedge accounting will need todesign, build and implementeffectiveness tests. However, IAS 39 discusses the need fortwo distinct types of testing.

Firstly, at inception of the hedgethe hedging relationship must beshown to be effective on aprospective basis, i.e. that thehedge is indeed expected to beeffective. The level ofeffectiveness required forprospective effectiveness in IAS39 is that the risks are ‘almostfully offset’. Whilst no numericalrange has been formally given asmeeting the ‘almost fully offset’criteria, it is viewed in practicethat the changes in the value orcashflows of the hedged item areexpected to be at least between95% and 105% of the changesin value or in the cashflows ofthe hedging instrument.

Secondly, there is a requirementto show that the hedge wasactually ‘highly effective’ on aretrospective basis. Here thedefinition of ‘highly effective’ is slightly less strict than forprospective testing, the rangebeing given within IAS 39 as80%-125% effective.

Hedge Effectiveness Tests

Guidance as to what is and is not an effective hedge doesnot, however, completelyaddress the question of whatconstitutes an acceptable hedgeeffectiveness test.

In practice there are a number ofgeneral factors to consider whenlooking at hedge effectiveness,including which one of a rangeof methods to use, from theintuitively straightforward, to themathematically sophisticatedproposed in the United Statesfollowing the introduction of FAS 133.

It is critical to consider carefullythe method of effectivenesstesting adopted, since the carefuldesign of an effectiveness testcan mean the differencebetween a hedging relationshippassing and failing the test.Furthermore many of thepopular methods do not

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necessarily produce consistentresults. Some hedge effectivenesstests will show a relationship tobe ineffective whereas othermethods may indicate a highdegree of effectiveness. This ishighlighted by looking at themost common method of testingeffectiveness the so-called ‘dollaroffset method’.

The dollar offset method has theadvantage of being easy tounderstand and to implement,providing the institution has thesystems capability to generatefair values for the instrumentsconcerned. In basic terms itcompares the ratio of the changesin fair value of the hedged itemand the hedging derivative. Theproblem with this method is thatwhere the underlying hedged

item is affected by a smallchange in value in a period, thetest often fails hedges evenwhere the cashflows and termsare highly correlated. As anillustration consider thescenarios given below (seeExample 2).

In both scenarios there is anabsolute difference of 1,000 in thechange in fair value of the hedgeditem and hedged instrument, butin Scenario A because thechanges in fair value are small thisleads to a failure of a test whereasin Scenario B, the relationshipappears highly effective.

This problem can be avoided byusing more advanced techniquessuch as a statistical regressionbased test. However, such

techniques are intuitively lessobvious and more timeconsuming to implement.

A further complication is that thechoice of hedge effectivenesstest cannot be made by lookingat each hedging relationship inisolation. Banks will need tobear in mind that where amethod of assessing is adoptedfor a particular hedgingrelationship there is therequirement that the samemethod will be applied to allsimilar hedges, groupwide.

A final point to note on themethods of assessingeffectiveness is that IAS 39 doesnot permit the use of the ‘short-cut method’ which is allowed byFAS 133, whereby if the criticalcontractual terms of individualhedged item and hedginginstrument match, then thehedge can be assumed to be100% effective. Many UKorganisations currently applyinghedge accounting for any USGAAP reporting will need torevisit their hedge

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Example 2:Scenario A Scenario B

Change in Fair Value

Hedged Item due to Hedged Risk 1,000 99,000

Hedging Instrument 2,000 100,000

Dollar-Offset Effectiveness 50% 99%

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documentation to ensure thatthey are not relying on the short-cut method when hedgeaccounting under IFRS. This maylead to the need to commenceeffectiveness testing.

Frequency of EffectivenessTesting

IFRS requires the performance ofeffectiveness testing at least asoften as the release of publiclyavailable financial reporting. Are there benefits to undertakingeffectiveness testing morefrequently than required by theaccounting standards?

This is a decision that will needto be weighed up by banks, theyshould balance the costs andeffort required in conductingfrequent testing against thebenefit achieved. If the hedgeeffectiveness test fails for aperiod then all of the movementson the hedging instrumentduring that period must be takento earnings, so in essence thelonger you leave it the worse itcan be. Therefore, although it iscostly for hedge effectivenesstesting to be undertaken morefrequently, if the test is failedduring any one period, anddepending when it fails, there is

a shorter timeframe over whichearnings are directly impacted.

The hedge accounting rules willalso have to be accompanied bya change in processes, andpotentially behaviour, as it isrecognised that a hedge beingeconomically effective does notnecessarily imply that the hedgewill be effective for accountingpurposes. A number of UKorganisations have alreadybegun to analyse the potentialeffectiveness of their currenthedging strategies from an IFRSperspective and to investigatealternative strategies which wouldmeet hedge effectiveness criteriawithout significantly changingthe economic substance orincurring excessive costs.

Macro-hedging and‘Consolidated’ interestrate risk management

The hedging of interest rate andother risks at a consolidatedmacro level is a commonpractice in the banking industry,owing principally to theeconomies of scale that it offersinstitutions given the tens ofthousands of individualexposures of a typical bank. Of

the many challenges that IAS 39raises for the banking industry,some of the most contentious arethe rules surrounding thispractice of macro-hedging.

The key IAS 39 requirement isthat there should exist a directone-to-one linkage between thehedging instrument and thehedged item. In practice, manyhedging relationships are on amany-to-one basis for examplethe situation where a mortgagelender hedges the interestexposure on the fixed rateportion of its portfolio using aninterest rate swap. Here a singlederivative has been used tohedge the exposure on a largenumber of individual mortgages.In order to consider theapplication of hedge accountingto this situation it is necessary tolink the swap on a mortgage-by-mortgage basis.

Practical experience has shownthat although the mortgageportfolio can be analysed itemby item, there are considerablepractical difficulties, such asbeing able to match the hedgingderivatives against the individualadvances to customers, givencurrent system specifications.Further, even if this can be

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achieved, the strictness of the‘almost fully offset’ requirementof the prospective test foreffectiveness means that almostany dissimilarity in the terms ofthe individual item being hedgedand the derivative will lead to afailure in the effectiveness test.Under IFRS it is possible to havea single hedging instrument for aportfolio of identical assets,however a considerable degreeof analysis will be required toidentify assets which aresufficiently similar to pass thetests. Overall, the currentmethods typically used by retailand some wholesale banks areunlikely to enable effectivenessto be proven on an instrument-by-instrument basis.

As a consequence many retailbanks will be facing thepossibility of the volatility on thefair value changes on theircurrent hedging instrumentsaffecting their earnings. From afinancial reporting perspective,many institutions will considerthis to be an unacceptablesituation and they will need tore-evaluate their hedgingstrategies in light of the newstandard. With new andcomplex products beingdeveloped in the industry,

effecting an accounting hedgewill become increasinglychallenging. Those bankshedging pools of assets whichredeem faster or slower thanexpected may need to take out alarge number of smaller swaps tomatch the maturity profile ratherthan one large swap, which willclearly be more costly.

For banks that have portfolios ofassets and liabilities and are notable to undertake micro hedging,IAS 39 in its ImplementationGuidance Question and Answers121-2 (‘IGC 121-2’) gives amethod whereby entitiesdesignate a single asset orliability with the samecharacteristics as the whole net

portfolio to be the hedged item.The intricacies of this processcan be illustrated by means of an example (see Example 3).

Another challenging problem forretail financial institutions hasbeen, and will continue to be,the application of hedgeaccounting for hedginganticipated, or pipelinetransactions. Current UK GAAPallows the hedging of suchtransactions, provided there is areasonable expectation that theanticipated transaction will beundertaken. IAS imposes morestringent criteria over theexpectation beyond just areasonable anticipation.Accordingly, how a bank

Example 3

A bank has a portfolio of interest rate bearing assets of 90, interest-ratebearing liabilities of 100 and it wishes to hedge the net interest rateexposure via an interest rate swap with notional 10. Following the guidanceof IGC 121-2, the bank would designate the swap as the hedge of aparticular liability of 10, put in place appropriate documentation andcommence effectiveness testing.

At a later date the asset profile of the bank has changed, such that it nowhas assets of 110, but liabilities of 100. If the bank wishes to hedge the netinterest rate risk exposure and takes out a swap with notional 20 to gain theappropriate exposure (from hedging a net liability of 10 to an asset of 10), it will need to designate the second swap as the hedge of an asset of 20.

Experience in territories where IAS has been implemented has shown thatthis process of designation and testing of effectiveness is a complex onerequiring considerable investment in developing suitable systems.

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chooses to hedge its pipeline riskwill need to be given carefulconsideration, and future hedgesmay need to be undertaken insmaller tranches for theassociated additional costs.

Systems and resources

The above issues highlight thathedging will have a majorimpact for institutions in theareas of both systems andresources. Where anorganisation undertakes asignificant volume of hedgingtransactions then the manpowerrequired to establish andmaintain documentation,identify and monitor the hedgedand hedging items and conducteffectiveness testing can beconsiderable. Existingtransactional level systems areunlikely to be configured toallow the designation and

documentation of hedges and toperform the associated hedgeeffectiveness testing.

Commercially available ITsolutions addressing these issuesare beginning to be developedby software providers. Suchsolutions will primarily bemeeting the requirements ofbanks undertaking smallnumbers of hedging transactionsand implementingstraightforward hedgingstrategies. Organisations lookingat undertaking some of thedesignation and re-designationstrategies of IGC 121-2 orundertaking hedge effectivenesstesting beyond the simple dollaroffset or regression methods mayfind the packages insufficientlyflexible without extensivemodifications.

Some organisations will need or choose to build dedicated

systems that maintain theunderlying data andautomatically conducteffectiveness testing. Such systems by their nature arecomplex and cannot bedesigned and built easily orcheaply given the cost ofemploying suitable IT resources.Experience has shown that evenwhen such systems are past thedevelopment phase considerabletime will be spent in testing thesystems given the complexnature of the task that it willperform. A challenge forinstitutions will be to weigh the costs of meeting therequirements for hedgeaccounting against theconsequences of the potentialearnings volatility arising by notimplementing hedge accounting.Hedging strategies may have tobe simplified greatly, purely onthe grounds of the systems costsneeded to maintain them.

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Conclusion

The introduction of IAS 39 willradically change the ability ofUK financial institutions toachieve hedge accounting,resulting in increased earningsvolatility. Many will feel thiseffect to be sufficiently severe or misleading of the ‘true’ (or economic) performance that it justifies incurring theadditional costs needed toachieve hedge accountingtreatment. Management ofinstitutions are advised toconsider the matter of hedgeaccounting thoroughly and assoon as possible to ensure thatthey are making an informeddecision and putting in place themost appropriate course of action.

With the potential difficultiesinherent in achieving hedgeaccounting, putting in theprocesses which will ensurecompliance may involvesubstantial effort and resourcesand involve a timescaledenominated in months andyears rather than days. Given thetimetable for the introduction ofIFRS, institutions need to bedeciding on their strategy now.

PricewaterhouseCoopers

If you would like to discuss any of the issues raised in this paper, please speak with your usual contact atPricewaterhouseCoopers.

This paper was prepared by:

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John HitchinsUK Banking LeaderTel: 44 207 804 2497E-mail: john.hitchins@uk.pwcglobal.com

Ed JenkinsSenior Manager, UK Banking GroupTel: 44 20 7804 8043E-mail: edward.jenkins@uk.pwcglobal.com

If you would like additional copies of this paper, please contact Abigail Palmer via e-mail atabigail.palmer@uk.pwcglobal.com

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Etienne BorisTel: 33 1 5657 1029E-mail: etienne.boris@fr.pwcglobal.com

Michael CodlingTel: 61 2 8266 3034E-mail: michael.codling@au.pwcglobal.com

Burkhard EckesTel: 49 30 2636 2222E-mail: burkhard.eckes@de.pwcglobal.com

Jeremy FosterTel: 44 20 7212 5249E-mail: jeremy.foster@uk.pwcglobal.com

Bernard HeinemannTel: 41 1 630 25 77E-mail: bernard.heinemann@ch.pwcglobal.com

Edmund HodgeonTel: 34 91 568 5180E-mail: edmund.hodgeon@us.pwcglobal.com

Karen LoonTel: 65 6236 3021E-mail: karen.loon@sg.pwcglobal.com

Johan MånssonTel: 46 8 555 33044E-mail: johan.maansson@se.pwcglobal.com

John McDonnellTel: 35 3 1 704 8559E-mail: john.mcdonnell@ie.pwcglobal.com

Lorenzo Pini PratoTel: 390 6 57025 2480E-mail: lorenzo.pini.prato@it.pwcglobal.com

Arno PouwTel: 31 20 568 7146E-mail: arno.pouw@nl.pwcglobal.com

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