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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 [email protected] or [email protected]

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Page 1: The IASB's Discussion Paper on Accounting for Dynamic Risk ...events.unifr.ch/eufin16/Papers/Paper_7.pdf · 2014, the IASB published the Discussion Paper (DP) on Accounting for Dynamic

The IASB's Discussion Paper on Accounting for

Dynamic Risk Management - Evaluation of

Comment Letters

Working Paper16/01

Edgar Löw/Sebastian Mauler1

Frankfurt School of Finance and Management

1 Please send comments to [email protected] or [email protected]

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TABLE OF CONTENTS

1. Introduction ................................................................................................................................. - 1 -

2. Overview: Discussion Paper on Accounting for Dynamic Risk Management ............................ - 2 -

3. Approach to Comment Letter Evaluation .................................................................................... - 5 -

4. Evaluation of Comment Letters................................................................................................... - 8 -

4.1 Difficulties with Current Standard and Need for a New Approach ..................................... - 9 -

4.1.1 Question 1: Need for a Specific Accounting Approach ............................................ - 11 -

4.1.2 Question 2a: Difficulties with Current Standard ....................................................... - 12 -

4.1.3 Critical Appraisal....................................................................................................... - 14 -

4.2 Scope of the PRA and Discussion About Obligatory Application .................................... - 15 -

4.2.1 Question 15: Scope of the PRA ................................................................................. - 17 -

4.2.2 Question 16: Mandatory or Optional Application ..................................................... - 23 -

4.2.3 Critical Appraisal....................................................................................................... - 25 -

4.3 Behaviouralisation within the PRA ................................................................................... - 27 -

4.3.1 Question 4: Elements of Behaviouralisation ............................................................. - 30 -

4.3.2 Question 9: Core Demand Deposits .......................................................................... - 36 -

4.3.3 Critical Appraisal....................................................................................................... - 39 -

4.4 Presentation of the PRA within Financial Statements ....................................................... - 40 -

4.4.1 Question 18: Presentation Alternatives ..................................................................... - 43 -

4.4.2 Critical Appraisal....................................................................................................... - 47 -

4.5 Overall Evaluation of the PRA .......................................................................................... - 48 -

4.5.1 Question 2b: PRA as Potential New Accounting Concept ........................................ - 48 -

4.5.2 Critical Appraisal....................................................................................................... - 52 -

4.6 Summary of Evaluation Results ........................................................................................ - 53 -

5. Outlook on Next Steps .............................................................................................................. - 55 -

5.1 IASB’s Evaluation of the Comment Period ...................................................................... - 55 -

5.2 Considered Approaches ..................................................................................................... - 56 -

5.3 Project Plan: Disclosures First........................................................................................... - 57 -

6. Conclusion ................................................................................................................................. - 59 -

REFERENCE LIST ........................................................................................................................... - 61 -

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TABLE OF FIGURES

Figure 1: Dynamic risk management within banks ............................................................................. - 3 -

Figure 2: The Portfolio Revaluation Approach ................................................................................... - 4 -

Figure 3: Comment letters by group .................................................................................................... - 6 -

Figure 4: Group composition of users and preparers of financial statements ..................................... - 6 -

Figure 5: Questions answered by frequency ....................................................................................... - 7 -

Figure 6: Evaluation of Question 1 ................................................................................................... - 11 -

Figure 7: Evaluation of Question 2a .................................................................................................. - 13 -

Figure 8: Scope alternatives of the PRA ........................................................................................... - 15 -

Figure 9: Evaluation of Question 15a ................................................................................................ - 17 -

Figure 10: Evaluation of Question 15b – Combination of risk mitigation scope and IFRS 9 ........... - 20 -

Figure 11: Evaluation of Question 15d ............................................................................................. - 22 -

Figure 12: Evaluation of Question 16a .............................................................................................. - 23 -

Figure 13: Evaluation of Question 16b ............................................................................................. - 23 -

Figure 14: Pipeline transactions ........................................................................................................ - 28 -

Figure 15: Core demand deposits ...................................................................................................... - 29 -

Figure 16: Evaluation of Question 4a ................................................................................................ - 31 -

Figure 17: Evaluation of Question 4b ............................................................................................... - 33 -

Figure 18: Evaluation of Question 4c ................................................................................................ - 34 -

Figure 19: Evaluation of Question 9a ................................................................................................ - 36 -

Figure 20: Evaluation of Question 9b ............................................................................................... - 38 -

Figure 21: Presentation alternatives in the statement of financial position ....................................... - 41 -

Figure 22: Actual net interest income presentation ........................................................................... - 42 -

Figure 23: Stable net interest income presentation ............................................................................ - 43 -

Figure 24: Evaluation of Question 18a .............................................................................................. - 44 -

Figure 25: Evaluation of Question 18b.............................................................................................. - 46 -

Figure 26: Evaluation of Question 2b................................................................................................ - 49 -

Figure 27: Predominant views on analyzed questions....................................................................... - 54 -

Figure 28: Proposed project plan ....................................................................................................... - 57 -

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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

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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 re-

designations, 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 17th

2014 the public was invited to

submit comment letters and thereby answer up to 26 questions posted by the IASB.

During this period 123 letters4 were submitted which are publicly available at the

IASB’s website.

2 Cf. IFRS Foundation (ed.) (2010), p. 2.

3 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.

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Despite some publications summarizing commentators’ aggregated views as well as

brief descriptions of reasoning regarding the important topics5, 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. 24.

7 IFRS Foundation (ed.) (2014b), p. 24.

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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 4.3.1. 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. 9.

9 Cf. IFRS Foundation (ed.) (2014b), p. 21.

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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. 8.

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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.

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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.

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

Financial markets associations Aggregate banking industry

(users of financial statements) (preparers of financial statements)

Banks:

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

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

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:

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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 sub-

questions (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

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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. 105. 14

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

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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 1st 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 39.86 17

See IAS 39.86 to IAS 39.101, IFRS. 18

Cf. Löw, E. (2015), p. 590 ff. 19

Cf. IFRS Foundation (ed.) (2014b), p. 11 f.

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replace IAS 39.20

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 one-

to-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 39.22

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. 9. 24

Cf. IFRS Foundation (ed.) (2014b), p. 20 f.

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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 4.3.

4.1.1 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. 22.

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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 4.2.1.

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.

4.1.2 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. 3. 28

Flores, F. (2014), p. 4. 29

Bradbery, D./Corbi, A. (2014), p. 3.

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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.”32

30

Cf. IFRS Foundation (ed.) (2014b), p. 12. 31

IFRS Foundation (ed.) (2014b), p. 23. 32

Reback, L. (2014), p. 3.

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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.34

4.1.3 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. 5. 34

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

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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. 56.

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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. 57. 37

Cf. IFRS Foundation (ed.) (2014b), p. 58 f. 38

Cf. IFRS Foundation (ed.) (2014c), p. 11. 39

Cf. Garz, C./Wiese, R. (2014), p. 295.

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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.

4.2.1 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 sub-

question, 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. 63. 41

IFRS Foundation (ed.) (2014b), p. 62.

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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. 6. 43

Lee, P./Miemietz, M./Goodhart, W. (2014), p. 3. 44

On this see for example Wehling, A./Saeglitz, H.J. (2014), p. 6 f. 45

Cf. Ernst & Young (ed.) (2011), p. 4.

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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 9.”49

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.”51

46

On this see for example Mulch, S. (2014), p. 22 f. 47

Cf. Hannah, D. (2014), p. 22. 48

Cf. Bancaria, A. (2014), p.5. 49

Adams, M. (2014), p. 15. 50

Cf. Mulch, S. (2014), p. 22. 51

Mezon, L. (2014), p. 4.

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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 above-

mentioned 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. 62. 53

Cf. Gallagher, S. (2014), p. 9.

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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 sub-

portfolio 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. 12. 55

Cf. Termer, T. (2014), p. 13. 56

Fuchs, E. (2014), p. 10. 57

On this see for example PricewaterhouseCoopers International Limited (ed.). (2014), p. 12. 58

Cf. IFRS Foundation (ed.) (2014b), p. 62. 59

On this see for example Schroeder, N. (2014), p. 3. 60

Cf. Rave, H./Kehm, P. (2014), p. 7.

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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. 6. 62

Cf. IFRS Foundation (ed.) (2014b), p. 62. 63

Cf. Viandier, M. (2014), p. 2. 64

On this see for example Patrigot, N. (2014), p. 8.

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respondent even notes that including other types of risk might result in a considerable

delay of the project.65

4.2.2 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. 7. 66

Cf. IFRS Foundation (ed.) (2014b), p. 64.

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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. 4. 68

Joyce, D. (2014), p. 17. 69

Maijoor, S. (2014), p. 16. 70

Huthmann, A. (2014), p. 11.

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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.

4.2.3 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. 20. 72

On this see for example Clifford, T. (2014), p. 8. 73

Cf. Peters, D. (2014), p. 13. 74

On this see for example Schneiß, U./Fieseler, U. (2014), p. 14.

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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 sub-

portfolios 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 4.2.1. 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. 64.

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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. 2. 77

Cf. IFRS Foundation (ed.) (2014b), p. 10.

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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. 26. 79

Cf. Spall, C./Tejerina, E./Harding, T. (2014), p. 18. 80

Cf. IFRS Foundation (ed.) (2014b), p. 26.

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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. 20. 82

Cf. IFRS Foundation (ed.) (2015a), p. 11. 83

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

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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.

4.3.1 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. 34. 85

Cf. Spall, C./Tejerina, E./Harding, T. (2014), p. 23. 86

Cf. IFRS Foundation (ed.) (2014b), p. 29.

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usefulness of information and consistency with the conceptual framework should be

taken into consideration.87

103 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. 28. 88

Cf. Poole, V. (2014), p. 5. 89

IFRS Foundation (ed.) (2015a), p. 41.

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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. 3. 91

Cf. Chng, S. (2014), p. 2. 92

Clifford, T. (2014), p. 6. 93

On this see for example Buggle, S. (2014), p. 6. 94

Cf. Schneiß, U./Fieseler, U. (2014), p. 6. 95

On this see for example Wong, E. (2014), p. 3. 96

IFRS Foundation (ed.) (2014b), p. 28.

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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.100

97

IFRS Foundation (ed.) (2015a), p. 46. 98

Cf. Ingves, S. (2014), p. 7. 99

On this see for example Jang, J. (2014), p.6. 100

Cf. Maijoor, S. (2014), p. 7.

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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. 6. 102

On this see for example Patrigot, N. (2014), p. 7. 103

Tovey, M./Lasik, M. (2014), p. 5. 104

Cf. IFRS Foundation (ed.) (2014b), p. 28.

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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 9.109

105

Cf. Chua, K. (2014), p. 5. 106

Cf. Chng, S. (2014), p. 2. 107

Cf. Scutt, S. (2014), p. 4. 108

Cf. Maijoor, S. (2014), p. 6. 109

Cf. Innes-Wilson, C. (2014), p. 2.

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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.111

4.3.2 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 sub-

question 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.”112

85 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. 4. 111

On this see for example Kilesse, A./Boutellis-Taft, O. (2014), p. 8. 112

IFRS Foundation (ed.) (2014b), p. 37.

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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 13.47 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. 36. 114

Cf. Chng, S. (2014), p. 2. 115

Cf. Kvaal, E. (2014), p. 7. 116

On this see for example Chien, L. (2014), p. 5. 117

Cf. Vaessen, M. (2014), p. 9. 118

Hannah, D. (2014), p. 15. 119

Rave, H./Kehm, P. (2014), p. 14. 120

Cf. PricewaterhouseCoopers International Limited (ed.) (2014), p. 8.

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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.122

66 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. 11. 122

Cf. IFRS Foundation (ed.) (2014b), p. 37. 123

Kilesse, A./Boutellis-Taft, O. (2014), p. 11. 124

Cf. Poole, V. (2014), p. 10.

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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.128

4.3.3 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. 16. 126

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. 12.

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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

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(aggregate adjustment alternative) and single net line item. The example of the DP is

used to illustrate the differences among those alternatives:

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.

DR/(CR)

Fair value

Assets

Retail loans 1000 11 1011 1000 1000

Commercial Loans 750 30 780 750 750

Debt securities 500 (20) 480 500 500

Dynamic risk management revaluation 21

Derivatives 25 25 25 25

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

4

Profit or loss from dynamic risk

management activities

Amortized

cost

Revaluation

adjustment Aggregate

adjustment

Single net

line item

Line-by-line

gross up

Presentation alternatives in the statement

of financial position

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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

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.131

130

Cf. IFRS Foundation (ed.) (2014b), p. 69 f. 131

Cf. IFRS Foundation (ed.) (2014c), p. 12.

in CU 30 Jun 20X1 31 Dec 20X1 30 Jun 20X2 31 Dec 20X2

Interest revenue 2.0 2.0 2.0 2.0

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 0.5 0.53 0.55 0.48

Revaluation effect from dynamik risk management 0.25 0.21 (0.67) (0.52)

Total profit/loss for the 6 month period 0.75 0.74 (0.12) (0.04)

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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.

4.4.1 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. 73. 133

IFRS Foundation (ed.) (2014b), p. 73.

in CU 30 Jun 20X1 31 Dec 20X1 30 Jun 20X2 31 Dec 20X2

Interest revenue 1.99 1.87 1.74 2.11

Interest expense (1.49) (1.37) (1.24) (1.61)

Net interest income 0.5 0.5 0.5 0.5

Revaluation effect from dynamik risk management 0.25 0.24 (0.62) (0.54)

Total profit/loss for the 6 month period 0.75 0.74 (0.12) (0.04)

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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. 22. 135

Cf. Peach, K. (2014), p. 16. 136

Cf. Joyce, D. (2014), p. 19. 137

Cf. Poole, V. (2014), p. 15.

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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.”143

138

Vaessen, M. (2014), p. 16. 139

On this see for example Peters, D. (2014), p. 15. 140

On this see for example Ludolph, S. (2014), p. 19. 141

Cf. Rave, H./Kehm, P. (2014), p. 22. 142

Maijoor, S. (2014), p. 17. 143

Faull, M. (2014), p. 7.

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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. 73. 145

On this see for example Schneiß, U./Fieseler, U. (2014), p. 14. 146

On this see for example Bertl, R. (2014), p. 13.

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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.”148

4.4.2 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. 18. 148

Vaessen, M. (2014), p. 17. 149

Menk, M./Rissi, R./Spillmann, M. (2014), p. 18.

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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.

4.5.1 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. 23.

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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. 3. 152

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

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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. 7. 154

Kenny, M. (2014), p. 1. 155

Cf. Chien, L. (2014), p. 3. 156

Cf. Tovey, M./Lasik, M. (2014), p. 3 f. 157

On this see for example Kvaal, E. (2014), p. 7.

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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. 3. 159

On this see for example Innes-Wilson, C. (2014), p. 2. 160

Cf. Patrigot, N. (2014), p. 5. 161

Cf. Barbett-Massin, M. (2014), p. 3. 162

Croteau, L. (2014), p. 2.

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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 2.163

4.5.2 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.

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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 4.2.3 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.

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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.

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%

Section 4.2

Section 4.3

Section 4.4

% of answers that share

predominant viewPredominant viewSubjectQuestion

Section 4.1

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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 20th

2015.

5.1 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.

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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.167

165

Cf. Yamashita, Y./Dasgupta, K. (2015), p. 1. 166

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

Cf. Yamashita, Y./Dasgupta, K. (2015), p. 9 f.

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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.169

5.3 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.

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Figure 28 illustrates the three project phases as suggested by the paper. The first phase

will focus on disclosures-only by considering “(…) information that is currently

provided to users by entities in the form of existing GAAP, non-GAAP measures and

regulatory requirements and build on the previous work done by staff when developing

the DP in the area.”170

The key focus will be on how to best address the need to better

understand drivers and sources of an entities’ net interest income via disclosures. With

regard to behaviouralisation, the staff will explore present regulatory requirements

demanding entities to disclose details about assumptions and models for core demand

deposits in order to ensure transparency. Once the appropriate range of disclosures in

the financial statements has been determined, the IASB could move on to the second

phase. During this phase, the IASB could benefit from the experiences and knowledge

from the first phase with a clearer picture on how to reconcile varying information

needs among stakeholders within primary financial statements via recognition and

measurement. The final stage will include considerations of other types of risk being

dynamically managed, for instance foreign exchange or commodity price risk. The

inclusion of other types of risk at a later stage could inter alia be justified by the fact

that the comment period revealed a rather low priority for other risks while most

pressing needs were articulated for dynamic interest rate risk management. Due to the

opposing views that prevailed during the comment period, the paper suggests to

constitute an Expert Advisory Panel to assist the IASB in developing a new approach

for accounting for dynamic risk management. However, this should happen at a later,

not yet defined stage, as a term of reference and a necessary skill set for participants

should first be definied. According to the paper, this is best possible after further

deliberations by the IASB.171

The staff paper formed the basis for the discussions at a public meeting of the IASB

from May 18-20th

2015 in London. On May 20th

2015, the IASB discussed the next

steps as proposed by the paper and in unison agreed to follow the proposed project plan

as outlined. The IASB tentatively decided “(…) that it should first consider how the

information needs of constituents concerning dynamic risk management activities could

be addressed through disclosures before considering those areas that need to be

addressed through recognition and measurement; to prioritise the consideration of

170

Yamashita, Y./Dasgupta, K. (2015), p. 11. 171

Cf. Yamashita, Y./Dasgupta, K. (2015), p. 10 ff.

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interest rate risk and consider other risks at a later stage in the project; and to establish

an Expert Advisory Panel at a later stage in the project.”172

6. Conclusion

The evaluation of all comment letters with regard to key questions of the DP was

driven by the goal to create further transparency on the outcome of the comment period.

Beside the quantitative analysis of these questions, an explicit focus was on the

confrontation of opposing arguments for individual problems.

This working paper revealed that the view on the PRA concept in general is not

homogeneous and remains to be further discussed. It was shown that the different views

are underpinned by substantial arguments that need to be seriously considered.

Especially due to the high number of commentators being unclear or undecided on their

view, many respondents argued that more details on the mechanism would be needed to

come to a final decision. Despite some ambiguous results, the evaluation also revealed

areas with a high degree of consensus. This includes for example the identification of

problems with current standards IAS 39 / IFRS 9. Being on the same side with regard to

the problems provides a solid basis to develop ideas on how to overcome these. Also,

respondents mainly agree that there is a need for a specific accounting approach for

dynamic risk management. Hence, the IASB can confidently refrain from adapting

general hedge accounting according to IAS 39 / IFRS 9 and continue to develop a

suitable model for accounting for dynamic risk management from scratch. Further,

respondents seem to prefer an optional application of the PRA with a risk mitigation

scope which, as explained previously, mainly addresses accounting mismatches arising

from dynamic risk management. Lastly, respondents in aggregate broadly agree that a

new standard should include behaviouralised elements, especially core demand

deposits, which seem to play a significant role in a commercial bank’s risk management

activity.

Besides the evaluation of questions on an aggregate level, specific analysis was

conducted for preparers of financial statements, namely the aggregate banking industry

and users of financial statements, represented by financial markets associations. This

procedure was founded on the initial presumption that both groups might have at least

partly conflicting interests in respect of the depiction of dynamic risk management in

172

IFRS Foundation (ed.) (2015b).

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financial statements. With regard to the evaluation of the PRA in general, no significant

differences did prevail: Both parties show an ambiguous result, each with a significant

share of supporters, opponents and undecided entities. While users of financial

statements in general also support an optional application of the PRA with a risk

mitigation scope, a comparably higher share also opted for a dynamic risk management

scope and a mandatory application. Differences also prevailed for certain elements of

behaviouralisation: While both parties mainly agree on the inclusion of core demand

deposits, users of financial statements emphasize conflicts with the conceptual

framework as well as involved subjectivity for pipeline transactions and the EMB.

Further research is necessary on how risk management is practiced in reality within

different banks. The topic is much too important to just rely on the argumentations of

banks. If risk management should be illustrated within the financial statements there has

to be a certain (accounting) system (being in line with the framework of accounting)

worked out. Within that research there is a need for a comparison of both regimes, the

accounting system where earnings managements should be restricted and internal risk

management where companies are free in the structure. Afterwards it has to be shown

qualitatively as well as quantitatively which part of internal risk management and

treasury activity cannot be included into an external accounting system and how big the

information lag would be. In summary, despite the consensus on several questions,

some parts of the evaluation showed conflicting interests that have to be balanced

carefully in the future.

In its search for consensus on recognition and measurement, the IASB should clearly

keep in mind which goal it wants to pursue. Especially, considerations on which

exposures to include are of high importance. They have to be based on a sound decision

about the ultimate goal of the project. This should not be either a decision to focus on

accounting mismatches and reduce earnings volatility or a decision to focus on a faithful

depiction of the effects of an entity’s dynamic risk management by also showing profit

and loss effects of open risk positions. A decision in favor of avoiding accounting

mismatch would open the question why at all derivatives should be on balance if

afterwards the entire effect would be eliminated from profit or loss. The global financial

crisis showed that there is an increasing need for transparency on a bank’s risk position.

As these risk positions usually are managed dynamically, a new approach on accounting

for dynamic risk management constitutes a significant pillar to enhance transparency.

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Thus, a solid accounting standard in the area of accounting for dynamic risk

management has the potential to further stabilize the financial system as a whole.

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