Hedge accounting under new environment

Process and system challenges to meet the new reporting requirements, bank will have to make major modifications to their existing processes and systems. In particular, processes and systems will be required to:

a.Identify and value embedded derivatives in contracts;

b.Analyze the components of earnings;

c.Disaggregate assets and liabilities into homogeneous pools and match derivatives with these pools to create viable hedging strategies;

d.Tag and track the changes in fair value and carrying amounts of individual instruments in each hedging strategy;

e.Calculate the fair values of both derivatives and hedged risks and track the changes in fair values;

f.Measure and track hedging effectiveness on a continuous, ongoing basis;

g.Adjust historical cost carrying values of individual items in a hedged portfolio for changes in the fair value being hedged; and,

h.Segregated income and expense items reportable for tax and financial reporting purposes.

To qualify for hedge accounting, each hedging transaction should be documented. Under IAS 39, a mere intention to hedge is not enough. Even having the terms of the derivatives match the underlying exposures does not ensure that hedge accounting will be applicable. Hedge accounting requires that hedge relationships must be designated and documented at the adoption date (or inception date for hedges entered into subsequently), and hedge effectiveness must be measured and monitored on an ongoing basis. The documentation for each hedging transaction should indicate the following:

a.Hedging instrument and hedge item;

b.Type of hedge, whether fair value, cash flow or net investment hedge;

c.Risk being hedged;

d.Risk management objective and hedging strategy; and

e.Method for assessing and measuring hedge effectiveness, both prospective and retrospective basis.

Failure to follow the strict designation and documentation rules prescribed by IAS 39 will result in non-hedge accounting treatment. Under IAS 39, hedge accounting is applied only upon compliance with the hedge accounting criteria, including the required documentation. Hedge accounting cannot be applied retrospectively (i.e., no backdating of documentation).

Internal hedging using centralized treasury

The issues of macro hedging care is important particularly for banks that historically have followed a practice of hedging exposures arising across the bank by entering into internal hedge transactions with the trading book or desk. The effect of this practice is that exposures created elsewhere in the bank can be used to form part of the positions of the trading desk. This prevents other units of the bank from transacting externally, which in turn means external trades are on a net basis, and reduced the number of transactions that the bank must make.

As a result of this practice, there are situations within the bank where business units execute derivatives transactions with the swaps desk to hedge interest rate exposures. The swaps book is managed on a portfolio basis and therefore, the specific positions created by these transactions may not be laid off externally on a one-on-one basis. This presents a problem under IAS 39, as these transactions would not constitute valid hedges for hedge accounting purposes.

Under IAS 39, it is not permitted to designate a net position (e.g., net interest exposure) as a hedged item, especially if the portfolio is comprised of financial instruments with different risk profiles (e.g., interested basis, repricing, maturity).

While accounting should not dictated on the risk management strategy of a bank, non-compliance with strict hedge accounting rules under IAS 39 may result in greater volatility of earnings. Under IAS 39, banks are not mandated to adopt hedge accounting treatment for derivative transactions.

However, non-hedge treatment will mean marking to market such derivatives regardless of the timing of income/loss recognition of the underlying hedged items. Banks should therefore evaluate how they can continue with their hedging strategies and at the same time comply with hedge accounting rules of IAS 39.

Banks will need to address the one-to-one hedging issue by identifying and designating individual asset or liability positions on the balance sheet as hedged items that represent net positions to be hedged. Banks will also need to ensure that there are external transactions in the trading book that can be designated as hedging instruments for the asset and liability positions designated as hedged items. (To be continued)

(Reprinted from The SGV Review, December 2003 issue)