IFRS 9 Financial Instruments EU endorsement

Despite having waited for the EU endorsement since 2014, there was still some surprise to see the EU Commission actually finally push it out in the last days of November. All of a sudden there is finally a firm end-date – is this for real?

– CHECK!

Warning: This article includes explicit accounting language and can cause dizziness, headache and other diseases.

Despite having waited for the EU endorsement since 2014, there was still some surprise to see the EU Commission actually finally push it out in the last days of November. All of a sudden there is finally a firm end-date – is this for real?

For those of you who actually have lives: IFRS 9 is the long awaited financial reporting standard to replace the notorious IAS 39 originally issued in 1998. IAS 39 was implemented together with all the other IAS and IFRS standards in 2005 in all EU companies that have issued listed securities. I was involved in several IFRS transition projects at the time, and for my own amusement counted that IAS 39 and its implementation guidance accounted roughly for 350 of the 2,200 total pages. Its hedge accounting rules have sown fear and loathing in many a finance professional over the years.

The main focus of the International Financial Reporting Standards has always been to provide the investors the most relevant information. The possible pains felt by the preparers are only of secondary interest. IFRS 9 is no exception if you are a bank. Even more so if you are an insurance company. When it comes to corporates, good times ahead. This is one of the only IFRS standards we’ve seen the preparers actually eagerly await. The standard has been ready since 2014, and the EU endorsement is the final seal of approval for its application, which will be mandatory in 2018. Unless you are an insurance company…

Risk components, hedge ratio & rebalancing

I’m guessing that corporates with major commodity exposures reacted to the endorsement like Usain Bolt reacts to the sound of the start gun. Now that we have the EU endorsement, you are allowed to implement the standard immediately. Pulling it off would mean that you had anticipated, but in this case the incentives for risking a false start have been obvious.

You can now get hedge accounting for your commodity hedges and the related FX hedges even if you dare to make decisions on them separately – a huge improvement compared to IAS 39!

You can also make your hedges using the most liquid instruments and markets. This can mean for example hedging the separately measurable crude oil component of jet fuel for longer periods. Another example is that you can use a publicly listed commodity for your hedges, even if its specifications don’t fully match your physical commodity. The standard introduces new concepts such as the hedge ratio and rebalancing to facilitate hedge accounting for such strategies. All the so-called proxy hedging strategies can now qualify, assuming they make economic sense.

Options and option strategies

If the IAS 39 hedge accounting principles for options have affected the instrument selection, we will now see a major increase in their use. IAS 39 does not allow hedge accounting for the time value of options. In IFRS 9 this changes. You can, for example, put in place a zero premium strategy against large FX movements and apply hedge accounting. If the large movements never take place, the hedge will never affect your P&L, nor will you have to worry about the liquidity effects when rolling the hedge. And if the large movements do take place, well, you have a hedge – brilliant!

Those already in the know might raise their eyebrows: “But what about the aligned time value and the respective ineffectiveness, the lack of CVA in the hypothetical derivative, and so on and so on…”. Yeah, you are right; any ineffectiveness will hit your P&L. But if you are, for example, hedging you operative cash flows with simple option strategies and smart about the documentation, then my claim is that you can get perfectly effective option hedges. At the very least you get to make the argument that the temporary and probably immaterial ineffectiveness nets out to zero (unless your bank defaults, but I doubt that there would be much focus on your effectiveness testing methodologies in that scenario).

Regarding the use of more exotic instruments: If your net exposure has less risk after those contraptions than it had before the hedge, you also have a good chance to achieve hedge accounting. Before you go ahead and knock out all of your existing outrights and knock in your TARF’s, you might want to read the next chapter.
(You might also want to read Juan’s book on Advanced Hedging Under IFRS 9 – even if it proves too thick to read, you can still use it as a weapon to chase away the nay-sayers).

Economic relationship and effectiveness testing

Many seem elated about the removal of the artificial 80–125% range used in IAS 39. I may be wrong, but some of them may have interpreted this to mean you no longer have to calculate effectiveness. Not so. At least if you plan to make economic hedges with built in ineffectiveness. Even if you would not need all the calculations to qualify for hedge accounting, you would still need the exact same numbers for your ineffectiveness bookings to P&L, and for all the new disclosure information. That’s why I believe that corporates looking for the simplest solution are better off designing perfectly effective hedges.

If you plan on doing something more sophisticated – the simplest example could be one big interest rate swap to hedge the Euribor risk of a diversified loan portfolio – you should have no problems qualifying for hedge accounting. Basically you can apply hedge accounting if your hedges make economic sense. But the more relaxed approach comes with an operational cost. With the so-called perfect hedges, you can utilise the derivative valuations as such: When you keep booking the valuations and reversing the booking to start the next period, the correct P&L comes together almost magically. When making hedges with built in ineffectiveness, you might need some magic of your own to extract the correct figures from your systems. In effect you are applying hedge accounting for the effective portion, and trading accounting for the ineffective portion.

Don’t get me wrong. I do believe that allowing hedge accounting for all hedges that work economically is a clear improvement to the old standard. Corporates who are inclined to use sophisticated hedging strategies most likely also have the resources to pull off the required calculations. All I’m saying here is that you’ll want to do cost-benefit before choosing which strategy is optimal for you. Quick wins may be easier to identify within interest rate risk management. This is because the treasury management system can also fully capture all the characteristics of the hedged items, which is typically not the case when the risk arises from operative cash flows.

Hedging net FX exposures

If something sounds too good to be true, it usually is. The new rules are not a free pass to designate the sumtotal-cell of your FX risk report as the hedged item. What you actually can get – after some serious maths and new sub-ledgers – with the new standard is a bottom line that looks like you hedged the gross items, even when you only hedged the net.

The problem being solved in IFRS 9 is that the P&L effects of the natural offset can hit different P&L periods. If this has not been your main concern, then move on. You are fine with the existing IAS 39 rules as long as your main objective is just to avoid trading accounting for your net hedges.

Derivative as the hedged item

An example of this issue could be a situation where you raise funding in foreign currency, swap the currency and interest basis with a cross currency swap, and then make a separate interest rate hedge. Before vs. after IFRS 9 comparison: No hedge accounting vs. yes hedge accounting. This has lots and lots of practical applications when you need to manage more than one risk factor.

Cost of hedging

Yet another change that will make your life easier, assuming it was hard to begin with.

Under IFRS 9 you can avoid the basis spread problem when using cross currency swaps. If you hadn’t even realised that there was a problem (with the ineffectiveness caused by the basis spread volatility), breathe easy! It has now been solved and the shortcut you may have unknowingly taken is now fully compliant!

A more common example is the forward component of FX forwards. Just memorise the words time-period related and transaction related hedge and you can amortise it or adjust the transaction when it is recognised. The same applies with option premiums. The fair valuation principle still stands, so in order to get your debits and credits to match, you get to book the residual – the volatility – to OCI. Definitely thumbs up.

What else?

Impairment! The new standard goes from incurred credit losses to expected credit losses. This is huge for banks.

Impact of the new impairment model on corporates? I’m not sure. The standard includes some shortcuts for trade receivables. (I remember a slight double-take way back when IAS 39 was implemented – “oh yes, trade receivables are in fact financial instruments…”). In some other affected areas a corporate might get to argue the effect of the expected loss to be immaterial.

The classification of financial assets changes, but I don’t see why these changes would be a game-changer for a typical corporate. The same conclusion about the changes on the liability side: The own credit issue is handled differently in the new standard, but I don’t see that to be relevant for most corporates.

I’m sure there are other issues of key significance which I have blatantly ignored here. The problem in finding them is that unless I’m looking to find a solution for a particular case, I tend to immediately forget what I just read. Either that or without proper context I don’t understand the text to begin with! If some of you have similar problems, I recommend reading the basis for conclusions first. They provide good context on what the final text aims to achieve. Understanding that context might prove helpful when trying to find out how to best benefit from the new and improved standard.

Antti Aittola
Chief Advisor

The author works within Nordea Markets, helping the bank’s corporate clients in developing their market risk management.

Further reading