Financial institutions, particularly retail banks, have as a core business, the collection of funds by depositors that are subsequently invested as loans to customers. This typically includes instruments such as current and savings accounts, deposits and borrowings, loans and mortgages that are usually accounted for at amortised cost. The difference between interest received and interest paid on these instruments (i.e., the net interest margin) is a main source of profitability.
A bank’s net interest margin is exposed to changes in interest rates, a risk most banks (economically) hedge by entering into derivatives (mainly interest rate swaps). Applying the hedge accounting requirements (as defined in IAS 39 or IFRS 9) to such hedging strategies on an individual item-by-item basis can be difficult as a result of the characteristics of the underlying financial assets and liabilities:
- Prepayment options are common features of many fixed rate loans to customers. Customers exercise these options for many reasons, such as when they move house, and so not necessarily in response to interest rate movements. Their behaviour can be predicted much better on a portfolio basis rather than an item-by-item basis.
- As a result of the sheer number of financial instruments involved, banks typically apply their hedging strategies on a macro (or portfolio) basis, with the number of individual instruments in the hedged portfolio constantly churning.
Although IAS 39 can be applied to macro hedging situations, and guidance exists for portfolio fair value and cash flow hedge accounting for interest rate risk, entities do not always use hedge accounting in those situations. This is because not all sources of interest rate risk qualify for hedge accounting, use of IAS 39 can be operationally complex and cash flow hedge solutions result in volatility of other comprehensive income. Some European banks have, instead, made use of the European Union’s carve out of certain sections of the IAS 39 hedge accounting rules.
Instead of developing particular hedge accounting requirements in IFRS 9 that are specifically tailored to macro hedging strategies, the IASB is seeking to create a separate accounting model for macro hedging situations that would be based on an entity’s risk management activities. The accounting for macro hedging was originally part of the IASB’s project to replace IAS 39 with IFRS 9. However, the IASB realised that developing the new accounting model would take time and probably be a different concept from hedge accounting. In May 2012, the Board therefore decided to decouple the part of the project that is related to accounting for macro hedging from IFRS 9, allowing more time to develop an accounting model without affecting the timeline for the completion of the other elements of IFRS 9.
Although mainly focused on financial institutions, the accounting model for macro hedging might also be beneficial for some corporate entities applying macro-type hedging strategies.