Interest rate benchmark reform, or: a change is gonna come!

The IASB has published for comment Interest Rate Benchmark Reform, an exposure draft of proposed amendments to IFRS 9 and IAS 39, with comments requested by June 17, 2019.

The main reference point for this effort was Reforming Major Interest Rate Benchmarks, a report carried out by the Financial Stability Board in 2014. As the FSB summarized the challenge: “The cases of attempted market manipulation and false reporting of global reference rates, together with the post-crisis decline in liquidity in interbank unsecured funding markets, have undermined confidence in the reliability and robustness of existing interbank benchmark interest rates. Uncertainty surrounding the integrity of these reference rates represents a potentially serious source of vulnerability and systemic risk.” The report set out “concrete proposals, plans and timelines for the reform and strengthening of existing benchmarks and for additional work on the development and introduction of alternative benchmarks.” It’s not entirely easy to track what’s happened since then, but this brief Ernst & Young overview may be helpful.

Here’s how the IASB explains the need for the exposure draft:

  • The Board has proposed to amend IFRS 9 Financial Instruments and IAS 39 Financial Instruments: Recognition and Measurement to provide relief from specific hedge accounting requirements that could have resulted in the discontinuation of hedge accounting solely due to the uncertainty arising from interest rate benchmark reform.
  • IFRS Standards require companies to use forward-looking information to apply hedge accounting. While interest rate benchmark reform is ongoing, uncertainty exists about when the current interest rate benchmarks will be replaced and with what interest rate. Without the proposed amendments, this uncertainty could result in a company having to discontinue hedge accounting solely because of the reform’s effect on its ability to make forward-looking assessments. This, in turn, could result in reduced usefulness of the information in the financial statements for investors.

So, to set out one example, IFRS 9 requires that to qualify for hedge accounting, a forecast transaction or a component thereof must be highly probable to occur. Such forecast transactions could include future interest streams calculated with reference to some existing benchmark. If the likelihood now exists that the benchmark will be eliminated and replaced at some point, with an alternative benchmark that hasn’t yet been fully defined, then perhaps that fact alone means that any future transaction stream calculated with reference to the existing benchmark is no longer highly probable.

The proposals would address this head on, by stating the following:

  • If the hedged item is a forecast transaction (or a component thereof), an entity shall determine whether the forecast transaction is highly probable assuming that the interest rate benchmark on which the hedged cash flows (contractual or non-contractually specified) are based is not altered as a result of interest rate benchmark reform.
  • This would end (unless the hedging relationship is discontinued earlier) when the uncertainty arising from interest rate benchmark reform is no longer present with respect to the timing and the amount of the interest rate benchmark-based cash flows of the hedged item.

Other aspects of the exposure draft deal in similar fashion with other aspects of the hedging model. It’s interesting that this is set out as a “temporary exception” from applying specific hedge accounting requirements. As we’ve covered here before, the most prominent temporary exception in current IFRS is found in IFRS 6, to allow greater latitude in developing an accounting policy for recognizing and measuring exploration and evaluation assets. It’s a temporary exception that’s remained in place now for over twelve years, with no end in sight. Presumably the interest rate benchmark reform will be wrapped up a little faster than that.

Although the articulation of the issue gets a little complex (well, it is about financial instruments after all) the basic premise I suppose is that the externality caused by the reform shouldn’t overturn the entire rationale behind the hedge accounting model. The basis for conclusions to IFRS 9 states that the standard changed “the entire paradigm of hedge accounting…to align more closely with the risk management activities of an entity” and that in the IASB’s view “this fundamental shift in focus – whereby the accounting and risk management objectives are brought in congruence – will result in better economic decision making through improved financial reporting.” For instance, if a reliable mechanism exists to ensure that the fair value gains or losses on certain financial instruments will never be realized by the company, then why confuse users by recognizing them in the financial statements at all? The IASB’s judgment is essentially that if an issuer continues to do the best they can to maintain this “congruence,” then an accounting model based on that premise continues to be the most meaningful one. Of course, some caution is necessary, given the reform-generated uncertainties, and so it proposes that the hedging relationships to which the exceptions apply would be disclosed separately.

As of eleven days before the June 17 deadline, the relevant page of the IFRS.org website wasn’t showing a single comment letter, so if all of this makes your mind go somewhat blank, you may not be alone…

The opinions expressed are solely those of the author

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