Credit risk exposures

Many financial institutions hedge the credit risk (i.e. insure credit risk exposures) arising from loans or loan commitments using credit default swaps (CDS). This would often result in an accounting mismatch, as loans and loan commitments are typically not accounted for at fair value through profit or loss. The simplest accounting would be to designate the credit risk as a risk component in a hedging relationship. However, the IASB noted that due to the difficulty in isolating the credit risk as a separate risk it does not meet the eligibility criteria for risk components. As a result, the accounting mismatch creates profit or loss volatility.

The IASB spent a considerable amount of its deliberations for the IFRS 9 hedge accounting project on credit risk hedging. This is reflected by the number of paragraphs used to describe the basis for the Board’s conclusion. The Exposure Draft leading up to the final published requirements did not propose any changes in this area, however, the IASB asked its constituents to comment on three alternative approaches. The feedback from the comment letters showed that accounting for credit risk hedging strategies is a major concern for many financial institutions.

In its redeliberations the Board confirmed its view that credit risk does not qualify as a separate risk component. However, the IASB decided that an entity undertaking economic credit risk hedging may, at any time, elect to account for a loan or loan commitment or a financial guarantee contract, to the extent that any of these instruments is managed for changes in its credit risk, at fair value through profit or loss.

This election can only be made if the asset referenced by the credit derivative has the same issuer and subordination as the hedged exposure (i.e., both the issuer’s name and seniority of the exposure match). The accounting for the credit derivative would not change, i.e., it would continue to be accounted at fair value through profit or loss.

Credit risk exposures

If the election is made, the difference at that time between the carrying value (if any) and the fair value of the financial instrument designated as at fair value through profit or loss is immediately recognised in profit or loss. This measurement adjustment would not only reflect any change in credit risk, but also other changes in fair value such as changes in interest rate risk.

Also different to a fair value hedge, once elected, the financial instruments hedged for credit risk are measured at their full fair value instead of just adjusted for changes in the risk actually hedged. As a result, by hedging the credit risk exposure, the entity also has to revalue the financial instrument for the general effect of interest rate risk, which will result in profit or loss volatility.

An entity has to discontinue the specific accounting for credit risk hedges in line with its actual risk management. This would be the case when the credit risk either no longer exists or if the credit risk is no longer managed using credit derivatives (irrespective of whether the credit derivative still exists or is sold, terminated or settled).

On discontinuation, the fair value of the loan becomes its deemed amortised cost and a new effective interest rate is calculated on that basis. The fair value of a loan commitment or a financial guarantee contract is amortised over the remaining life of the instrument unless IAS 37 Provisions, Contingent Liabilities and Contingent Assets would require a higher amount than the remaining unamortised balance. Credit risk exposures

In contrast to the fair value option under IFRS 9, the possibility to elect to measure at fair value through profit or loss those financial instruments whose credit risk is managed using credit derivatives, has the following advantages: Credit risk exposures

  • The election can be made after initial recognition of the financial instrument Credit risk exposures
  • The election is available for a proportion of the instrument (instead of only the whole instrument) Credit risk exposures
  • The fair value through profit or loss accounting can be discontinued Credit risk exposures

Consequently, even though it is not an equivalent to fair value hedge accounting, the new accounting does address several concerns of entities that use CDSs for hedging credit exposures.

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