Impact of credit risk

IFRS 9 requires that, to achieve hedge accounting, the impact of changes in credit risk (in short Impact of credit risk) should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging instrument. Credit risk can arise on both the hedging instrument and the hedged item in the form of counterparty’s credit risk or the entity’s own credit risk.

Judgement has to be used in determining when the impact of credit risk is ‘dominating’ the value changes. But clearly, to ‘dominate’ would mean that there would have to be a very significant effect on the fair value of the hedged item or the hedging instrument. The standard provides guidance that small effects should be ignored even when, in a particular period, they affect the fair values more than changes in the hedged risk. In other words, it is not only a relative but also an absolute assessment.

The assessment of credit risk for hedge effectiveness purposes, which in many cases may be carried out on a qualitative basis, should not be confused with the requirement to actually measure and recognise the impact of credit risk on the hedging instrument and the hedged item.

Credit risk on the hedging instrument  Impact of credit risk Credit risk on the hedged item

IFRS 13 Fair Value Measurement is clear that the effect of credit risk, both the counterparty’s credit risk and the entity’s own credit risk, has to be reflected in the measurement of fair value. The effect of credit risk on the measurement of the hedging instrument would obviously result in some hedge ineffectiveness. The expected effect of that ineffectiveness should not be of a magnitude that it neutralises the offsetting impact of a significant change in the values of the hedging instrument and the hedged item (see ‘Economic relationship‘).

We expect the assessment of the effect of credit risk to be a qualitative assessment in most cases. For example, entities typically have counterparty risk limits defined as part of their risk management policy. The credit standing of the counterparties is monitored on a regular basis.

The risk management policy may include measures to be taken once a significant deterioration in the credit risk is identified. Such measures could include settling the derivative and possibly novating it to another party (in which case, the hedging relationship would have to be discontinued), or negotiating collateral or other credit enhancements (which would significantly improve the hedging relationship).

However, a quantitative assessment of the impact of credit risk on the value changes of the hedging relationship might be required in some instances, e.g., to find out what factors contribute to a low offset between the changes in the value of the hedging instrument and the hedged item and the magnitude of their influence.

Nowadays, most over-the-counter derivative contracts between financial institutions are cash collateralised. Furthermore, current initiatives in several jurisdictions, such as, the European Market Infrastructure Regulation (EMIR) in the European Union or the Dodd-Frank Act in the United States, will result in more derivative contracts being collateralised by cash. Cash collateralization significantly reduces the credit risk for both parties involved, meaning that credit risk is unlikely to dominate the change in fair value of such hedging instruments.

Impact of credit risk

Credit risk on the hedged item

The analysis of the hedged item is somewhat different, as credit risk does not apply to all types of hedged items. For example, inventory and forecast transactions would not have credit risk. Loan assets typically have counterparty credit risk, while financial liabilities bear the issuing entity’s own credit risk.

Credit risk cannot dominate the value change in a hedge of a forecast transaction as the transaction is, by definition, only anticipated but not committed. Credit risk is defined as ‘risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation’. For the same reason, inventory also does not involve credit risk.

Consequently, credit risk can only apply if the entity enters into a contract (e.g., if the hedged item is a firm commitment or a financial instrument). This should be contrasted with the assessment of whether a forecast transaction is highly probable. Even though such a transaction does not involve credit risk, depending on the possible counterparties for the anticipated transaction, the credit risk that affects them can indirectly affect the assessment of whether the forecast transaction is highly probable.

For example, assume an entity sells a product to only one particular customer abroad for which the sales are denominated in a foreign currency and the entity does not have alternative customers to sell the product to in that currency (or other sales in that currency). In that case, the credit risk of that particular customer would indirectly affect the likelihood of the entity’s forecast sales in that currency occurring. Conversely, if the entity has a wider customer base for sales of its product that are denominated in the foreign currency then the potential loss of a particular customer would not significantly (or even not at all) affect the likelihood of the entity’s forecast sales in that currency occurring.

For regulatory and accounting purposes, banks usually have systems in place to determine the credit risk on their loan portfolios. Therefore, banks should be able to identify loans with a significant deterioration in the credit standing that would require a qualitative assessment of whether credit risk is dominating the value changes in the hedging relationship.

The systems to assess the credit risk of loans would also permit banks to determine the appropriate economic hedge when hedging the interest rate risk of such loans, as below:

Impact of credit risk

The example should not be taken to imply that for an individual loan with an expected loss of 5% an entity could not hedge the interest rate risk using an interest rate swap that has a notional amount equal to the loan’s face value. In such a situation the credit risk of the loan would not dominate the interest rate related changes unless and until the credit risk changes. However, if the loan deteriorated in its credit quality to an extent where the credit risk related changes start dominating the interest rate risk related changes, the hedging relationship would have to be discontinued.

The assessment of the effect of credit risk on value changes for hedge effectiveness purposes, which, in many cases, may be carried out on a qualitative basis, should not be confused with the requirement to measure and recognise the impact of credit risk on the hedging instrument and the designated hedged item, which will normally give rise to hedge ineffectiveness recognised in profit or loss.

Impact of credit risk

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