1. Accounting for Dynamic Risk Management: A Portfolio Revaluation Approach to Macro Hedging May 2014 www.pwc.co.uk

2. PwC Agenda 1. Introduction 2. Portfolio revaluation approach (PRA) 3. Scope 4. Illustration – Dynamic interest rate risk management 5. Presentation and disclosures Appendix – Discussion Paper: Summary of questions 2 May 2014Accounting for Dynamic Risk Management

3. PwC 1. Introduction 3 May 2014Accounting for Dynamic Risk Management

4. PwC 1. Introduction In April 2014 the IASB issued a Discussion Paper (DP) to address the possible accounting for risks dynamically managed DP prescribes some solutions but also explores alternatives. Presents an illustration on interest rate risk as applied by banks, but explores its application to other risks (e.g. FX and commodity price risk). DP asks questions on whether an accounting approach that reflects dynamic risk management is: necessary; provides useful information; and operational. Comments due by 17 October 2014. 4 May 2014Accounting for Dynamic Risk Management

5. PwC 1. Introduction What is dynamic risk management (DRM)? Analysis Mitigation (hedging) Risk identification 5 May 2014Accounting for Dynamic Risk Management DRM = continuous reassessment of the net open risk positions arising from managing open portfolios. Open portfolios = frequently new exposures are added and existing exposures removed. DRM

6. PwC 1. Introduction Why is there a need for an accounting model for dynamic risk management? Currently IFRS 9/IAS 39: Has one-to-one linkage between: a)hedged item, and b)hedging instrument. Requires tracking mechanism Considers open portfolios as a series of closed portfolios. Limits qualifying hedged items. Allows a limited degree of behaviouralisation (e.g. demand deposits, equity and pipeline transactions not accepted). Therefore, difficult to accommodate DRM (or accommodates only indirectly). IFRS 9 / IAS 39 Dynamic Risk Management 6 May 2014Accounting for Dynamic Risk Management

7. PwC 2. Portfolio Revaluation Approach 7 May 2014Accounting for Dynamic Risk Management

8. PwC 2. Portfolio Revaluation Approach Overview 8 May 2014Accounting for Dynamic Risk Management The DP explores the use of a Portfolio Revaluation Approach (PRA): Not a full FV approach. Revalues managed risk only. Net revaluation adjustment taken to P&L. Should PRA be: optional or mandatory? Fair value of risk management instruments (derivatives) Assets Open Portfolios Liabilities Open Portfolios Revaluation of exposures for the managed risk (present value) ABCABC Managed risk Other risks

9. PwC 2. Portfolio Revaluation Approach Incorporation/removal of risk exposures The DP asks the following questions: Incorporation of risk exposures after origination: Should the Day 1 adjustment be: Immediately recognised in P&L? Amortised to P&L over time? ….. this would increase operational complexity. Removal of risk exposures prior to maturity : If managed exposures are removed prior to their maturity or derecognition, should the revaluation adjustment (recognised up to that point) be: Amortised over time? ….. it would be operationally burdensome. Recognised immediately in P&L? 9 May 2014Accounting for Dynamic Risk Management

10. PwC 2. Portfolio Revaluation Approach Application of PRA to different risks 10 May 2014Accounting for Dynamic Risk Management The DP explores PRA as applied by banks to dynamic interest rate risk management (see detailed example in section 4). However, it explores the possibility of its application to other risks, for example, commodity price risk: Inventory ProductionPurchasesSales Net Open Risk Position Risk management instruments

11. PwC 3. Scope 11 May 2014Accounting for Dynamic Risk Management

12. PwC 3. Scope The DP explores two scope approaches: 1)Focus on dynamic risk management 2)Focus on risk mitigation: a)Sub-portfolio approach b)Proportional approach In addition, the DP asks whether risk limits should be considered as part of PRA. 12 May 2014Accounting for Dynamic Risk Management

13. PwC 3. Scope Approach 1 - Focus on dynamic risk management 13 May 2014Accounting for Dynamic Risk Management DRM on a net basis Mortgages (including behaviouralisation) Corporate loans Core demand deposits Time deposits RM instruments (derivatives) AssetsLiabilities PRA is applied to all managed portfolios (even unhedged exposures). Equity

14. PwC 3. Scope Approach 1 - Focus on dynamic risk management Advantages: Enable users to understand profits and corresponding risks by profit source. Provides information about managed risks and all risk management activities. Consistency between the scope of accounting and dynamic risk management. Operational. It uses existing risk management data for accounting purposes. Tracking of hedged items and hedging instruments not needed. Disadvantages: Introduces P&L volatility from the revaluation of net open risk positions left unhedged. Reduces comparability. Costs might outweigh the benefits. Single approach cannot portray the different objectives of all forms of DRM. 14 May 2014Accounting for Dynamic Risk Management

15. PwC 3. Scope Approach 2(a) - Focus on risk mitigation Sub-portfolio approach 15 May 2014Accounting for Dynamic Risk Management DRM on a net basis Mortgages (including behaviouralisation) Corporate loans Core demand deposits Time deposits RM instruments (derivatives) AssetsLiabilities PRA is limited to the sub-portfolios dynamically managed (only for those which risk mitigation and hedging activities are undertaken). Equity

16. PwC 3. Scope Approach 2(b) - Focus on risk mitigation Proportional approach 16 May 2014Accounting for Dynamic Risk Management DRM on a net basis Mortgages (including behaviouralisation) Corporate loans Core demand deposits Time deposits RM instruments (derivatives) AssetsLiabilities PRA is applied to a proportion of the dynamically managed portfolios. Equity

17. PwC 3. Scope Approach 2 - Focus on risk mitigation Advantages: Reflects how successful an entity has been in meeting DRM objectives. Similar scope to IAS 39 and IFRS 9. Disadvantages: Definition of sub-portfolios potentially could be arbitrary. PRA could be used to achieve specific accounting results. Introduces tracking requirements and therefore increases operational complexity (e.g. if the designated percentage changes over time). ‘Toolkit’ to reduce P&L volatility, instead of reflecting economics. 17 May 2014Accounting for Dynamic Risk Management

18. PwC 3. Scope Risk limits The DP asks whether risk limits should be incorporated into the PRA. Risk limits are thresholds set for risk levels that entities are willing and/or entitled to bear. They are entity specific and trigger risk mitigation (hedging). Conceptual challenge: Could imply no P&L volatility when net open position is within the risk limits set by management. The wider the limits, the less P&L volatility. 18 May 2014Accounting for Dynamic Risk Management

19. PwC 4. Illustration – Dynamic interest rate risk management 19 May 2014Accounting for Dynamic Risk Management

20. PwC 4. Illustration – Dynamic interest rate risk Dynamic interest rate risk management in banks ASSETS LIABILITIES Mortgages Corporate Loans Core Demand Deposits Time Deposits Dynamic Interest Rate Risk Management (net basis) 20 May 2014Accounting for Dynamic Risk Management Risk management instruments (derivatives) No one-to-one linkage EQUITY

21. PwC 4. Illustration – Dynamic interest rate risk What is transfer pricing? 21 May 2014Accounting for Dynamic Risk Management Transfer prices are those that entities (e.g. banks) internally use when different business units transfer funds and risks. Step 1: External funds are obtained @4.1% Step 2: Funds are transferred internally by Treasury to the lending business units (BU) Step 3: BU price loans to external clients @ 7.1% Benchmark (e.g. LIBOR) 3.9% Own credit spread 0.2% Customer- specific margin 3% Benchmark (e.g. LIBOR) 3.9% Own credit spread 0.2%

22. PwC 4. Illustration – Dynamic interest rate risk The revaluation adjustment on interest rate risk 22 May 2014Accounting for Dynamic Risk Management Cash flows that represent the managed risk exposure Discount Rate = current interest rate for the managed risk * Revaluation Adjustment * The discount rate is always updated, regardless of whether the cash flows (the numerator) arise from fixed or variable interest rate exposures. Fixed IR exposures based on historical interest rate Variable IR exposures updated (projecting using forward curves) Practical expedient Transfer Pricing (TP) can be used as proxy.

23. PwC 4. Illustration – Dynamic interest rate risk Proposed approaches PRA considers the following alternatives when TP is used: 23 May 2014Accounting for Dynamic Risk Management Alternative 1 Funding Index Cash flows & discount rate = Benchmark Interest Rate (e.g. LIBOR 3.9%). Alternative 2 Funding Index Cash flows = Full transfer price (benchmark 3.9% + spreads 0.2%, e.g. credit spread). Discount rate = Benchmark only. Alternative 3 Funding Index Cash Flows = Full transfer price. Discount rate = Full transfer price, but spreads other than the market funding index are ‘fixed’ at the original spread. Alternative 4 Pricing Index Only when the pricing index is identified as the managed risk. Cash flows & discount rate = Pricing index (excluding any other risks, e.g. credit).

24. PwC 4. Illustration – Dynamic interest rate risk Proposed approaches (cont.) In selecting the appropriate approach for the interest rate, banks should consider: Whether dynamic risk management is appropriately reflected. Degree of subjectivity in the outcome. How faithfully economic events are reflected. Comparability across entities. 24 May 2014Accounting for Dynamic Risk Management

25. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items Similar to IFRS 9 accounting requirements, it allows: However, the DP explores additional qualifying hedged items: 25 May 2014Accounting for Dynamic Risk Management

26. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Core Demand Deposits Demand deposits can be withdrawn at a little or short notice. At a portfolio level, a portion (core demand deposits) is maintained for a particular time frame. Core demand deposits are generally insensitive to changes in market interest rates, therefore behave like a fixed interest rate portfolio. PRA considers the deemed interest rate profile of the core demand deposit as part of the managed portfolio. 26 May 2014Accounting for Dynamic Risk Management Core Demand Deposits Demand Deposits

27. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Core Demand Deposits (cont.) Benefits: Better representation of DRM. Conceptual challenges: Selection of term and volume involve significant judgement. Disclosures on key assumptions would be necessary. Difficult to identify effect resulting from: a)changes in customers’ behaviour, b)reflection of bank’s actions, or c)effect of other factors (e.g. liquidity risk). 27 May 2014Accounting for Dynamic Risk Management

28. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Pre-payable items Impact on revaluation adjustment could be based on: a)Modifications in cash flows, or b)Revaluation of the prepayment option (if managed using options). If a ‘bottom layer’ approach is used, tracking and amortisation would be necessary (unless homogeneous items). 28 May 2014Accounting for Dynamic Risk Management Prepayment behaviour is significantly influenced by interest rates.

29. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Pre-payable items (cont.) Benefits: Consistent with the way banks manage their risk. Conceptual challenges: Operationally challenging when managed for ‘one-sided’ risk. If bottom layer approach is used, tracking and amortisation would be needed, and therefore, some of the benefits of PRA would not be achieved 29 May 2014Accounting for Dynamic Risk Management

30. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Sub-benchmark rate managed risk instruments 30 May 2014Accounting for Dynamic Risk Management Potential approaches under DRM: Sub-benchmark instruments Financial instruments priced at an interest rate based on a benchmark index less a margin. Generally include an embedded floor so that the coupon cannot be negative. Should PRA consider the embedded floor?

31. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Sub-benchmark rate managed risk instruments (cont.) Benefits of using full benchmark: Consistent with the way banks apply DRM, therefore, reflecting the embedded floor is not relevant. Conceptual challenges of using full benchmark: Deemed cash flows might be greater than actual cash flows. Expectation that negative margin should be presented in similar way to positive margins. Not correct to ignore the effect the embedded derivative has on the strategy to stabilise net income. 31 May 2014Accounting for Dynamic Risk Management

32. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Pipeline transactions Key characteristics: No contractual commitment. Considered binding for reputational or other reasons. May or may not be ‘highly probable’ (as per IFRS 9/IAS 39). Risk profile similar to writing a short-term put option (for fixed IR products at a predetermined interest rate). For DRM purposes, the volume of customer balances to be drawdown is estimated on a behavioural basis. 32 May 2014Accounting for Dynamic Risk Management Pipeline transactions are forecast issuance of fixed interest rate products at an advertised interest rate.

33. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - Pipeline transactions (cont.) Benefits: Consistent with the way banks manage their risk. Similar to constructive obligations. The current DP on Conceptual Framework distinguishes economic compulsion from constructive obligations… however, the boundary is not always clear. Conceptual challenges: Presumes fair value risk for exposures not accounted for. Results in recognition of an asset or liability before an entity becomes a party to the transaction. Conceptually similar to accounting for internally generated goodwill. 33 May 2014Accounting for Dynamic Risk Management

34. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - E quity model book (EMB) For EMB, return on own equity instrument is disaggregated as follows: a)Base return (similar to interest). b)Residual return (resulting from the total net income that accrues to equity holders) EMB is included as interest rate exposure for DRM purposes (even though no actual interest expense would be paid). 34 May 2014Accounting for Dynamic Risk Management Some banks determine a target compensation (similar to interest) for their equity holders.

35. PwC 4. Illustration – Dynamic interest rate risk Qualifying hedged items - E quity model book (EMB) (cont.) Benefits: Consistent with the way banks manage their risk. May provide transparency on the bank’s ability to achieve its targeted base return on equity. Conceptual challenges: May be seen as arbitrary or artificial Does not satisfy the definition of assets or liabilities under the Conceptual Framework for Financial Reporting. Is complete alignment between accounting and risk management achievable or desirable? 35 May 2014Accounting for Dynamic Risk Management

36. PwC 4. Illustration – Dynamic interest rate risk Risk exposures in foreign currency 36 May 2014Accounting for Dynamic Risk Management Risk exposures are often denominated in foreign currency. The DP asks should PRA combine the DRM of FX risk and interest rate risk? The DP explores three potential PRA approaches. Each approach is dependent on the way risk is actually managed. Approach A: Exposures are converted to local currency using derivatives on a one-to- one basis (e.g. cross currency swap). Two potential PRA approaches arise: a)The managed exposure is the aggregated exposure (similar to IFRS 9) b)The managed exposure is in foreign currency. The derivatives used to convert the currency will be considered as part of the risk management instrument as per the DRM

37. PwC 4. Illustration – Dynamic interest rate risk Risk exposures in foreign currency (cont.) 37 May 2014Accounting for Dynamic Risk Management Approach B: Bank raises foreign currency funding for lending to customers in the same currency. DRM and PRA are applied to the foreign currency lending and funding exposures. Additional analysis required on the interaction with IAS 21. Approach C: Bank lends and raises funds in a foreign currency in the normal course of business. Bank uses cross currency derivatives on a portfolio basis. DRM approach similar to approach b) in Scenario A.

38. PwC 5. Presentation and disclosures 38 May 2014Accounting for Dynamic Risk Management

39. PwC 5. Presentation and disclosures The DP explores the following presentation alternatives: Statement of Financial Position - Three alternatives: 1.Line-by-line gross up 2.Aggregate adjustment 3.Single net line item Statement of Comprehensive Income - Two alternatives: 1.Actual net interest income presentation 2.Stable net interest income presentation It also explores an alternative PRA approach through OCI. 39 May 2014Accounting for Dynamic Risk Management

40. PwC 5. Presentation and disclosures Statement of Financial Position 40 May 2014Accounting for Dynamic Risk Management The DP explores the following three presentation alternatives: Statement of Financial Position DR/(CR)Presentation alternatives Amortised cost PRA revaluation adjustment Derivatives fair valueTotal Line-by-line gross up Aggregate adjustment Single net line item Assets Retail loans1,00011-1,011 1,000 Commercial loans75030-780 750 Debt securities500(20)-480 500 Dynamic risk management revaluation-----21- Derivatives--25 Total assets2,25021252,296 2,275 Liabilities Deposits(400)5-(395) (400) Issed debt securities(1,500)(40)-(1,540) (1,500) Firm commitments-(15)- -- Dynamic risk management revaluation-----(50)(29) Total liabilities(1,900)(50)-(1,950) (1.950)(1,929) Net amount350(29)25346

41. PwC 5. Presentation and disclosures Statement of Comprehensive Income 41 May 2014Accounting for Dynamic Risk Management The DP explores the following two presentation alternatives: Actual net interest income presentation 30 Jun 20X131 Dec 20X130 Jun 20X231 Dec 20X2 Interest revenue 2.00 Interest expense (1.49) (1.37) (1.24) (1.61) Net interest from DRM (0.01) (0.10) (0.21) 0.09 Net interest income 0.50 0.53 0.55 0.48 Revaluation effect from DRM 0.25 0.21 (0.67) (0.52) Total P&L for the six-month period 0.75 0.74 (0.12) (0.04) Stable net interest income presentation 30 Jun 20X131 Dec 20X130 Jun 20X231 Dec 20X2 Interest revenue 1.99 1.87 1.74 2.11 Interest expense (1.49) (1.37) (1.24) (1.61) Net interest income 0.50 Revaluation effect from DRM 0.25 0.24 (0.62) (0.54) Total P&L for the six-month period 0.75 0.74 (0.12) (0.04)

42. PwC 5. Presentation and disclosures Presentation of d erivatives The DP explores the possibility of ‘grossing up’ the offsetting internal derivatives in the statement of comprehensive income. Objective - to reflect DRM separately from trading activities. No net impact on profit or loss. The DP asks whether the gross presentation: Enhances the usefulness of financial information. Enhances PRA operational feasibility. 42 May 2014Accounting for Dynamic Risk Management

43. PwC 5. Presentation and disclosures Disclosures The DP seeks input about disclosures aggregated in the following categories: 43 May 2014Accounting for Dynamic Risk Management Qualitative information on the objectives and policies for DRM, including the identification of risks within exposures. Qualitative and quantitative information on the net open risk position(s) and impact on the application of the PRA. Qualitative and quantitative information on the impact of DRM on the current and future performance of an entity. Application of the PRA.

44. PwC Appendix – Discussion Paper: Summary of questions 44 May 2014Accounting for Dynamic Risk Management

45. PwC Appendix: Discussion Paper: Summary of questions 45 May 2014Accounting for Dynamic Risk Management The IASB asks 26 questions on the topics discussed in the DP. Below we list the topics considered as part of the questions *: 1.Need for an accounting approach for dynamic risk management 2.Current difficulties in representing dynamic risk management in financial statements 3.Dynamic risk management 4.Pipeline transactions, EMB and behaviouralisation 5.Prepayment risk 6.Recognition of changes in customer behaviour 7.Bottom layers and proportions of managed exposures * This is a list of topics only. Refer to the DP for the full questions.

46. PwC Appendix: Discussion Paper: Summary of questions 46 May 2014Accounting for Dynamic Risk Management 8.Risk limits 9.Core demand deposits 10.Sub-benchmark rate managed risk instruments 11.Revaluation of the managed exposures 12.Transfer pricing transactions 13.Selection of funding index 14.Pricing index 15.Scope 16.Mandatory or optional application of the PRA 17.Other eligibility criteria 18.Presentation alternatives Below we list the topics considered as part of the questions (cont.): * This is a list of topics only. Refer to the DP for the full questions.

47. PwC Appendix: Discussion Paper: Summary of questions 47 May 2014Accounting for Dynamic Risk Management 19.Presentation of internal derivatives 20.Disclosures 21.Scope of disclosures 22.Date of inclusion of exposures in a managed portfolio 23.Removal of exposures from a managed portfolio 24.Dynamic risk management of foreign currency instruments 25.Application of the PRA to other risks 26.PRA through OCI Below we list the topics considered as part of the questions (cont.): Remember, the comment period ends 17 October 2014! * This is a list of topics only. Refer to the DP for the full questions.

48. Thank you... This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2014 PricewaterhouseCoopers LLP. All rights reserved. In this document, "PwC" refers to the UK member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.www.pwc.com/structure