1. Financial Assets and Liabilities Overview for Banks David Cairns

2. © 2006 David Cairnswww.cairns.co.uk Financial Instruments Equity instrument Bank deposit Bank loan Debt security Financial liability/ equity instrument of … Issuer Bank Borrower Borrower/issuer Financial asset of … Investor Depositor Bank Investor

3. © 2006 David Cairnswww.cairns.co.uk Financial Instruments: Derivatives Corporate entity obligation to deliver $1.3m (financial liability) right to receive €1m (financial asset) Bank obligation to deliver €1m (financial liability) right to receive $1.3m (financial asset) Corporate entity enters into contract with bank to pay $1.3m and receive €1m in three months time

4. © 2006 David Cairnswww.cairns.co.uk Financial Instruments When does a bank recognise financial assets and financial liabilities on its balance sheet? How does a bank classify financial assets and financial liabilities on its balance sheet? When does a bank remove (derecognise) financial assets and financial liabilities from its balance sheet? How does a bank measure financial assets and financial liabilities: –on initial recognition? –at subsequent balance sheet dates? How does a bank report the resulting income and expenses?

5. © 2006 David Cairnswww.cairns.co.uk Derecognition Risk & rewards approach –transfer, and test of transfer, of substantially all risks and rewards Control and continuing involvement approach –possible reacquisition of contractual rights and/or –exposure to performance

6. © 2006 David Cairnswww.cairns.co.uk (1) (2) (3) Derecognise (4) (5) No derecognition (6) Derecognise (7) (8) Derecognise No derecognition Continuing involvement Y Y Y Y Y Y N N N N N N 1)Consolidate all subsidiaries 2)All or part of an asset? 3)Has right to cash expired? 4)Transfer of right to collect cash? 5)Pass-through conditions met? 6)Substantially all risks/rewards transferred? 7)Substantially all risks/rewards retained? 8)Control retained? Derecognition: Financial Asset

7. © 2006 David Cairnswww.cairns.co.uk Derecognition: Financial Liability Remove a financial liability when it is extinguished –when the obligation is discharged, cancelled or expires Extinguishment occurs through: –entity repays the creditor or –entity is legally released from primary responsibility for the liability

8. © 2006 David Cairnswww.cairns.co.uk Measurement How does a bank measure financial assets and financial liabilities: –on initial recognition? –at subsequent balance sheet dates? How does a bank report the resulting income and expenses?

9. © 2006 David Cairnswww.cairns.co.uk Measurement Fair Values – the Myth Under IAS 39 –a bank must measure all financial assets and financial liabilities at each balance sheet date at fair value –a bank must include all the resulting gains and losses in profit and loss

10. © 2006 David Cairnswww.cairns.co.uk Measurement Fair Values – the Truth Under IAS 39 –a bank must measure all transactions in financial assets and financial liabilities at fair value –a bank must measure all derivatives, other held-for-trading financial assets/financial liabilities and available-for-sale financial assets at fair value at each balance sheet date –a bank may measure all other financial assets and most financial liabilities at historical cost-based amounts at each balance sheet date

11. © 2006 David Cairnswww.cairns.co.uk Subsequent Measurement Fair Values – the Truth The Fair Value Option –under IAS 39, a bank has the option to measure many financial assets and most financial liabilities that would otherwise be measured at historical cost-based amounts at fair value

12. © 2006 David Cairnswww.cairns.co.uk The Fair Value Option Measurement –fair value Income and expenses –profit or loss Fair value option without hedge accounting How does the fair value option work? –on initial recognition, the bank classifies a financial asset or financial liability as fair value through profit or loss

13. © 2006 David Cairnswww.cairns.co.uk Profit or loss Loans and Receivables Fair value option (fair value through profit and loss) Amortised Cost Fair value Loans, Receivables etc. Category Measurement Gains and losses

14. © 2006 David Cairnswww.cairns.co.uk Profit or loss Other Liabilities Fair value option (fair value through profit and loss) Amortised Cost Fair value Deposits and Other Financial Liabilities Category Measurement Gains and losses

15. © 2006 David Cairnswww.cairns.co.uk The Fair Value Option When is a bank allowed to use the fair value option? –for most financial instruments that contain embedded derivative(s) for example, structured loans –to eliminate, or reduce significantly, measurement or recognition inconsistency (accounting mismatch) for example, when assets are measured at fair value but matching liabilities would be measured at amortised cost –for financial assets/financial liabilities managed and evaluated on a fair value basis

16. © 2006 David Cairnswww.cairns.co.uk Profit or loss Equity Held for Trading (Fair value through profit and loss) Available-for- sale financial assets Fair value Investments in Equity Securities Category Measurement Gains and losses

17. © 2006 David Cairnswww.cairns.co.uk IAS 27 SIC 12 IFRS 3 Control Subsidiary IAS 31 SIC 13 IAS 28 Joint Control Significant Influence Joint VentureAssociate Investments in Equity Securities

18. © 2006 David Cairnswww.cairns.co.uk Special Purpose Entities A special purpose entity (SPE) is a subsidiary when the substance of the relationship indicates control, for example when: –the bank predetermines the SPE’s activities makes decisions about the SPE or the SPE’s net assets has right to majority of the SPE’s benefits guarantees interests of other parties in the SPE –the SPE conducts activities on behalf of the bank Consider SPEs used for securitisations, other off- balance sheet financing etc.

19. © 2006 David Cairnswww.cairns.co.uk Venture Capital Investments Investments held by a venture capital entity, mutual fund, unit trust, private equity or similar entity –if investor controls the investee, consolidate –if the investor has significant influence over the investee, classify investment as either associate and use equity method or held for trading financial asset (IAS 39) and measure at fair value with changes in fair value included in the profit or loss –in all other cases, apply IAS 39

20. © 2006 David Cairnswww.cairns.co.uk Loans and Receivables Financial assets with fixed or determinable payments except –loans and receivables that the bank intends to sell immediately –derivatives –debt securities quoted in active market –loans and receivables for which the bank may not recover substantially all initial investment (other than because of credit deterioration)

21. © 2006 David Cairnswww.cairns.co.uk Loans and Receivables Measurement at recognition Transaction price plus Transaction costs minus Origination and commitment fees charged to borrower Without fair value option

22. © 2006 David Cairnswww.cairns.co.uk Financial Service Fees Origination fees and most commitment fees charged to borrower on creation or acquisition of loans and receivables carried at amortised cost  deduct from amount of loan or receivable  recognise as income through application of effective interest rate

23. © 2006 David Cairnswww.cairns.co.uk Loans and Receivables Subsequent measurement –amortised cost using effective interest rate method Gains and losses –profit or loss Without fair value option

24. © 2006 David Cairnswww.cairns.co.uk Amortised Cost of Loan or Receivable Amount at which measured at recognition minus Repayments of principal plus or minus Cumulative amortisation of premium or discount on settlement, origination and commitment fees, transaction costs, etc. less Impairment losses

25. © 2006 David Cairnswww.cairns.co.uk Interest Income on Loan or Receivable Under the effective interest rate method, interest income is: –interest plus or minus –amortisation of any premiums, discounts, origination and commitment fees, transaction costs etc.

26. © 2006 David Cairnswww.cairns.co.uk Impairment of Assets If the carrying amount of an asset exceeds the amount that the entity expects to recover from the sale or use of that asset –the asset is impaired –write down asset to amount that expect to recover Applies to all measurement models Applies to all assets

27. © 2006 David Cairnswww.cairns.co.uk Impairment: Loans and Receivables Loan or receivable is impaired only when: –there is objective evidence of impairment as a result of one or more events before balance sheet date that has impact on future cash flows Incurred, not expected, loss model

28. © 2006 David Cairnswww.cairns.co.uk Impairment: Loans and Receivables Impairment –carrying amount of loan or receivable exceeds –present value of expected future cash flows discounted at original effective interest rate Carrying Present value ofImpaired amount future cash flows Loan 1,000 1,000 No Loan 1,000 200 Yes Loan 1,000 - Yes

29. © 2006 David Cairnswww.cairns.co.uk Evidence of Impairment Significant financial difficulty of borrower Breach of contract by borrower Special concessions by lender to borrower Probable borrower will enter bankruptcy etc. Measurable decrease in estimated future cash flows since initial recognition –even though decrease cannot be identified with individual loans and receivables

30. © 2006 David Cairnswww.cairns.co.uk Assessment of Impairment Separately for individually significant loans and receivables Collectively for other loans and receivables with similar credit risk –include significant loans which are not identified separately as impaired

31. © 2006 David Cairnswww.cairns.co.uk Assessment of Impairment General provisions –must reflect objective evidence of impairment as a result of one or more events before balance sheet date that has impact on future cash flows

32. © 2006 David Cairnswww.cairns.co.uk Impairment: Loans and Receivables Ignore: –losses that arise from events between balance sheet date and date of approval of financial statements –losses that may arise from other future events –effect of changes in market rate of interest on fair value of loan or receivable carried at amortised cost –additional requirements of banking supervisors or regulators

33. © 2006 David Cairnswww.cairns.co.uk Interest Income on Loan or Receivable Under the effective interest rate method, interest income is: –interest plus or minus –amortisation of any premiums, discounts, origination and commitment fees, transaction costs etc. After impairment loss –interest income is determined based on rate used to determine impairment loss

34. © 2006 David Cairnswww.cairns.co.uk Hedge Accounting How does a bank measure financial assets and financial liabilities at subsequent balance sheet dates if it uses hedge accounting? How does a bank report the resulting income and expenses?

35. © 2006 David Cairnswww.cairns.co.uk Fair Value Hedge Accounting Hedging instrument (usually derivative) –fair value Hedged item –adjust carrying amount for gain or loss attributable to hedged risk Gains and losses on hedging instrument and hedged item –profit or loss

36. © 2006 David Cairnswww.cairns.co.uk Cash Flow Hedge Accounting Hedging instrument (usually derivative) –fair value Hedged item –no change Gains and losses on hedging instrument –equity (effective portion) –profit or loss (ineffective portion)

37. © 2006 David Cairnswww.cairns.co.uk Hedge Accounting A bank is allowed to use hedge accounting only when the hedging instrument is a –derivative (other than a written option) –written option when used to hedge purchased option –non-derivative financial asset or liability used to hedge foreign currency risks

38. © 2006 David Cairnswww.cairns.co.uk Hedge Accounting A bank is allowed to use hedge accounting only when the hedged item is a –recognised asset –recognised liability –unrecognised firm commitment –highly probable forecasted transaction –net investment in foreign operation Single items or groups of items with similar risk characteristics

39. © 2006 David Cairnswww.cairns.co.uk Hedge Accounting A bank is allowed to use hedge accounting only when: –it formally designates and documents the hedging relationship, objective and strategy –it expects the hedge to be highly effective –hedge effectiveness can be measured reliably –it assesses hedge effectiveness on an ongoing basis –for a cash flow hedge, any forecasted transaction is highly probable and must ultimately affect profit

40. © 2006 David Cairnswww.cairns.co.uk Disclosure IFRS 7 applies to: –all entities – not just banks or financial institutions –all financial instruments except those covered by more specific standard interests in subsidiaries, associates and joint ventures interests in post employment benefits share-based payments insurance contracts

41. © 2006 David Cairnswww.cairns.co.uk Disclosure Application of IFRS 7 depends on an entity’s use of financial instruments Manufacturer – only has receivables & payables Bank – extensive use of FI

42. © 2006 David Cairnswww.cairns.co.uk Disclosure Accounting –significance of financial instruments to financial position and performance Risk –extent of exposure to risks arising from financial instruments

43. © 2006 David Cairnswww.cairns.co.uk Accounting Disclosure Financial assets and financial liabilities –measurement categories –fair value through profit or loss –reclassifications –compound instruments with multiple embedded derivatives –fair value Financial assets –transfers not qualifying for derecognition –collateral –allowance for credit losses –defaults and breaches

44. © 2006 David Cairnswww.cairns.co.uk Accounting Disclosure Income, expenses, gains, losses Accounting policies Hedge accounting –types of hedges –hedging instruments –risks being hedged Fair value –methods and valuation techniques –non-market based assumptions

45. © 2006 David Cairnswww.cairns.co.uk Risk Disclosure Qualitative information –exposures to risk and how they arise –objectives, policies and process for managing risk –methods used to measure risk –changes from previous period Quantitative information –based on information provided to key management personnel –concentrations

46. © 2006 David Cairnswww.cairns.co.uk Risk Disclosure Credit risk –maximum exposure to credit risk, past due and impaired financial assets, collateral Liquidity risk –maturity analysis and how liquidity risk is managed Market risk –sensitivity analysis

47. © 2006 David Cairnswww.cairns.co.uk Capital Disclosures IAS 1 (revised 2005) –objectives, policies and processes for managing capital –description and quantification of what bank regards as capital –if subject to externally imposed capital requirement nature of requirements whether complied with requirements and, if not, the consequences

48. Financial Assets and Liabilities Overview for Banks David Cairns