No Time to Hedge: Preparing for New International Financial Reporting Standards
More than three years after the crisis that rocked the financial world, the banking industry remains awash in regulatory uncertainty. It continues to await clarification on and timelines for implementation of various provisions of Dodd-Frank and Basel III. The Securities and Exchange Commission’s (SEC) consideration of transitioning the US financial reporting system to one incorporating International Financial Reporting Standards (IFRS) continues to receive much attention. For financial services organisations, IFRS 9, accounting for financial instruments, aims to establish new provisions for valuations and hedge management that will directly impact these institutions – presenting both new challenges and opportunities along the way.
While the US timeline for adoption of IFRS remains a moving target, financial services organisations should begin planning today, at the same time reassessing their risk and finance environments for the implementation of Dodd-Frank and Basel III provisions. In doing so, they can effectively, holistically and singularly address the realignment of risk and finance that will be critical to compliance with all three sets of regulations.
In late 2010, the International Accounting Standards Board (IASB) proposed a new model for IFRS 9 to better align hedge accounting with risk management, establish a more objective-based approach to hedge accounting, and address inconsistencies and weaknesses in the existing hedge accounting model. The new model is expected to enable financial services organisations to mitigate recognition and measurement differences between hedging instruments (such as derivatives), and hedged items (such as forecast sales), when certain requirements are met, with the goal of better reflecting risk management activities in financial statements.
While many financial services organisations welcome the potential of reducing hedge accounting complexity, complying with the emerging regulations presents new challenges. For example, financial services institutions require specific functional capabilities to calculate the effective interest rate and fair value, to determine overall hedge effectiveness. In some instances, legacy processes for managing valuations and hedge management are unable to adapt to new IFRS standards. In addition, many financial services organisations lack a complete view of business models and the nature of product offerings needed to meet valuations requirements, as current valuation processes are often fragmented and not transparent. Finally, many organisations lack processes to define hedging strategies and relationships, and have an inadequate understanding of the effectiveness of hedging relationships. All of this is compounded when one considers the complexity in accounting for these sophisticated instruments in a volatile market environment.
The answer begins at an organisational level, with an examination of the overall alignment between risk and finance. Over the past few years, financial institutions have been painfully reminded of the fundamental link between risk and profitability. As we have seen many times in recent history, a miscalculating of risk can lead to significant financial loss. Better alignment between a bank’s risk and financial functions is an important step toward compliance with IFRS, as well as Basel III and Dodd-Frank.
Beyond compliance, closer alignment can also help to drive improved performance, as documented by a recent study by the Economist Intelligence Unit (EIU) and sponsored by Oracle Financial Services. The study, ‘Transforming the CFO Role in Financial Institutions: Towards Better Alignment of Risk, Finance and Performance Management’, found that financial institutions scoring themselves highly on their ability to align risk and finance functions within the organisation appear to be performing better financially than their peers. In some cases, organisations may decide to realign reporting duties to have risk and finance executives reporting to the same C-level entity. Cross-functional teams will also be increasingly important. Today, in many financial services organisations, the resources needed to fulfill regulatory requirements might reside in separate teams that do not regularly collaborate. Moving forward, some organisations may want to have some individuals who span both the risk and finance teams to facilitate better communication and collaboration.
Beyond organisational realignment, banks will need to examine their systems and processes. In order to create and tune hedging strategies for optimal capital utilisation, banks must be able to monitor retrospective hedge effectiveness, apply what-if and stress scenarios to test prospective hedge effectiveness, and readily handle hedge de-recognition processes. They should leverage a common computation engine that enables consistent valuations between treasury and accounting, and use common data quality and reconciliation processes across finance and risk applications.
The time to act is now. Financial institutions have much to gain by taking a proactive role in preparing for IFRS at the same time that they begin to tackle Dodd-Frank and Basel III provisions. Closer alignment between the risk and finance functions, as well as a unified analytical platform that enables end-to-end enterprise visibility, will be essential to compliance as well as continued profitability moving forward.