Derivatives IAS39 Risk Training 28th June 2005

1. Derivatives & IAS39Risk Training 28th June 2005 Brandon Davies Managing Director GARP Risk Academy

2. Potential effects of changes to current market practices � lessons from FAS133 First a couple of slides to scare anyone Don�t think this could not happen to you, Barclays FAS v UK GAAP reconciliation showed swings over the last 5 yrs of close to USD 1 billion on income.

3. IFRS 39 � FAS 133 Fannie Mae

4. IFRS 39 � FAS 133 Fannie Mae

5. Potential effects of changes to current market practices � lessons from FAS133 Issues of FAS133/IAS39 Mixed attribute standards Carve out for liabilities No portfolio hedging (a big problem for retail market risk managers) Mixed Interpretation within IAS39 (what is embedded and what is not)

6. Potential effects of changes to current market practices � lessons from FAS133 A host of problems IAS32/39 reconciliation Operating Leases (not Financial Instruments) Provisioning issues Equity Hedging Credit Risk deterioration and own issues Insurance contracts I will focus on 2 as illustrative

7. Potential effects of changes to current market practices � lessons from FAS133 What are the biggest causes? Commertzbank since 2001. Securities Holding for Investment & Liquidity. Hedging and Hedge Accounting. Fannie Mae holds fixed rate mortgages and hedges them with callable bonds and swaptions. Barclays holds current accounts and hedges them with RA 5yr interest rate swaps.

8. Potential effects of changes to current market practices � lessons from FAS133 Lesson No 1. Biggest lesson from FAS 133 is that you may hedge to a model but you cannot account on a model basis for a hedge. Lesson No 2. P&L does matter and that is an accounting outcome not a cash flow outcome. Lesson No 3. FAS 133 had a much smaller effect on US than IAS 39 is going to have on Banks elsewhere in the world � US Banks are more disintermediated.

9. Potential effects of changes to current market practices � lessons from FAS133 Exploring these conclusions US Banks hold less assets and liabilities on their balance sheets for the same level of business activity. Assets � Securitisation (Countrywide). Liabilities - Investment Accounts with �Checking� facilities.

10. Potential effects of changes to current market practices � lessons from FAS133 The assets and liabilities which give the most problems are heavily influenced by their behavioural characteristics. Fixed Rate Mortgages and prepayment options. Current Account: 0%interest/indeterminate duration. Cash flow (over a 1+ yr horizon) can be modelled but value much more difficult to model. If P&L (or Capital) reflects value it will become unstable.

11. Potential effects of changes to current market practices � lessons from FAS133 FAS133 v IAS39 FAS 133 allows a �short cut� approach to hedge recognition, IAS39 does not. In practice the short cut approach does allow a degree of model recognition, basically show you can demonstrate a hedging relationship and as long as it meets the 80% - 125% rule OK.

12. Major issues in derivatives hedging for commercial banks Real issues:- Presentation of financial results. Volatility of P&L = higher cost of capital. Pro cyclicality of P&L and Capital, implies higher capital �reserve�. Worst case scenario = more & higher capital cost to support the same level of business OR change the business model.

13. Major issues in derivatives hedging for commercial banks Presentation of financial results. Problems for Banks, inc. differences in approach to IAS. Cash Flow Hedging/ Macro Fair Value Hedging/ Micro Fair Value Hedging. In practice many banks will use all approaches. Problems for analysts? Recent AFGAP Conference no analyst willing to present! Problems for Auditors � they don�t always agree within a firm let alone across firms.

14. Major issues in derivatives hedging for commercial banks Volatility of P&L is it inevitable? What can be done to avoid it? Answers Volatility of P&L - Not for everyone and maybe not for anyone! Avoiding P&L volatility � How creative are you and how creative are you willing to be?

15. What is efficient risk management and what is not? Basel II and IAS the conflicts:- Under Basel II Current Account hedging is encouraged on the basis of behavioural models see �Principles for the management of interest rate risk� Basel Committee publication, July 2004. In practice these model can not qualify as a basis for hedging under IAS39 Note �day one recognition�.

16. What is efficient risk management and what is not? Under Basel banks are encouraged to bifurcate complex instruments and to hedge optionality using options portfolios. Fixed rate loans with prepayment options are an excellent example of a complex instrument with imbedded optionality. Under IAS fixed rate mortgages with prepayment options are imbedded �clearly and closely related� options and cannot be bifucated. Swaptions portfolios held to hedge prepayment risk will be marked to market as trading portfolios!

17. What is efficient risk management and what is not? If you (or more importantly the Finance Director) accepts that the Basel II compliant hedging techniques are efficient but will lead to P&L volatility what might their reaction be? Be reasonable and choose either to risk real net interest income volatility by not hedging OR P&L volatility by hedging. OR be unreasonable and demand both stability of NII and stability of IAS based P&L.

18. Current hedging instruments and their limitations under IAS39 Who ever heard of a reasonable FD? Limitations of current hedging instruments under IAS39 comes in 2 categories: Category 1, the limitations of their use. Category 2, the limitations of the instruments themselves. Caregory1 offers the easiest route, let us look at Current Account hedges for an example of what can be done.

19. Current hedging instruments and their limitations under IAS39 Category 1 If we hedge current accounts with interest rate swaps (let us suppose these are pay floating receive 5yrs fixed rates on a rolling average basis) and this would be disallowed under IAS we are long a receive 5yrs position. Is there anything we currently do not hedge (and indeed would not want to hedge on an economic basis) that we could attach the swaps to? We could under IAS39 cash flow hedge our floating rate loans book to fix it�s cost of funds, moreover we could partially hedge this book ,thus ensuring this allowable hedge exactly matched the disallowed current account hedge.

20. Current hedging instruments and their limitations under IAS39 What does this lead us to? Economic hedging �books� and accounting hedging �books�. FOR � it works. AGAINST � accounting and risk management do not meet, is this a problem? Can we ever account for risk? Risk = probabilistic, Accounting = deterministic. Risk = future outcomes, Accounting = past outcomes.

21. Current hedging instruments and their limitations under IAS39 Category 2 Swaptions (options on swaps) have interest rate volatility as a parameter within their pricing model. Retail customers prepay mortgages based on falling interest rates available to them � they do not have access to every move in rates and do not value their option based on volatility as they cannot realise any value simply from volatility. Could we construct prepayable swaps as a perfect hedge (it would be a cash funding instrument). � YES. Moves risk to the trading book (OTC) but why not Exchange Traded?

22. Structured Products or Financial Engineering who can help the most? Case by case basis. Prediction No1 � in the short run, Financial Engineering: in the long run, Structured Products. Prediction No2 � business models will change.

23. Will IAS encourage the disintermediation of commercial banks? The short answer is YES. Disintermediation will allow commercial banks to focus on their key strength of understanding customer needs. Hedging will be less necessary in a world where the bank does not hold so much risk. IAS = the death of hedging � in the long run YES.