Financial Assets and Liabilities Overview for Banks David Cairns

Financial Assets and Liabilities

Overview for Banks

David Cairns

© 2006 David Cairns

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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


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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


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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?


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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


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(1)

(2)

(3) Derecognise

(4)

(5) No derecognition

(6) Derecognise

(7)

(8) Derecognise

No derecognition

Continuing involvement

Y

Y

YY

Y

Y

N

N

N

N

NN

1) Consolidate all subsidiaries2) 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


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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


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Measurement

• How does a bank measure financial assets and financial liabilities:– on initial recognition?

– at subsequent balance sheet dates?



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MeasurementFair 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


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MeasurementFair 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


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Subsequent MeasurementFair 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


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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


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Profit or loss 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


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Profit or loss 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


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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


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Profit or loss Equity

Held for Trading

(Fair value through profit and loss)

Available-for- sale financial

assets

Fair value Fair value

Investments in Equity Securities

Category

Measurement

Gains and losses


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IAS 27SIC 12IFRS 3

Control

Subsidiary

IAS 31SIC 13

IAS 28

JointControl

Significant Influence

Joint Venture Associate

Investments in Equity Securities


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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.


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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


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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)


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Measurement at recognition

Transaction price plus

Transaction costsminus

Origination and commitment fees charged to borrower

Without fair value option


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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


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• Subsequent measurement– amortised cost using effective interest rate method

• Gains and losses– profit or loss

Without fair value option


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Amortised Cost of Loan or Receivable

Amount at which measured at recognitionminus

Repayments of principalplus or minus

Cumulative amortisation of premium or discount on settlement, origination and commitment fees,

transaction costs, etc.less

Impairment losses


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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.


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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


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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


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• Impairment – carrying amount of loan or receivable exceeds – present value of expected future cash flows discounted at

original effective interest rate

Carrying Present value of Impaired amount future cash flows

Loan 1,000 1,000 No

Loan 1,000 200 Yes

Loan 1,000 - Yes


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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


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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


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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


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• 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


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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


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Hedge Accounting• How does a bank measure financial assets and

financial liabilities at subsequent balance sheet dates if it uses hedge accounting?



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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


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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)


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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


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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


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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


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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


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Disclosure

• Application of IFRS 7 depends on an entity’s use of financial instruments

Manufacture

r – only

has

rece

ivables &

payables

Bank – extensive use of FI


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Disclosure

• Accounting– significance of

financial instruments to financial position and performance

• Risk– extent of exposure to

risks arising from financial instruments


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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


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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


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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


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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


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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

Financial Assets and Liabilities

Overview for Banks

David Cairns

Documents

Financial Assets and Liabilities Overview for Banks David Cairns