Athens, February 2019

Chris Ragkavas, BA, MA, FCCA, CGMA

IFRS technical expert, financial consultant.

IFRS 9 carries forward the concept of dealing with accounting mismatches from IAS 39 Financial Instruments, which has been withdrawn since 31/12/2017. Accounting mismatches will continue to exist in the foreseeable future due to the inherent structure of the global banking system, therefore it is necessary to allow for its proper treatment in the reporting entity’s financial statements.

What’s the challenge? 

Α short-term liability from the money markets, measured at fair value through profit or loss….

Assume that Global Bank Plc issues on 1/3/2019, “270 days, 1% commercial paper, negotiable to maturity, and redeemable anytime between origination and maturity, worth $ 23 million”. In simple words, the bank has raised on 1/3/2019, $ 23 million from the money markets by issuing redeemable financial instruments that are also marketable between other participants. So the bank receives on origination $ 23 million, undertakes the obligation to repay them in no later than 270 days, while:

  • The bank may redeem them at fair value anytime between the origination date and the end of the 270-day period. The bank will pay the holders the interest due and the fair value of the capital at the moment of the repurchase.
  • Holders of the commercial paper (the original financiers of the the bank) may choose to sell them to other participants before maturity, or early redemption by the bank. Likewise, new owners of the commercial paper will pay the current holders the interest due and the fair value of the capital at the moment of the repurchase.

A bank of high caliber that has a solid financial backbone, or is perceived to be a systemic player that is considered to be too big to fail by all stakeholderscan comfortably act as an issuer of such liabilities in the money markets.

This financial liability will in all likelihood be classified and measured at fair value through profit or loss, as:

  • There is a market for these instruments, so fair values can be easily obtained.
  • The issuer itself has the motive and the intention to redeem them anytime to maturity, in fact, trade desks actively seek new financiers to raise money from, at more favourable terms with the intention to redeem the original commercial papers. This means, that, assuming on the 34th day the bank finds financiers to raise $ 23 million or part of it, at more favourable terms to the original issue, they will do so, repay the original commercial papers, and owe the new holders $ 23 million. In fact, banks are constantly doing this exercise, seeking the best finance option for “refinancing” their existing short-term liabilities, on a rolling basis. So the seemingly short-term liability of 270 days, is in fact a constantly rolling one that is renewed at an even more favourable terms, at least, that is the bank’s intention.

Even assuming that the bank does not redeem the commercial papers before maturity, they will need to do so on maturity. In all likelihood, they will have found by then new financiers to raise $ 23 million from, and repay the original ones, or, extend the redemption of the original commercial papers, say, for another 270 days. This is a constant exercise.

…..matched with a long-term receivable measured at amortized cost. 

The bank uses the $ 23 million to originate mortgage loans to its own customers, say, at an effective rate of 4.5%. The spread between the effective rates of borrowing and lending results in a handsome income of (4.5% – 1%) = 3.5% for Global Bank, in our example.

The mortgage loans are originated with the intention to hold them, say, to maturity of 20 years. So naturally they would be classified and measured at amortized cost.

Short-term borrowing and long-term lending is the typical function of a modern bank, called credit transformation. The system works on trust on the solvency of the banking institutions, thus the willingness to lend them short, whereas the same monies are transformed into a long-term receivable. 

Every participant in this transaction trusts that:

  • The banks will be able to refinance their short-term liabilities, on a rolling basis.
  • The long-term receivables will suffer no, or very limited impairments.

The origination of the mortgage loans and their holding to maturity, means that the bank will:

  • Gradually recognize income, based on the effective interest rate. 
  • Will measure and where necessary recognize expected credit losses for them.
  • Will not measure the fair value gains and losses on these assets.

…….thus the mismatch

In order to eliminate this accounting mismatch, i.e. that the same $ 23 million are measured at amortized cost on the asset side and at fair value through profit or loss on the liability side, the standard allows entities at initial recognition, irrevocably, to designate a financial asset as measured at fair value through profit or loss if doing so eliminates or significantly reduces an accounting mismatch. 

As there is assumed to always be a market for Global Bank’s long-term receivables, i.e. there exist other banks or mutual funds, that would be willing to purchase these receivables and collect cash flows from the individuals to which Global Bank originated the mortgage loans, a fair value for those receivables also exist. 

Assuming Global bank does make this designation, both the asset and the liability will be measured at fair value, with movements recognized in the profit or loss, so that fair value movements of both elements to a great extent, offset each other. The accounting mismatch will, by so doing, be either eliminated or significantly reduced.

Queries, comments, are welcome at [email protected]