Banks’ economic controlling of foreign currency (FX) risks in the banking book is generally position-based, meaning financial instruments in the same currency are considered together and open currency positions are closed or deliberately managed in accordance with the respective risk strategy by means of appropriate hedges.
The appropriate accounting treatment of economic controlling relationships is made more difficult by the general valuation principles of the Commercial Code (HGB), where the prevailing principle of prudence leads to an imparity treatment of FX gains and losses and a maximum valuation of FX positions at the respective acquisition cost.
Banks may, however, circumvent the general valuation principles by applying the special standard under Section 340h of the German Commercial Code (HGB), which allows them to recognize income from currency translation directly in the income statement if there is special hedging in the same currency.
Special Hedging Requires Adequate Documentation
The German Institute of Public Auditors (IDW) has defined the requirements for the existence of special hedging and the resulting accounting consequences in more detail within the framework of IDW BFA 4 “Special Aspects of Foreign Currency Translation at Institutions under Commercial Law.” There is special hedging in accordance with Section 340h of the Commercial Code (HGB) or BFA 4 if
- a special relationship is established between assets and/or liabilities denominated in the same currency, or
- a special hedge is concluded for assets, liabilities and forward exchange transactions denominated in foreign currency for hedging purposes
Both the special relationship between assets and liabilities denominated in the same currency and the special hedging require appropriate documentation. The criteria for special hedging should not be defined arbitrarily and be objectively understandable. It is always advisable to use internal risk management in this context.
Selection of Suitable Transactions
Various positions and instruments are suitable for hedging banking book positions in foreign currencies. These include not only bonds and client deposits in foreign currency, but also cash holdings in foreign currency, forward exchange transactions or currency swaps. The decisive factor is that the transactions included in the special hedge are free of identifiable default risks. In addition, it must be possible to verify the hedging eligibility of the transactions at any time. In particular, in the case of real estate located abroad or foreign investments, a regular review is required to determine whether payment transactions are sufficiently likely to take place at the defined points in time.
In addition to the selection of suitable transactions and documentation, it is also particularly important to ensure identical amounts and matching maturities for the establishment of a special hedging relationship. As a rule, incongruities over time are eliminated by appropriate follow-up transactions when controlling an overall currency position. If a currency is considered fungible and the economic controlling provides for corresponding follow-up transactions, an original matching of maturities may be explicitly waived in accordance with BFA 4.
Neither Section 340 of the Commercial Code (HGB) itself, nor BFA 4 provide explicit guidance on how the documentation and/or the proof of the special hedging is to take place. In practice, on the one hand, it is common to refer to the corresponding guidelines and controlling approaches in bank management. The proof of special hedging also depends on the complexity and scope of the FX transaction. If the case is less complex, the special hedging can often also be proven purely qualitatively. If the models are more complex, quantitative proofs and selection criteria are sometimes necessary for special hedging.
Hedging of Interest-Bearing Transactions by Using Forward Exchange Transactions
If forward exchange transactions are used to hedge interest-bearing balance sheet positions, the forward rate must be separated into its spot rate and swap rate elements in accordance with BFA 4. The swap rate represents the difference between the forward rate and the spot rate resulting from the different interest income opportunities in the individual currencies. While the spot rate component can be included in the special hedging, the swap amounts as an interest component are to be distributed pro rata temporis over the term in net interest income.
FAS AG Support in the Context of Special Hedging
FAS AG has extensive experience in the area of implementing the special hedging for banks in accordance with Section 340 of the Commercial Code (HGB) or BFA 4. In addition to an integrated approach for the consolidation and harmonization of economic FX management and position determination as well as commercial law disclosure regulations, we offer support in identifying eligible positions, developing reporting tools to prove special hedging and drawing up booking logic on the basis of existing booking systems. In addition, we provide advice on the implementation of the existing disclosure requirements and the required disclosures in the Notes to the Financial Statements. If a special hedging relationship between individual FX transactions cannot be established, we develop alternative solutions for adequately reflecting the currency risk.
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