Derivatives in banking

The income of banks is in the form of interest, fees and commissions.

The main tax and accounting issues in banking finance are:

Taxation of banks is different to that of other companies, because of the special nature of the banks’ trade, namely, banking transactions. For example, the taxation of profits on the disposal of bank investments as part of trading income on a realisation basis, and the taxation of interest payable and receivable on an accruals basis. The issue of whether transactions (e.g. forex transactions fees, and transactions in treasury instruments) are taxable on an accruals basis, or on a realisation basis may be problematic.

Interest

Banks receive interest on loans made by them to borrowers, and pay interest to depositors and other lenders. The differential between interest received and interest paid, called the interest spread, represents the bank’s net income from its lending business.

A bank’s interest receipts and payments can be structured in three ways: fixed rate, variable rate, or notional (a variation on fixed interest). A bank may make a loan at a fixed rate for a period, and then at a variable rate, or at a variable rate which is limited to a fixed rate if interest rates rise or fall. If the interest rate is variable, then its variation is in relation to some form of publicly quoted rate or index, e.g. LIBOR.

A bank might enter into a matched interest rate futures contract to control this risk. For example, bank undertakes to lend £10,000 in 3 months time, for 3 months, at 14 percent, and it agrees to accept a deposit of £10,000 in 3 months, for 3 months, at 11.5%. There are a number of ways in which the interest can be accounted for. The best practice is said to be to reflect the receipt and payment of interest on a daily basis, commencing in 3 months time. This has the effect of spreading the profit from the matched contracts over the 3 month period.

For accounting purposes, bank interest is usually accounted for on the accruals basis, with interest shown in the accounts as income when it is accrued or earned, irrespective of when it is received. There are no compulsory accounting policies for interest income, and it is usually assumed that the accounts are prepared on the accruals basis. The underlying approach should be substance over form, with transactions accounted for and presented in accordance with their financial reality, taking into account underlying risks and rewards, rather than legal form.

Fees and commissions

Auditing guideline 307 Banks in the United Kingdom states that banks should account for fee and commission income:

If the risks underlying a fee-generating transaction continue over a period, the fee should be apportioned. This approach is said to be prudent and to reflect the underlying risks of the transaction. Costs should be offset against the income, but only to the extent that those costs that are clearly linked to the transaction. If there is no continuing risk, then the fee should be recognised up front when the payment is received. For example, when the bank has given advice on a “without prejudice” basis, or has arranged the transaction entirely at the customer’s risk.

Derivative risks

Banks that enter into derivative contracts are forced to deal with a number of forms of risk that result from such contracting.

Credit risk is the most important risk that a bank runs. It is the risk that a debtor or counterparty will be unable to meet its obligations to the bank. A bank charges its customers for assuming credit risk, and the higher the risk, the greater the price that is charged.

Interest rate risk is the risk that arises from a bank running a mismatch on interest rates. It is easy for a bank to attract short-term funds, in the form of call or notice deposits and current accounts, that for withdrawal require either no notice or notice of 3 months or 12 months. Very short term borrowing is renewed regularly at market rates. On the other side, borrowers often demand funding for longer periods and may even demand fixed interest rates, so that they can plan their own cost of funding precisely. Consequently, there may be a mismatch between variable rate interest paid to account holders and the money markets, and longer term fixed interest commitments.

Position risk is the risk that changes to the value of assets, liabilities and commitments will occur as a result of movements in prices, for example, changes in exchange rates or interest rates. Position risk includes currency risk or foreign exchange risk, which is similar in nature to interest rate risk, but which relates to a bank failing to match the currency position of its assets and liabilities. A bank will also retain positions in a range of other assets and liabilities the value of which may vary in accordance with various indices. These include securities positions which vary in accordance with stock market indices, bullion, and other forms of investment. Each of these asset classes may rise or fall in value, resulting in a profit or loss for the bank.

Settlement riskis the risk that a counterparty will not meet its obligations under a transaction to which the bank is a party. It can take the form of payment not being made on the expected date, an asset not being delivered, or documents not being produced when expected. It is also called “delivery risk”. The cost to the bank could be a default charge, or the costs associated with finding an alternative counterparty willing to meet the obligations under the contract.

Bank balance sheet

A bank’s trading assets (also called dealing assets) are marked to market on a regular basis, so that the results of the bank accurately reflect the actions taken and the decisions made during the period. In this way, if the value of a trading asset increases, the bank can sell the asset in the market and obtain a higher price for it immediately. Accordingly, there would be little gain in forcing a bank to call an increase in value of a trading asset an “unrealised profit”, when it could easily be realised. There is no market similar to the financial markets to which there is immediate access, which would permit the increase in value of assets to be unlocked and therefore quickly recognised.

Valuation of trading assets. Trading assets are included in the bank’s accounts at market value. If market value involves a bid-offer spread, then accounting policy is to take one quarter up, as the price to use in the accounts. In practice, most banks use middle market price, which is not as conservative as one quarter up price.

Some trading assets do not, however, have a readily ascertainable market value. For example, fixed property that was purchased as a trading asset; shares that are not listed on a stock exchange; or commodities for which there is no active market. The market in the asset class may also be thin or dirty, so that the price quoted is unreliable. In these cases, a directors’ valuation is made, and this can be reviewed for reasonableness, and must be tested for credibility, based on the experience of the directors involved. If the assets that are to be valued are substantial, then a professional valuer may be used.

A thin market is a market in which there is little or no activity. If there has been no trading in the market for some time, the last traded price may be shown as the market price. But there is no indication that this price would be available to a seller currently. The price is therefore indicative, but cannot be relied on for revaluation purposes. Consequently, the directors’ valuation is relied on instead.

A dirty market is a market in which the prices are fixed in some way, such as where a major player in the market buys up assets that are available, thereby distorting the price of the asset, so that it cannot be used to value the asset. The directors’ valuation is used instead.

Accounting for trading assets. A distinction is drawn in the accounts of a bank between assets that are held for the longer term, either until maturity or as a fixed asset investment, and assets that are purchased for trading purposes. The distinguishing factor is intention at the date of purchase, as this establishes the accounting treatment to be followed.

Generally, trading assets are reported in the accounts at market value, while fixed asset investments are treated as investments but are shown at purchaser price. This has the effect of enabling a bank to maintain one asset type in two portfolios at different prices.

Transfers between portfolios are only made for good commercial reasons.

Transfers from the trading portfolio to the fixed asset portfolio are made at market value. Any gains or short-term falls in value that result subsequent to the transfer are not recognised, unless the asset is periodically valued, matures, or is disposed of.

Transfers from the fixed asset portfolio to the trading portfolio are made at cost. If the asset had previously been stated at a premium to cost, then this will immediately result in a transfer to income as the asset is revalued to market value.

The reason why a bank would want to hold the same instrument both as a trading instrument and as an investment, is that the trading asset is held for a short time with the aim of making a quick profit. If a bank holds assets as trading assets, it should turn them round on a regular basis. A bank holds an asset as an investment for a number of reasons: yield; the matching of a structural imbalance in the bank’s business; or the view that it will generate a good long-term return.

Auditing guideline 307 says that dated securities held as long-term assets are usually accounted for at cost plus or minus the amortisation of any premium or discount, or at cost less some provision for permanent diminution. Dealing securities are usually valued individually, at either the lower of cost or market value, or at market value. These alternative valuation methods can, however, result in similar securities being shown at different values in the bank’s financial statements, depending on the purpose for which they were purchased or held.

Where an instrument has been acquired or used in a trading transaction, it must be revalued or marked to market, and the resulting profit taken to revenue immediately. This is the only way in which the bank’s results can effectively reflect the current risk position relative to that instrument. Some banks, however, when transferring from investment portfolio to trading portfolio at market value, transfer the unrealised gain on transfer to a suspense account, and only recognise the profit as income when the asset is sold.

Interest: Some trading assets are interest-bearing and other are not. This raises the problem of how to account for accrued interest. There is no definite rule. Some banks accrete the interest to the asset that generates it, others show it as a separate asset. Some maintain that because the value of the asset does not truly include interest, asset value should not fluctuate just on account of the payment of periodic and interest receipts that are usually certain to be received; the interest should therefore be shown as a separate balance sheet item.

Investments. Investments are either valued at cost, with provision made for any permanent diminution in value, or at the lower of cost or market value. Investment assets are not revalued upwards or downwards, unless there is a permanent increase or diminution in value.

Trading liabilities. Trading liabilities are the counterparts of trading assets. They usually arise when a trader has entered into a short position (that is, he has sold more of an asset than he has purchased), or has undertaken a matched deal (a purchase and a sale carried out at the same nominal amount to match effectively the risks arising). Trading liabilities are accounted for in the same way as trading assets, but are not netted off against such assets.

Distributable reserves A bank’s reserves include several unrealised items, which may be either gains and losses. These can result from the revaluation of investments, properties, dealing assets, or liquid assets. The value of liquid assets varies due to movements in market prices or interest rates.

Current legislation generally allows banks to treat as “realised” any unrealised profits that are derived from the operation of the bank’s banking business. But the position is not clear with regard to all circumstances, and some cases can cross the borderline. In particular, where an asset which is part of the bank’s fixed assets is revalued, the revaluation gains do not represent realised gains for purposes of reserves and distributions. Losses, irrespective of how they arise, are always considered to have been realised.

Liabilities. If the rule is that liabilities are accounted for according to the circumstances prevailing at the date of issue, in the case of non-equity instruments, implies that the method of liability valuation effectively prohibits valuing at market value. The result is the unusual situation that as a company’s market value falls, its liabilities also fall, giving it a boost. This does not reflect the true position.

Foreign exchange

A foreign exchange transaction is a contract to exchange a bank balance in one currency with a bank balance in another currency, at an agreed rate of exchange at a specific point in time. The price at which the exchange takes place is called the rate.

Foreign exchange transactions that are “spot” are executed currently, for cash settlement two days after execution.

Banks that participate in the interbank market, move large sums of money.

The underlying purpose of forex transactions may be to supply some form of customer requirement for currency, perhaps as a result of a trade finance transaction; or because a customer wishes to create an investment position; or to hedge an existing position. Banks also enter into arbitrage transactions to take advantage of imperfections in market pricing, apart from taking investment positions on their own account. Banks’ customers participate in the forex market for a number of reasons, including the faciliation of international trade; the matching of known cash inflows or outflows from subsidiaries or branches; or for speculative purposes.

Brokers act as intermediaries between commercial counterparties and charge a commission (brokerage) for their services. Their role is to match buying and selling orders.

A foreign exchange dealer may be a market maker who has agreed to make a market in a particular currency. Rates will be quoted for both purchase and sale, and these are the prices at which the dealer agrees to trade. The bid rate is the price at which the dealer or market maker is prepared to puchase foreign currency; the offer rate is the rate at which the dealer is prepared to sell foreign currency; the middle price is the price midway between the offer price and the bid price, often used for valuation or accounting purposes; the spot bid is the price of currency for spot delivery, that is, two days after deal; the spot rate is the price of one currency against another expressed as a ratio, with both currencies’ prices being based on delivery in two days’ time; a hit is a bid rate at which a counterparty has agreed to transact business; and the contract rate is the rate at which the contract has been entered into. The standard contract in the foreign exchange market is a spot contract, designed for delivery in two business days’ time. Next day or even same day settlement is possible, but such transactions are not standard foreign exchange contracts. The market maker will quote a dual price representing a bid price and an offer price. The bid price is always given before the offer price. Where both prices are quoted, it is called a two-way price. If only either a bid price or an offer price are quoted, then the price is called a one-way price. The difference between the bid and the offer prices is the spread or margin. In the London market, the identity of the counterparty is not disclosed until the transaction is finalised. Until that time, both parties are able to withdraw, particularly if they do not have the required credit lines in place. When making a market, a bank commits itself for a short period of time to deal at quoted prices for a set minimum currency amount. Once the quote has been made, the market maker is unable to refuse a transaction if the quote is accepted by a counterparty (ie the market maker is hit). In the foreign exchange market, the physical delivery of funds is rare, and the term ‘delivery’ has a slightly different meaning in this context. In the context of foreign exchange, delivery is achieved through exchanging control over funds, rather than physically transferring them. The delivery is achieved through the banks making accounting entries. If the transaction is with another bank, then the funds will be passed from one bank to another utilising the facilities of the central bank or of some form of clearing house specialising in such transactions. Valuation for foreign exchange purposes For accounting purposes, the results of a company must be measured in either local currency, or reporting currency, or both. This requires the foreign exchange positions to be included in either local or reporting currency equivalents, taking into account any resulting exchange gains or losses. The problem is to determine the basis for valuing such positions. The most common method is the ‘buy-back’ method (also known as the ‘cover method’). It involves valuing forward transactions at the amount for which they could be purchased or sold at the balance sheet date. Spot assets and liabilities are valued at the middle market spot rate on the valuation date. The recording of foreign exchange transactions reflects the purchase (cash outflow) of one currency, in exchange for the sale (cash inflow) in another currency. The transactions themselves merely generate entries across the various nostro accounts, and do not themselves result in any profit or loss. The second phase of foreign exchange accounting is the revaluation of the remaining positions, which is the point at which profits and losses arise. When a bank enters into a foreign exchange transaction, it is increasing a position in one currency, and reducing a position in another currency. The positions in both currencies will have changed, and at the point at which the transaction is entered into, the equivalents of the changes would be the same. The local currency equivalent value of the position retained will, however, move with changes in market exchange rates. Any series of positions that a bank maintains is worth an amount of money in local currency equivalents. As the exchange rates when compared to local currency vary, the difference will constitute a profit or loss in local currency. The bank would maintain a “revaluation account”, to which revaluation gains would be credited and revaluation losses debited. SSAP 20 It sets out the standard accounting practice for foreign currency translation, but does not deal with the method to be used to calculate profits or losses arising from a company’s normal currency dealing operations, nor specifically with the determination of distributable profits. It says that the object of translation of foreign currency is to produce results that are generally compatible with the effects of rate changes on a company’s cash flows and its equity. These principles are as appropriate for a bank as for any other company, and therefore the rules of SSAP 20 still apply. The standard says that at the balance sheet date, monetary assets and liabilities denominated in foreign currency (eg cash, bank balances, loans, and amounts receivable and payable) should be translated at the rate of exchange prevailing at that date, or where appropriate, at the rate fixed under the terms of the relevant transaction. It says that an exchange gain or loss will arise on unsettled transactions, if the rate of exchange used at the balance sheet date differs from the rate used previously. The standard provides that where foreign currency borrowings have been contracted, in order to finance or hedge foreign equity investments, the investment should be translated at the closing rate, with the exchange gain or loss on the foreign currency borrowing being offset against it, through reserves. Cox says that 10 years previously, there were more transactions that could be put through reserves, but the mood of the accounting profession has gone against reserve accounting. Schedule 9 of the Companies Act Schedule 9 of the Companies Act 1985 (which was revised as a result of the EC Bank Accounts Directive 86/635/EEC) makes legal rules for foreign currency accounting for banks, as opposed to the standard that applies to other companies. The basic rule is that assets and liabilities denominated in foreign currencies should be translated at the spot rate ruling on the balance sheet date. There is an exception for fixed asset investments denominated in foreign currencies, where there is the option of using an historic rate. Uncompleted spot transactions which remain outstanding at the balance sheet date must be revalued at the current spot rate. All gains and losses are taken directly to the profit and loss account. The only exception to this is any gain or loss resulting from the revaluation of a fixed asset, or a transaction entered into to hedge a fixed asset position, in which case the gain or loss can be posted to a non-distributable reserve. The BBA SORP “Off Balance Sheet Instruments ….” highlights the importance of a position, and any instrument entered into in order to hedge such a position being accounted for on a consistent basis.