23 Derivatives and hedge accounting
Use of derivatives and hedge accounting
As described in the Risk management section, ING Group uses derivatives (principally interest rate swaps and cross currency interest rate swaps) for economic hedging purposes in the management of its asset and liability portfolios and structural positions. The objective of economic hedging is to enter into positions with an opposite risk profile to an identified exposure to reduce that exposure. The impact of ING Group’s hedging activities is to optimise the overall cost to the Group of accessing debt capital markets and to mitigate the market risk which would otherwise arise from structural imbalances in the duration and other profiles of its assets and liabilities. In addition, hedging activities are undertaken to hedge against the interest rate risk in the mortgage offer period in relation to retail mortgages and to lock-in the interest margin in relation to interest bearing assets and the related funding.
The accounting treatment of hedge transactions varies according to the nature of the instrument hedged and whether the hedge qualifies under the IFRS-EU hedge accounting rules. Derivatives that qualify for hedge accounting under IFRS–EU are classified and accounted for according to the nature of the instrument hedged and the type of IFRS-EU hedge model that is applicable. The three models applicable under IFRS-EU are: fair value hedge accounting, cash flow hedge accounting and net investment hedge accounting. These are described under the relevant headings below. The company’s detailed accounting policies for these three hedge models are set out in section ‘Principles of valuation and determination of results’.
To qualify for hedge accounting under IFRS-EU, strict criteria must be met. Certain hedges that are economically effective from a risk management perspective do not qualify for hedge accounting under IFRS-EU. The fair value changes of derivatives relating to such non qualifying hedges are taken to the profit and loss account. However, in certain cases, the Group mitigates the resultant profit and loss account volatility by designating hedged assets and liabilities at fair value through profit and loss. If hedge accounting is applied under IFRS-EU, it is possible that during the hedge a hedge relationship no longer qualifies for hedge accounting and hedge accounting cannot be continued, even if the hedge remains economically effective. As a result, the volatility arising from undertaking economic hedging in the profit and loss account may be higher than would be expected from an economic point of view.
With respect to exchange rate and interest rate derivative contracts, the notional or contractual amounts of these instruments is indicative of the nominal value of transactions outstanding at the balance sheet date; they do however not represent amounts at risk. ING Group uses credit derivatives in managing its exposure to credit risk, including total return swaps and credit default swaps, to sell or buy protection for credit risk exposures in the loan, investment and trading portfolios. Hedge accounting is not applied in relation to credit derivatives.
Fair value hedge accounting
ING Group’s fair value hedges principally consist of interest rate swaps and cross-currency interest rate swaps that are used to protect against changes in the fair value of fixed-rate instruments due to movements in market interest rates.
Gains and losses on derivatives designated under fair value hedge accounting are recognised in the profit and loss account. The effective portion of the fair value change on the hedged item is also recognised in the profit and loss account. As a result, only the net accounting ineffectiveness impacts the net profit.
For the year ended 31 December 2007, ING Group recognised in the profit and loss account EUR 697 million (2006: EUR 41 million) of fair value changes on derivatives designated under fair value hedge accounting. This amount was partly offset by EUR 663 million (2006: EUR –8 million) fair value changes recognised on hedged items. This resulted in EUR 34 million (2006: EUR 49 million) net accounting ineffectiveness recognised in the profit and loss account. At 31 December 2007, the fair values of outstanding derivatives designated under fair value hedge accounting was EUR 994 million (2006: EUR 474 million), presented in the balance sheet as EUR 1,952 million (2006: EUR 1,080 million) positive fair values under assets and EUR 958 million (2006: EUR 606 million) negative fair values under liabilities.
ING Group applies fair value hedge accounting for portfolio hedges of interest rate risk (macro hedging) under the EU ‘carve out’ of IFRS-EU. The EU ‘carve-out’ macro hedging enables a group of derivatives (or proportions) to be viewed in combination and jointly designated as the hedging instrument and removes some of the limitations in fair value hedge accounting relating to hedging core deposits and under-hedging strategies. Under the IFRS-EU ‘carve-out’, hedge accounting may be applied to core deposits and ineffectiveness only arises when the revised estimate of the amount of cash flows in scheduled time buckets falls below the designated amount of that bucket.
Cash flow hedge accounting
ING Group’s cash flow hedges principally consist of (forward) interest rate swaps and cross-currency interest rate swaps that are used to protect against its exposure to variability in future interest cash flows on non-trading assets and liabilities that bear interest at variable rates or are expected to be refunded or reinvested in the future. The amounts and timing of future cash flows, representing both principal and interest flows, are projected for each portfolio of financial assets and liabilities, based on contractual terms and other relevant factors including estimates of prepayments and defaults. The aggregate principal balances and interest cash flows across for the respective portfolios form the basis for identifying the notional amount subject to interest rate risk that is designated under cash flow hedge accounting.
Gains and losses on the effective portions of derivatives designated under cash flow hedge accounting are recorded in Shareholders’ equity. Interest cash flows on these derivatives are recognised in the profit and loss account in interest income consistently with the manner in which the forecast cash flows affect net profit. The gains and losses on ineffective portions of such derivatives are recognised immediately in the profit and loss account.
For the year ended 31 December 2007, ING Group recognised EUR –925 million (2006: EUR –690 million) after tax in equity as effective fair value changes on derivatives under cash flow hedge accounting. As a consequence, the balance of the cash flow hedge reserve in equity at 31 December 2007 was EUR 463 million (2006: EUR 1,819 million) gross and EUR 431 million (2006: EUR 1,356 million) after deferred tax. This cash flow hedge reserve will fluctuate with the fair value changes on the underlying derivatives and will be reflected in the profit and loss account under Interest income/expense over the remaining term of the underlying hedged items. The cash flow hedge reserve relates to a large number of derivatives and hedged items with varying maturities, up to 40 years for insurance operations and 21 years for banking operations, with the largest concentration in the range of 20 to 25 years for insurance operations and 5 to 10 years for banking operations. Accounting ineffectiveness on derivatives designated under cash flow hedge accounting of EUR –9 million (2006: EUR –7 million) was recognised in the profit and loss account.
At 31 December 2007, the fair values of outstanding derivatives designated under cash flow hedge accounting was EUR 229 million (2006: EUR 1,921 million), presented in the balance sheet as EUR 3,417 million (2006: EUR 3,617 million) positive fair values under assets and EUR 3,188 million (2006: EUR 1,696 million) negative fair values under liabilities.
At 31 December 2007 and 31 December 2006, there were no non-derivatives designated as hedging instruments for cash flow hedge accounting purposes.
Included in Interest income and interest expense on non-trading derivatives is EUR 2,317 million (2006: EUR 3,440 million) and EUR 2,042 million (2006: EUR 3,097 million) respectively relating to derivatives used in cash flow hedges.
Hedges of net investments in foreign operations
ING Group’s net investment hedges principally consist of derivatives (including currency forwards and swaps) and non-derivative financial instruments such as foreign currency denominated funding that are used to protect against foreign currency exposures on foreign subsidiaries.
Gains and losses on the effective portions of derivatives designated under net investment hedge accounting are recorded in Shareholders’ equity. The balance in equity is recognised in the profit and loss account when the related foreign subsidiary is disposed. The gains and losses on ineffective portions are recognised immediately in the profit and loss account.
At 31 December 2007, the fair values of outstanding derivatives designated under net investment hedge accounting was EUR –71 million (2006: EUR –4 million), presented in the balance sheet as EUR 281 million (2006: EUR 3 million) positive fair values under assets and EUR 352 million (2006: EUR 7 million) negative fair values under liabilities.
At 31 December 2007, the fair values of outstanding non-derivatives designated under net investment hedge accounting was EUR –1,318 million (2006: EUR –1,520 million), presented in the balance sheet as negative fair values under liabilities. Non-derivatives designated as hedging instruments consist mainly of loan agreements.
Accounting ineffectiveness recognised in the profit and loss account for the year ended 31 December 2007 on derivatives and non-derivatives designated under net investment hedge accounting was EUR –14 million (2006: EUR –12 million).
