new accounting standard could make hedging with derivatives a more-viable risk
management strategy for banks that had previously avoided them.
Financial Accounting Standards Board sought to remove some barriers that
previously discouraged many banks from using derivatives to hedge exposure to
fluctuating interest rates. Now is an appropriate time for board members at
banks of all sizes to ask their executive teams about their risk management
strategies, and whether derivatives should play a larger role.
The standard – Accounting Standards Update (ASU) 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities” – went into effect for publicly traded institutions in the fiscal year beginning after Dec. 15, 2018. It takes effect for privately held banks in the fiscal year beginning after Dec. 15, 2020, though early adoption is permitted.
In theory, using derivatives such as interest-rate swaps should be an effective way for banks to fine-tune portfolios and offset risks that come with having a mix of fixed rate and floating rate assets and liabilities. In practice, however, many banks chose not to hedge with derivatives because of complicated accounting and financial reporting practices required by generally accepted accounting principles.
hedging rules required banks to separately measure and report hedge
ineffectiveness, or any amounts by which a derivative did not perfectly mirror
the instrument being hedged -even if the hedge was effective overall. Separately
reporting ineffectiveness was confusing for investors and often conveyed a
misleading impression of a bank’s derivatives-based hedging practices.
new standard eliminates that requirement, resulting in hedge accounting that more
accurately reflects a bank’s risk management activities and provides financial
statement users more worthwhile information about the effect of hedging
initially establishing a hedge, banks must document how they will evaluate its effectiveness
in offsetting the changes in the fair value or cash flow of the hedged instrument.
This evaluation must be performed quarterly.
the past, when a bank chose the “shortcut” method for evaluating hedge effectiveness,
it was bound to that method throughout the life of the hedge. If management later
determined that the more complicated “long-haul” method would be more
appropriate, they could not simply start using that method prospectively.
Rather, they would also have to evaluate for a possible restatement of previous
financial statements, as if hedge accounting had never been applied.
The new standard changes that. Banks now may specify a long-haul method in their documentation to be used as a fallback method if they later determine that the shortcut method is no longer appropriate.
also have gotten simpler for banks that choose the long-haul method at inception.
Previously, banks using the long-haul method were required to perform a
quantitative assessment (such as a regression analysis) every quarter for the
life of a hedge. The new standard still requires a quantitative assessment at
inception, but now in certain circumstances banks can perform subsequent quarterly
assessments using only qualitative methods, validating that the terms and
conditions of the hedged transaction and hedging derivative have not changed.
new guidance also revises how a bank may measure the change in a hedged item’s
fair value due to changes in its benchmark interest rate. Instead of calculating
fair value based on all the cash flows of the instrument’s coupon, banks now
can calculate the change in fair value based solely on the benchmark interest
rate component, which is a more targeted and appropriate measure.
Under old hedging rules, hedging the change in fair value of an instrument (such as a fixed-rate loan) generally required the life of the hedged instrument and the life of the hedging derivative (such as an interest-rate swap) to match. The new standard removes that burden and allows for partial-term fair value hedges. For example, a bank can hedge a 10-year fixed rate loan for only two years, using a two-year interest-rate swap.
Another new opportunity known as the “last-of-layer” technique lets banks hedge the change in fair value of a pool of long-term fixed rate assets such as loans or securities – a hedge that generally was not possible in the past. Upon adoption of the standard, banks are permitted to transfer eligible held-to-maturity securities to available for sale, even if the bank eventually chooses not to hedge the securities at all.
Bank directors should familiarize themselves with the ways the new standard simplifies hedge accounting and enables new hedging techniques before engaging management to decide if it’s time to introduce or expand derivatives as risk management tools.