A Fresh Look At Derivatives Under New Hedging Rules

A new accounting standard could make hedging with derivatives a more-viable risk management strategy for banks that had previously avoided them.

The 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.

Old 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.

The 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 activities.

When 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.

In 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.

Things 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.

The 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.

Proposed Accounting Changes Should Make Hedging More Attractive to Community Banks


interest-rate-risk-3-31-17.pngIn the regular course of business, banks are exposed to market risks from movements in interest rates, foreign currencies and commodities. Many banks respond by utilizing over the counter derivative instruments to hedge against volatility. Under current accounting standards, banks must account for derivatives under the ASC 815 (formerly FAS 133) models.

There are three hedge accounting “models” under ASC 815: 1) cash flow, 2), fair value, 3) and net investment hedging. There are specific times when one model is required over the others, and the mechanics of each are different in many ways. Because of its breadth, hedge accounting could be seen as intimidating and difficult to understand. There have been instances where banks made mistakes in their adherence to hedge accounting which resulted in income statement volatility. As a result, the perception hedge accounting is difficult and fraught with potential danger has discouraged many banks from entertaining derivative solutions

On September 8, 2016, the Financial Accounting Standards Board (FASB) submitted a proposed draft to update hedge accounting. Specifically, the draft seeks to better align a bank’s economic results with its financial reporting and simplify hedge accounting.

The proposed changes appear to better align the accounting rules with a bank’s risk management objectives and simplifies some important items of ASC 815. Many of the existing rules remain unchanged, but the proposed changes should produce greater interest in the use of derivative solutions among community banks.

Specifically, the proposal for improving how economic results are portrayed on financial statements includes:

  • Expanding the use of component hedging for both nonfinancial and financial risks.
  • Adding the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate as an eligible benchmark interest rate for fair value accounting in the United States.
  • Eliminating the separate measurement and reporting of hedge “ineffectiveness,” a concept that has been difficult for companies to explain and for readers of financial statements to understand.
  • Requiring for cash flow and net investment hedges that all changes in fair value of the hedging instrument included in the hedging relationship be deferred in other comprehensive income and released to the income statement in the period(s) when the hedged item affects earnings.
  • Requiring that changes in the fair value of hedging instruments be recorded in the same income statement line item as the earnings effect of the hedged item.
  • Requiring enhanced disclosures to highlight the effect of hedge accounting on individual income statement line items.

Highlights of the Proposed Changes Most Likely to Affect Financial Institutions

The proposal also includes some ways to simplify hedge accounting, including the following:

  • Providing more time for the completion of initial quantitative assessments of hedge effectiveness.
  • Allowing subsequent assessments of hedge effectiveness to be performed on a qualitative basis when an initial quantitative test is required.
  • Clarifying the use of what’s known as the critical terms match method for a group of forecasted transactions.
  • Allowing an institution that erred in using the shortcut method to continue hedge accounting by using a “long-haul” method.