Simplified Hedging Guidance Provides Opportunities for Financial Institutions

A recent accounting standard update has significantly improved hedge accounting guidance, by simplifying it and by better aligning hedge accounting with risk mitigation activities. These improvements have unveiled interest-rate risk management strategies that were previously unavailable to credit unions and banks. Accounting Standard Update (ASU) 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, delivers efficient interest-rate risk hedging strategies that are more easily implemented and managed by credit union and bank management teams. For nonpublic entities, this ASU is effective in 2020, however early adoption is permitted.

Although the ASU has resulted in targeted improvements across hedge accounting, in this article, we will focus on the improvements that will most significantly impact credit unions and banks. Because credit unions and banks are in the business of turning short-term deposits into longer-term loans, they are inherently exposed to interest-rate risk. Most credit unions and banks would be negatively impacted by an increasing interest-rate environment, oppositely some may also have significant downside risks.

Interest-rate swaps provide credit unions and banks a method to manage the negative impacts that interest-rate changes may have on cash flows. However, formerly, Topic 815’s guidance only provided limited hedging options for credit unions and banks. For example, entering an interest-rate fair-value hedge on pool of pre-payable fixed-rate assets (e.g., a pool of mortgage loans) was not considered feasible or an effective hedging strategy. Instead many financial institutions would enter interest-rate cash flow hedges on liabilities, which is a strategy that may have undesired consequences, such as negatively impacting future re-pricing decisions on the hedged liability (e.g., needing to keep member six-month CD rates in alignment with the six-month LIBOR for hedge effectiveness purposes).

 

 

 

However certain targeted improvements of this ASU has opened the door to effective and less complex fair-value hedges that may be used to directly hedge the interest-rate risk exposure created by a pool of long-term assets (e.g., mortgage loans or investments):

Key targeted improvements simplifying fair value hedges:

• Entities may exclude the credit spread component of fixed-rate cash flows on hedged item(s) (assets/liabilities) when measuring the fair value of the hedged item(s). As well as, exclude the prepayment component not related to the hedged risk (e.g., interest-rate risk), such as defaults on mortgage loans. These changes will result in more effective hedge relationships that may be supported by less complex calculations.
• Entities may designate a portion of the term of the hedged financial instrument as the hedged item (i.e., only the first three years of a five year instrument). This feature will significantly improve strategy options, such as options to hedge the “last-of-layer” or callable financial instruments.
• The “last-of-layer” designation combined with the above changes, will be the critical allowing credit unions and banks to hedge a pool of pre-payable assets (e.g., loans or investments) with very low risks of ineffectiveness. This designation allows for an entity to designate a specific “last layer” on a closed pool of fixed-rate assets as the portion or the “layer” hedged. When paired with the correct strategy, these designations will nearly eliminate concerns of prepayments causing hedge ineffectiveness.

 

 

 

 

 

Additionally, to reduce the cost and complexity of applying hedge accounting, the ASU has simplified tedious requirements surrounding ongoing assessments of hedge effectiveness:

Key targeted improvements simplifying hedge accounting:

• After selecting a strategy and performing initial quantitative effectiveness assessments, credit unions and banks may perform subsequent assessments of hedge effectiveness qualitatively if certain conditions are met.
• Ineffectiveness no longer needs to be specifically measured or reported, as it no longer needs to be recognized separately from effective activity. This will greatly simplify and improve the recognition and presentation of hedge activity.

 

 

 

 

Presentation and Disclosures:

There are new presentation and disclosure requirements that will result in a much more transparent and understandable presentation.

Conclusion:

Management teams may have previously considered using swaps as interest-rate hedges, but determined the benefits (e.g., interest-rate risk mitigation or possible income resulting strategies) of implementing hedge accounting were not in alignment with the costs. However, for some credit unions and banks this ASU may have rebalanced the scale. If your management team believes your current mortgage loan or security investment strategies are being dictated by interest-rate risk, we recommend reviewing the potential of a risk mitigation transaction to hedge interest-rate risk.

Transactions in interest-rate swaps have significant risks, including but not limited to, substantial risk of loss. Therefore, management teams should consult internal and/or external advisors when considering interest-rate swap transactions, and not enter any interest-rate swap transaction without fully understanding all risks. When applying the guidance under the new ASU, credit unions and banks should closely review their facts and circumstances with the provisions. If you have specific implementation questions, contact top CPA firm Doeren Mayhew. Our credit union CPAs and bank CPAs stand ready to assist you.