FASB Update Facilitates Hedging of Fixed-Income Risk

After a pandemic-induced delay, Financial Accounting Standards Board (FASB) guidance is allowing banks and others greater flexibility to hedge fixed-income assets and potentially benefiting those seeing interest rates rising significantly.

An Accounting Standards Update (ASU 2022-01), issued in March, further clarifies guidance for fair-value hedge accounting of interest rate risk by introducing the portfolio-layer hedging method. It improves on the ASU 2017-12 “last of layer” concept, which enabled institutions to hedge a portfolio of fixed-rate loans or securities categorized as available for sale (AFS), rather than hedging the individual assets.

“That was the first time the FASB allowed this type of strategy, and it was a huge improvement,” said Eri Panoti, who leads the Financial Institutions Hedge Accounting practice at Chatham Financial. “But there were a lot of boundaries that firms had to operate within.”

Under the 2017 last-of-layer guidance, institutions had to define a portfolio of fixed-rate assets that were prepayable before, but contractually matured after, the constant- or bullet-notional term swap’s maturity date. While that was a step forward, Panoti said, the unpredictability of prepayment risk, the use of non-amortizing swaps, and the one-portfolio to one-hedge approach, was still difficult for banks to use.

Eri Panoti, Chatham Financial

After industry concerns were raised, the FASB began deliberations that were slowed by the need to address issues arising during the pandemic.

The recent update allows for a wider variety of hedges, including amortizing swaps. And institutions can create multiple layers of derivatives to hedge a portfolio of assets, to account for the changing volumes of prepayable – and now also non-prepayable assets – as they run off.

“That’s why ‘portfolio layer’ method was a more appropriate term for describing the complex layering methodology to hedge a closed portfolio of assets,” Panoti said.

Banks Are Main Focus

The timing of the new flexibility, as bond prices fall and rates rise, may be fortuitous for some, since FASB permits early adoption on or after the update’s issuance date, as long as the entity has also adopted all the amendments in the 2017 update. The changes, however, were primarily instituted to benefit banks; they typically hold significant volumes of fixed-rate assets such as mortgages and government bonds that are funded with shorter-term liabilities.

Long-term mortgages are not likely to be refinanced in a rising rate environment, creating an asset/liability mismatch. Banks use derivatives to hedge that risk and protect their interest margins. Their new flexibility, in terms of the derivatives they can use and assets they can hedge, enables easier hedging of the mismatch, said Jon Howard, a senior consultation partner in the Financial Instruments Group of Accounting Services, Deloitte & Touche. 

Jon Howard, Deloitte & Touche

In fact, numerous banks’ formal comments about the update were highly supportive.

“We believe the multiple-layer model would better align hedge accounting guidance with risk management objectives,” wrote Brad Kimbrough, controller and chief accounting officer of Regions Bank, Birmingham, Alabama. “It will provide flexibility to designate hedging relationships based on management’s expectations regarding prepayment timing in a more effective manner.”

Flexibility in Layering

One of the most important changes, Howard said, is the ability to layer on more derivatives. A bank that sees its $100 million portfolio of fixed-rate loans decreasing by $10 million each year could put on a hedge of $90 million the first year, $80 million the second, and $70 million the third. Under the last-of-layer approach, a bank wanting to hedge for three years could hedge only with a $70 million notional swap, because it had to make sure the entire balance would be outstanding for the life of the swap.

“So they’re really allowed to have bigger coverage over a longer period of time,” Howard said.

Before last-of-layer, Chatham’s Panoti said, institutions at times had to manage interest-rate risk on their balance sheets by routinely replacing numerous old hedges with new ones. Besides additional operational risk and costs, volatility stemming solely from the hedging activity could impact institutions’ financial statements.

“The update allows organizations to better align their risk objectives with derivative activity in their financial statements,” Panoti explained.

Corporate Implications

Nonbanks can also benefit. Corporates, for example, typically invest excess cash in highly rated and shorter-term government bonds, asset-backed securities and corporate bonds, as they seek returns while keeping cash available for acquisitions or other needs. Now they have more flexibility to set up hedges to protect assets amid market volatility.

For those intending to hold fixed-rate assets to maturity, price fluctuations in the interim are irrelevant as long as interest payments are made on time. But if they foresee a possible need to sell prior to maturity, it is now easier to hedge any changes in fair value.

“If rates go up, and now I’m going to lose money selling a portfolio of securities, at least my swap will have a positive fair value, and I can close it out and offset some of the loss,” Howard said.

HTM to AFS

Institutions desiring more flexibility can now reclassify held-to-maturity (HTM) as AFS, as long they put the holdings in a portfolio-layer-method hedge within 30 days – the same amount of time they have to decide which securities to reclassify. A potential side benefit for a corporate, Howard said, is to reduce assets that are subject to the current expected credit loss (CECL) methodology, which applies to HTM but not AFS securities.

“You could hedge for a short period of time after the reclassification,” he said. “For example, an entity could reclassify a 10-year bond out of HTM, hedge it for a year, and now you don’t have to apply CECL going forward.”

The change’s primary purpose, however, is to facilitate banks’ hedging of fixed-rate assets. Panoti said those could vary widely, from Treasuries and other government securities to mortgage-backed and commercial mortgage-backed securities, and the maturities could vary widely. She added that, if beneficial from a cost and/or risk perspective, an institution could aggregate all those assets in a massive portfolio and hedge them with multiple derivatives, either all at once or over time as its interest-rate risk profile changes.