Proposed changes in an accounting standard could give depository institutions greater flexibility to hedge in an uncertain interest-rate environment.
“We’ve got banks that are now hedging both up-rate and down-rate scenarios,” said Adam Byers, director of hedge accounting at Derivative Path. “They need to have that earnings sanity and balance-sheet sanity that comes from hedge accounting.”
The Financial Accounting Standards Board (FASB) is reviewing feedback on three proposed amendments to its hedge accounting standard that were open for public comment until mid-August. They are the latest in a series of targeted changes to FAS 133, “Accounting for Derivative Instruments and Hedging Activities.”
Adam Byers
The most consequential amendment would permit hedge accounting for interest-rate risk in portfolios of held-to-maturity (HTM) debt securities. Without it, prudent risk management strategies can be discouraged, according to the American Bankers Association’s comment letter.
The other proposals would broaden use of the Secured Overnight Financing Rate (SOFR) as a benchmark and expand available net investment hedges.
“The ABA strongly supports each of the specific proposals, which will remove unnecessary constraints on hedging and better align financial reporting with institutions’ risk management activities,” Josh Stein, vice president of accounting and financial management, said in a statement accompanying the association’s formal comment.
Other financial industry representatives, including the International Swaps and Derivatives Association and Financial Executives International, also supported the proposals.
Allowing hedges of held-to-maturity securities is particularly relevant to depository institutions, which typically hold significant portfolios of Treasuries and other government bonds. Some are designated as available-for-sale for liquidity purposes, others as HTM to reduce volatility from gains or losses being recognized in earnings or regulatory capital. Current accounting language, however, prohibits applying hedge accounting to HTM portfolios.
“A securities HTM accounting classification does not eliminate its underlying interest-rate risk, yet current GAAP generally prevents an institution from applying hedge accounting to that risk,” Rob Hybiak, managing director at Chatham Financial, pointed out.
Rob Hybiak
Institutions would be able to more effectively hedge the net impact of their actual economic interest-rate risk profile, stemming from assets and liabilities and financial instruments that may be fixed- or floating-rate and include floors, caps and other contractual mechanisms.
“That’s a big deal for them, especially in the post-Libor world where floating-rate assets may be priced over a variety of benchmarks,” Byers said. “Trying to group those exposures today into sensible pools for hedges sometimes requires stitching things together in challenging ways. Opening up HTM securities as another eligible risk in a hedging relationship can be easier.”
ISDA in its comment called it “clear and operable,” to allow application of fair value and cash flow hedge accounting to HTM securities without jeopardizing the HTM classification. Under the proposal, financial-statement preparers should benefit from applying hedge accounting’s “portfolio layer method” (PLM), to designate a specific portion of securities as a hedged item. It recommends one-time transition relief allowing entities to add HTM debt securities previously precluded from hedge accounting to existing PLM portfolios without having to de-designate and re-designate them.
Insurance companies and corporates may also benefit from the change, although they tend to have smaller HTM portfolios, Byers said.
Clayton Legear, chairman and CEO of Merchants & Marine Bancorp and TownBridge Bank, Mobile, Alabama, a former FDIC examiner, said removing an accounting obstacle to prudent risk management makes sense for institutions with the sophistication and infrastructure to use derivatives. He added, however, that the accounting change is likely to prompt a wave of products and “tailored strategies” by brokers and consultants
Clayton Legear
Banks could be encouraged to pair longer-duration HTM securities to capture additional yield with swaps to mitigate the resulting interest-rate exposure. That may produce an attractive risk-adjusted return on paper, Legear said, but it also introduces additional counterparty, liquidity, basis, operational, accounting and termination risk.
A bank forced to sell an HTM security in a stress situation faces economic and accounting consequences, he added, and a derivative hedge may also require addressing its fair value, collateral requirements, termination economics, and related hedge-accounting impact.
“That adds complexity at precisely the moment when liquidity, simplicity and optionality may matter most,” the banker said.
Another proposed amendment would make term SOFR eligible as a hedging benchmark. Eligibility is currently limited to the SOFR Overnight Index Swap (OIS) rate. That can require an institution to choose between a derivative that best matches its economic exposure or the hedge accounting provisions.
“Allowing any tenor of SOFR to qualify would reduce that tension and simplify certain hedge relationships,” said the Chatham hedge accounting expert.
The third FASB amendment may have a bigger impact on corporates, since it could permit foreign-exchange, net-income hedges without having to return to the dealer to obtain separate basis swaps for transaction legs with different reset dates.
“That’s going to make it cheaper and less burdensome for internationally operating corporates to do net investment hedging with cross-currency swaps,” Byers said.
Since FASB would allow hedges currently not permitted, rather than introducing new concepts, they should pose few implementation obstacles. ISDA said its application should require minimal effort, and because hedge accounting is elective, firms can adopt the guidance at their convenience.
Longer term, Hybiak said, one of the clearest sources of operational relief is having fewer accounting-driven workarounds, and therefore “less need to introduce artificial mismatches or use more complex accounting approaches simply to fit the guidance.”
The ABA noted the amendments are part of FASB’s broader plan to address hedge accounting issues in the short and medium term, and to reconsider hedge accounting more broadly for the long term.