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POLAR - Path of Least Accounting Resistance

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1 In our last FI Bulletin, we reviewed the balance sheet risk management framework and determined the set of transactions that broadly support a desired change to the financial institution's interest rate risk position. The following traditional on- and off-balance sheet strategies were examined: • Purchase or sell an asset • Incur or repay a liability • Pay- or receive-fixed with an interest rate swap As mentioned in the prior bulletin, selection of the desired interest rate risk position and the corresponding transactions that can be used to "move the needle" is critical, but still only half the story. The next steps, discussed in this bulletin, are to assess the accounting implications of each transaction and pursue the risk mitigating strategies that best accomplish the FI's economic and accounting objectives. POLAR can help guide the FI to the simplest, most efficient, and accounting-friendly solution that has the desired impact on the FI's interest rate risk position. With respect to derivative transactions, the default accounting treatment is to record derivatives on the balance sheet at fair value, with changes in fair value each period recognized directly in earnings. As the earnings volatility that can result from this treatment is often unwanted, it generally limits the usefulness of derivatives for most FIs who want to manage their interest rate risk positions. Under the provisions of ASC Topic 815 (formerly FAS 133), derivatives may qualify for hedge accounting to substantially mitigate or even eliminate earnings volatility. Under the fair value hedge accounting model, both the changes in fair value of the derivative and the designated "hedged item" are recognized directly in earnings. As the two changes substantially offset each other each period, the net impact of these two FI Bulletin

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