Resources

Liability Sensitive Financial Institutions – Improvements to Cash Flow Hedge Accounting

Issue link: https://resources.chathamfinancial.com/i/935538

Contents of this Issue

Navigation

Page 0 of 4

Hedge Accounting Bulletin #5 Liability Sensitive Financial Institutions – Improvements to Cash Flow Hedge Accounting The majority of medium-size commercial banks and most community banks are exposed to rising interest rates due to the natural composition of their balance sheet. They are often faced with high demand for fixed rate lending while they may not be able to secure long term fixed-rate financing of their own. As a result, they may alter their interest rate risk position by entering into pay-fixed, receive-floating interest rate derivatives to hedge their risk. These hedges are typically designated in cash flow hedging relationships against a variety of floating rate liabilities. The following list outlines the most common hedged items used in cash flow hedging relationships for liability sensitive banks and the related impact to volatility in income statement presentation due to ineffectiveness: Hedged Transactions Ineffectiveness Source Wholesale Rolling Funding Misalignment of rolling periods over time Wholesale Term Funding Reset date or convention mismatches Indexed Deposits Reset date or convention mismatches Managed Rate Deposits Lagging of rate movements over time While the new hedge accounting standard that is expected to be issued in August 2017, allows for any contractually specified rate to be designated as the hedged risk in a cash flow hedging relationship, it does not have a direct impact on the abovementioned strategies. Most already enjoy the benefit of benchmark interest rate designation which minimizes the presence of ineffectiveness. The overall amount of ineffectiveness will not be impacted by these changes, but the timing and presentation of ineffectiveness on the income statement will be different. Managed Rate Deposit hedges cannot utilize the benchmark interest rate designation technique under the current standard nor will they be able to take advantage of the contractually specified rate designation under the new hedging standard; therefore, ineffectiveness will always be present, but will be presented differently. Current Accounting The swap is carried on the balance sheet at fair value with the effective portion of the changes in value running through AOCI. Settlements on the swap are recognized in Interest Expense. The ineffective portion of the changes in fair value flow through the Income Statement in the current period. Ineffectiveness is always present in these hedging relationships as financial institutions often lag or incrementally adjust deposit pricing as compared to market rate movements. Impact: Timing of ineffectiveness will change. Redesignation not required for changes in hedge risk after transition. More time to complete initial quantitative effectiveness assessment. Qualitative effectiveness assessments possible when no mismatches exist.

Articles in this issue

view archives of Resources - Liability Sensitive Financial Institutions – Improvements to Cash Flow Hedge Accounting