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Asset Sensitive Financial Institutions – Improved Cash Flow Hedge Accounting Standard

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Hedge Accounting Bulletin #4 Asset Sensitive Financial Institutions – Improved Cash Flow Hedge Accounting Standard Financial Institutions that are exposed to falling interest rates often enter into receive-fixed interest rate swaps to preserve their Net Interest Margin. These hedges are typically designated in a cash flow hedging relationship against two types of floating rate assets: (1) pools of LIBOR indexed assets and (2) pools of PRIME indexed assets. The effectiveness of these hedging relationships is directly related to what is recognized under Accounting Standards Codification (ASC) 815, Derivatives and Hedging as a benchmark interest rate. Currently LIBOR, OIS, and US Treasury are identified benchmark interest rates, which allows benchmark risk designations to ignore any credit spread variations in the hedged population. This means that for cash flow hedging relationships where a derivative is designated against floating rate assets, LIBOR indexed assets achieve superior effectiveness and financial reporting as compared to PRIME indexed assets where credit spreads cannot be ignored. This is one of the concerns the new hedging standard improvements will address that will help better align the economic results of an entity's risk management activities with its financial reporting. Hedged Risk Under the proposed standard that is expected to be issued in August 2017, ANY contractually specified rate may be designated as the hedged risk in a cash flow hedging relationship. As a result, PRIME indexed assets will be able to achieve similar effectiveness and financial statement presentation as LIBOR indexed assets currently enjoy. Current Accounting The prime pool is disaggregated into groupings by credit spread. The disaggregated groupings become the designated hedged transactions which result in multiple derivatives structured to match the credit spread composition of the respective pool. 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 Income. The ineffective portion of the changes in fair value flow directly through the Income Statement in the current period in Noninterest Income. Updated Accounting Using the contractually specified component concept, the prime pools can be aggregated at a higher level, eliminating the consideration of credit spreads. Excluding the credit spread significantly reduces mismatches between the swap and prime-based assets; therefore, ineffectiveness will likely be present only if the swap conventions are not structured to perfectly match the prime-based asset conventions (i.e. differences between bank specific Prime rates and the traded Prime H.15 rate) or when prime pools experience shrinkage below the Impact: Prime pools can be aggregated without regard to credit spreads. Redesignation not required for changes from Prime to LIBOR hedged risk after transition. Timing of ineffectiveness will change. More time to complete initial effectiveness assessment. More qualitative effectiveness assessments.

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