Complex hedge accounting rules are high on the list of reasons that community banks have chosen to avoid derivatives as risk management tools. But the Financial Accounting Standards Board (FASB) created a stir a little over a year ago, when it promised to improve accounting for hedging activities. That stir turned into a wave of fanfare from community banks in August 2017, when the final Accounting Standards Update (ASU 2017-12) was issued for ASC 815 - Derivatives and Hedging, the standard formerly known as FAS 133. In order to appreciate the excitement surrounding the new hedging guidance from FASB, it helps to take a quick look at the history behind the accounting standard that is widely considered to be the most complex the accounting organization has ever issued.
When derivatives were introduced in the mid-1980s, they were known as “off-balance sheet” instruments because there was not a neat way to fit them onto a firm’s financial statements. Derivatives were instead relegated to the footnotes. As derivative structures became more complex and began to be used more aggressively by treasurers who often viewed derivatives as profit centers, a sharp unexpected rate hike in 1994 led to large derivative losses at Procter & Gamble and others. With speculative trades buried deep in the footnotes, demands for transparency from the investor community led to FAS 133 which, starting in 2000, required for the first time that derivatives be carried at fair value on the balance sheet.
In order to prevent having on-balance sheet derivative values lead to wild swings in earnings, hedge accounting rules were created as a shock absorber. But while the original intent of hedge accounting was to be helpful, in practice it was difficult to apply and unforgiving when applied incorrectly. It also lacked viable solutions for some of the most common challenges facing community banks.
With that as a backdrop, here are three changes included in ASU 2017-12 that will make hedging with derivatives much more practical and worry-free for community banks.
1. Portfolio Hedging of Fixed-Rate Assets
What made hedging a portfolio of fixed-rate mortgages impractical under the original standard was the caveat that almost every loan in the pool needed to be homogeneous with regard to origination date, maturity date and prepayment characteristics. Some banks would occasionally hedge larger commercial loans one at a time, but this very common source of interest rate risk was either hedged in a different manner or ignored in the past. The newly introduced “last-of-layer” designation eliminates this unattainable caveat and will enable liability-sensitive banks to hedge a portion of an identified closed portfolio of prepayable assets. As a result of this new strategy, banks will have a one-time opportunity to reclassify held-to-maturity securities as available for sale if they are eligible for the last-of-layer designation. Mitigating interest rate risk in both the loan and securities portfolios will now be squarely on the table for community banks’ consideration.
2. Impact of Hedging on NIM
Most banks undertaking a derivative strategy are looking to protect or enhance the bank’s net interest margin (NIM). The original standard required that hedge ineffectiveness be measured, which sometimes created unwanted accounting surprises. By eliminating the concept of ineffectiveness from the hedging framework, FASB will reduce complexity associated with interpreting hedging results. Hedge mismatches will no longer need to be separately measured and reported in financial statements. The economic impact from mismatches between the hedge and the hedged item will be reported in the same income statement line item when the hedged item affects earnings. For banks, this will enable typical hedging activities to impact NIM as intended.
3. Reduced Restatement Risk
In the past, some banks attempted to reduce the burden of hedging through the use of the “shortcut method,” where the assumption of a perfectly effective hedge was permitted by FASB when specific conditions were met. But the breach of any shortcut criterion, due to a minor missed detail or an unexpected change in business conditions, led to a loss of hedge accounting privileges and sometimes an embarrassing accounting restatement. The new ASU introduces an improvement to the shortcut method of assessing effectiveness by allowing for a fallback, long-haul method to be documented at the time of designation. This change will significantly reduce the risk of a restatement, and banks will be able to pursue prudent hedging activities with less fear of an accounting misstep.
By reducing complexity and making more hedging strategies viable, the new guidance is expected to be adopted prior to the mandatory 2019 deadline by most banks who actively hedge. In addition, more community banks are likely to consider installing hedging capabilities for the first time thanks to FASB clearing this long-time roadblock.