Derivatives can be effective tools for managing various risks in financial institutions, especially interest rate risk; however, not many community financial institutions use derivatives for a variety of reasons, including:
- Derivatives are not always well understood.
- Derivatives can change the risk profile of a balance sheet very quickly, sometimes causing unintended consequences, especially if the impact of the derivatives isn’t well understood up front.
- Accounting for derivatives when hedge accounting is not used can result in volatility in the income statement since the change in fair value of derivatives is reported in net income.
- Taking advantage of hedge accounting rules, which can minimize volatility in the income statement, can often be complex and costly.
Institutions that utilize or are interested in the hedge accounting rules recently received some good news. In August 2017, the Financial Accounting Standards Board (FASB) finalized Accounting Standards Update (ASU) No. 2017-12, Targeted Improvements to Accounting for Hedging Activities. This standard does not generally change the overall hedge accounting requirements, but it does simplify the application of some of those requirements. As a result, many financial institutions may consider utilizing hedge accounting in the future. This article will explore the changes in the new standard and how institutions may be able to take advantage of those changes.
The FASB began looking at hedge accounting changes as part of its larger financial instruments project. Feedback from stakeholders consistently indicated financial reporting using the hedge accounting model should more closely reflect an entity’s risk management activities. Under existing rules, it can be very challenging to apply the hedge accounting requirements, and if hedges are highly effective but not perfectly effective, identifying and reporting the ineffective portions of the hedge can require some time and effort. The new standard is intended to make it easier for entities to apply hedge accounting rules and report hedging activities in financial statements.
Some of the simplifications include:
- Hedge documentation must still be completed before or at the same time the hedge is designated, but the initial effectiveness test does not have to be completed until the end of the quarter in which the hedge is designated, giving the institution more time to perform the assessment. (The institution must have an expectation that the hedge will be highly effective when it is designated.)
- If the initial hedge effectiveness assessment must be a quantitative assessment, subsequent effectiveness assessments may be qualitative provided that the institution can document that the facts and circumstances related to the hedging relationship have not changed and that the institution can assert the hedge was and continues to be highly effective.
- If a hedging relationship qualifies for the shortcut method, the institution can also identify a long-haul method the institution would use in the future if the shortcut method no longer qualifies to be used.
- All amounts related to the hedge are to be presented in the same line item in the income statement, and the institution is no longer required to separately calculate and report the ineffective portion of a hedge in the financial statements.
Changes to Cash Flow Hedges
The new standard also made some changes to hedge accounting rules that make it easier to apply the rules to certain transactions or to report the hedge in the financial statements. For example, institutions are now able to hedge the variability of any contractually specified interest rate rather than only specified benchmark interest rates. As a result, institutions can now apply hedge accounting to prime rate instruments and other instruments that do not contain an acceptable benchmark interest rate.
Institutions can to exclude certain components (e.g., time value) from hedge assessments involving certain instruments, such as options, interest rate caps, and interest rate floors. Currently, the excluded components are still measured at fair value in the balance sheet, and changes in fair value are recognized in the income statement. Under the new standard, excluded components in cash flow hedges can be amortized to net income using a systematic and rational method over the life of the hedging instrument, reducing volatility in the income statement. The excluded components will still be measured at fair value, but any difference between changes in fair value of the excluded component and the amortization amount will be recognized in other comprehensive income (OCI).
Changes to Fair Value Hedges
The most significant changes in ASU No. 2017-12 impact fair value hedges. Historically, financial institutions generally have not used fair value hedges because the hedge accounting rules can be more challenging to apply to these hedges and hedge ineffectiveness was usually more significant. The new standard includes several provisions that make it easier to apply hedge accounting to fair value hedges by permitting institutions to:
- Measure the change in fair value of the hedged item solely on the basis of the benchmark rate component rather than all of the contractual coupon cash flows, which in effect excludes the credit spread inherent in a fixed coupon rate and results in higher levels of hedge effectiveness.
- Hedge a partial term of an instrument and only include the cash flows during the partial term of the instrument in the effectiveness assessment.
- Use a “last-of-layer approach” for a pool of assets.
The last-of-layer approach allows institutions to hedge a pool of prepayable assets by hedging the “last” cash flows in the pool. This allows the hedge to continue to be effective even though payments are received on the pool. For example, an institution could hedge the last $10 million of a
$25 million pool of fixed rate loans for five years. Even though the institution receives principal payments on loans in the pool, as long as the outstanding principal of the pool is at least $10 million, the hedge can remain highly effective. This may allow an institution to effectively convert a large portion of a loan pool from a fixed rate to a variable rate with relative ease. However, there are some qualifications for using this type of approach:
- The pool can only consist of assets (e.g., this approach cannot be used for deposit liabilities).
- The pool must be a closed pool—that is, the institution cannot subsequently add different loans to the pool.
- The outstanding principal balance of the pool cannot drop below the notional amount of the hedging instrument, so institutions may need to be rather conservative in their estimates of how much principal will remain outstanding during the term of the hedge.
Several changes to financial statement disclosures will be made upon adopting the new standard. Disclosures regarding the ineffective portion of hedges will be removed since institutions will no longer be required to calculate and report the ineffective portion. New disclosure requirements include information about the following:
- The effect of hedging on income statement line items
- Cumulative basis adjustments for assets and liabilities that are part of fair value hedges
- Excluded components that are being amortized
- The institution’s strategy when using the last-of-layer approach
Effective Date and Transition
The new standard is effective for public business entities for years beginning after December 15, 2018, including interim periods within those years, and for other entities for years beginning after December 15, 2019. Early adoption of the standard is permitted for those institutions that would like to take advantage of the simplifications sooner than later. At the time of adoption, certain impacts will have to be adopted on a modified retrospective basis, and various transition elections will need to be considered since they can only be elected at the date of adoption, so a careful understanding of these transition provisions is necessary.
ASU 2017-12 will make hedging simpler for institutions that have utilized or are thinking about utilizing certain hedging strategies. If you are interested in learning more about the changes available in the new standard and how they might help your institution, please contact your Wipfli relationship executive.