Swap Basics: Hedge Accounting

by AMG

**note: this post is part 5 of a series, "swaps basics."  click here for the rest of the series.

One of the first arguments against community financial institutions using interest rate swaps (usually made by those offering an alternative product) is that hedge accounting is too complex.  First things first, yes, hedge accounting CAN be quite complex and beyond the technical resources of most small banks.  However, for the simpler structures that community banks should be using anyway, the accounting is actually simple and straightforward.

Also, before getting into specifics, AMG is not an accounting firm and this is not accounting advice.  The summary here is intended to give bank managers a basic understanding of how swaps will be carried on their books.  Any bank executing swaps should be discussing the detailed entries with their accountants.

So, now for the basics.  Generally speaking, a derivative carried by a bank will be marked to market, with any gains or losses running through the income statement.  That is simple enough, but also less than desirable for most community banks that would rather avoid that kind of earnings volatility.  So, instead, banks generally prefer to elect hedge accounting on their derivatives.  Hedge accounting is covered by FAS 133 (ASC 815), and allows portions (or all) of those value changes to be carried on the balance sheet instead of through earnings.  That is achieved by designating a hedge as either a Cash Flow Hedge or a Fair Value Hedge.

Cash Flow Hedge
A cash flow hedge is used when the bank wants to hedge the risk of future (and unknown) cash flows of a particular instrument or book of instruments.  In other words, when you want to hedge the risk of variable rates by converting them into a fixed rate.  In this scenario, a swap is put in place alongside a hedged item.  So, a floating rate asset is paired with a pay floating, receive fixed swap, or a floating rate liability is paired with a pay fixed, receive floating swap.  At the end of a period (month or quarter, depending on structure), the swap will have a market gain or loss based on what happened to interest rates.  The remaining terms of both swap and the hedged item are compared (using a predetermined method) to see how much of the swap is an effective hedge, and how much is an ineffective hedge**.  The effective portion is carried on the balance sheet in Other Comprehensive Income (OCI), just like the unrealized gains or losses on your bond portfolio.  The ineffective portion is written through the income statement.

This is why using simple structures is the key to hedge accounting.  If you use a simple swap, and use it to hedge a specific item on your balance sheet that is clean and predictable, all of the value change should be effective, meaning it is all carried in OCI.  Again, discuss the specifics with your accountant, but a plain vanilla and properly structured swap should be no more complicated to account for than an AFS bond.  The only impact on income would be the difference between the fixed and the floating rates, as intended.

Fair Value Hedge
A fair value hedge is used when the bank wants to hedge the risk to the fair value of fixed rate holdings as rates changes.  In other words, this is used when you want to hedge the risk of holding fixed rate instruments by converting them to floating rates.  Again, you put a swap in place alongside a specific hedged item.  In this case a fixed rate asset is paired with a pay fixed, receive floating swap, or a fixed rate liability is paired with a receive fixed, pay floating swap.  At the end of the period, the swap will have a market gain or loss based on interest rate changes.  That change is recorded in earnings.  Then, the value change of the hedged item is also entered in earnings as an offsetting entry.  An effective hedge would mean that those two entries exactly offset each other, and the only remaining accounting entry is the difference between the fixed and floating rates as intended.

Again, using simple structures with as much specificity as possible is critical.  If the hedged item exactly mirrors the terms of the swap, the fair value changes will exactly offset.

**As an added benefit, hedge accounting allows the use of a "shortcut method" for effectiveness testing if a list of specific criteria are met.  This list is found in paragraph 68 of FAS 133.  If all of the criteria are not met, then standard long haul approaches should be used for effectiveness testing.  There are many low cost sercice providers that can help with this detail.

FAS 133 is a very long and complex rule, which is what scares away many community banks.  However, keep in mind the reduced usage of capital and the 50+ basis points advantage of using swaps.  These will more than pay for a little extra time with your accountant to help implement hedge accounting, especially since the specifics for the simple tactics used by community banks are very straightforward.

If you have any further questions or wish to discuss the specifics of our Advisory Services, feel free to contact us.  Interest rate swaps are growing in use, and with every basis point now more important than ever, it is worth your time to learn more and see if it might be a fit for your balance sheet.