Swap Your Stance on a Hedging Program: Key Considerations for Community Banks

Why should community banks consider a hedging program? Community banks should consider the implementation of a hedging program for certain loans given the rising interest rate environment, as well as recent accounting changes meant to simplify hedge accounting. A hedging program can mitigate interest rate and credit risk, generate fee income and respond to customer demand and competition.

Interest rate hedges provide banks the ability to earn a floating rate while the borrower pays a fixed rate, which provides a benefit to both the bank and borrower when rates are rising. A potential for improved credit quality exists with a hedging program as banks may be able to extend longer fixed rate terms, mitigating repricing risk with their more credit worthy borrowers. Fees earned on hedging programs can provide significant increases in non-interest income. Hedging products allow community banks to remain competitive against peer banks as well as larger, national banks. Not exclusively, but many commercial focused borrowers pursue banks that are able to lend with longer term, fixed rate products. The ability to accommodate those requests using hedging strategies can be an effective way to meet customer and competitive demands.

Why have community banks been reluctant in the past?

Many financial institutions have created economic hedges using derivatives or other instruments. Often these relationships were not accounted for as accounting hedges due to the complexities involved in achieving an accounting hedge. It is important to distinguish between a derivative, an economic hedge and an accounting hedge. According to the Financial Accounting Standards Board’s (FASB) glossary, a derivative instrument is a financial instrument or other contract with an underlying, notional and payment provision. The instrument also requires little or no initial investment and allows for net settlement.

A common example would be an interest rate swap based on LIBOR (the underlying), the loan balance (the notional) and that settles monthly (payment provision).

An economic hedge is a situation where a company enters into a derivative transaction but does not designate the transaction as an accounting hedge.

An accounting hedge involves both a derivative instrument and a hedged item that have been both designated as and qualified for special treatment under generally accepted accounting principles (GAAP). While a derivative instrument can be effective in mitigating volatility in cash flows without designating it for hedge accounting, hedge accounting usually is necessary to mitigate income statement volatility due to the different accounting rules for derivative instruments and the assets, liabilities or cash flows that an entity may be trying to hedge. An example would be an interest rate swap that is used to hedge the fair value of a fixed rate loan receivable measured at amortized cost.

Historically, community banks have been hesitant to implement hedge strategies due to their complex nature. Additionally, hedging programs result in increased accounting and documentation requirements. Before implementing any hedging program, education of the board, key members of management as well as the lending team is necessary. The ability to understand and explain the hedging products and strategies both within the bank and to the bank’s borrowers is essential to a successful program. Banks should ensure they have the appropriate accounting resources and experience to account for hedging relationships appropriately.

What has changed with the accounting requirements?

In August 2017, the FASB adopted ASU 2017-12 Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, with the intent to simplify hedge accounting requirements and to allow for more strategies to qualify for hedge accounting treatment. The change most relevant to community banks is the reduction of documentation requirements related to ongoing effectiveness testing. For highly effective hedges, a bank now may be able to qualitatively assess effectiveness quarterly after initially performing a quantitative analysis. Further, the new standard eliminates the requirement to measure and record the ineffective portion of a highly effective hedge. Another change included simplifications related to measuring changes in the fair value of hedged items in a fair value hedge. The new standard also incorporated a “last of layer” concept, which should allow more hedging strategies on pools of pre-payable financial assets to qualify for favorable accounting treatment.

DHG has professionals available to help banks understand the new guidance and accounting requirements and share best practices for hedging programs for institutions that want to give derivatives a second look.

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