In a recent webinar, Alison Fletcher, Treasury Market Specialist at Bloomberg, L.P., and Animesh Jaiswal, Hedge Accounting Product Manager at Bloomberg, discussed strategies for hedge effectiveness for bank treasuries. The discussion has been transcribed into the following Q&A. Note that the commentary has been edited for flow.
AF: Why have bank treasuries increased inquiries into hedge accounting?
AJ: One of the key reasons for this has been the increase in the interest rate over the last few years. Bank treasuries are mostly invested in long term securities. What happens is that if the rate goes up, you lose a significant value on your investments. Given that scenario, now they have actively started trading interest rate swaps, which are generally fixed to float swaps.
These swaps qualify as a fair value hedge. Whatever you lose on your investments, pretty much you gain the same amount on your swaps. Hedge accounting is optional and up to the discretion of a particular entity to adopt it. In this environment, if you do have swaps, it makes sense to comply with hedge accounting guidelines and apply it because it’s now easier to implement.
We have also seen a shift in the way businesses hedge or manage risk. Previously, firms used mostly linear hedging instruments, bonds are hedged by a fixed to float swap. Additionally, we have seen a shift in how entities are experimenting with the derivatives – they are buying caps along with swaps to hedge rising interest rates. When you buy a cap, it qualifies as a fair value hedge – whatever money you lose, when the rate goes up on your investments, you gain the same amount on your cap. However, there are some challenges when you look at these nonlinear trades just because the payoffs are different. When you undertake a linear versus non-linear strategy, it now makes sense to do a pre-trade analysis to gauge whether it will be effective hedge or not.
AF: How does FASB’s relaxing guidelines of hedge accounting impact bank treasuries?
AJ: This is another big reason for the interest in hedge accounting. Previously, if you did a trade, the treasury or the accounting team had to provide documentation within a few days. Now, they have until the end of the quarter.
Why is documentation so key? It’s because you must define your risk management objective, strategies and trade details of your hedge and your exposure. If it’s a cash flow hedge for example, then you have to provide details for your hypothetical derivative as well. In addition, you also are required to state how often you want to do testing, what kind of testing you want to do, how you’re going to factor certain indicators, and so on. This documentation is quite cumbersome and time consuming. Having that extra time to report until the end of the quarter gives you a lot of comfort, especially if there is a completely new hedging strategy.
AF: Please talk about the ‘last of layer’ and how modifications to these rules impact bank treasuries in the U.S.
AJ: The “last of layer” was introduced under ASU 2017-12. It’s a fair value hedge. It can be applied to a stated amount of a closed portfolio of pre-paid mortgage-backed securities. Here, you don’t have to consider any prepayment risk, which is obviously important with mortgage-backed securities. You can exclude credit risk as well, and do your analysis based on that last layer.
For example, say you have a mortgage-backed security, with $100 million outstanding for a timespan of five years. Out of this $100 million, $20 million remains outstanding for the whole five years. This $20 million will not get impacted by any prepayments. This is what we qualify as ‘last of layer.’ Now we can account for this particular last layer and say there’s no prepayment risk, and hedge with a plain vanilla fixed to float swap.
ASU 2022-01 made some changes to “last of layer” and renamed it to the “portfolio layer” method. It expanded the scope of this guidance to allow entities to select multiple layers of a closed pool of financial assets – including both prepayable and non-prepayable financial assets and apply hedge accounting to these different layers.
In the previous example, we initially selected $20 million as the last layer for five years, now for different periods we can have different layers. So, until year four we can have an additional $20 million, and the same goes for years three, two, and one.
We also need to perform a documented analysis every reporting period to ensure that the amount being hedged will remain outstanding. So, it’s best to be conservative with the notional you determine as a layer being hedged or else you might have to de-designate that particular layer if it gets breached.
Also, one can select different types of swaps like spot swap, forward starting swap, amortizing swap, and a mix of any of these swaps in a hedging relationship for portfolio layer. It’s always best to keep all the layers independent, and have separate swaps hedging these layers, so that at any point in time if there is a breach then we will have to only worry about that particular layer which was impacted by early pre-payments.
AF: What opportunities exist to automate the hedge accounting process?
AJ: Most of us started working from home when the pandemic started. There was always this concern about how different teams will be in sync and how you can do all your daily activity without accessing the terminal. These questions keep coming up.
The Hedge Accounting module (MARS HEFF) itself is fully integrated within Bloomberg. As an example, if we talk about the FX and Commodity trade execution tools, trades will automatically flow into our hedge accounting module. Similarly, any swap or bond you have on a Bloomberg OMS, also flows into our hedge accounting tool seamlessly.
Further, there is a feature called Batch Scheduler, which helps you automate your month end process. You can schedule this process to run at any given time, and the system will run the process and compile the reports and save it on a SFTP site. From there you can just put in your user ID and password and fetch the reports. So that’s very easy. The process is automated, which provides peace of mind. You can get the report in CSV, Excel or PDF format. Plus, with Bloomberg’s API capabilities, you can customize the reports, and can even sync the output with your downstream accounting vendor.
AF: How can a Bloomberg solution increase comfort that auditors have in the bank’s treasuries, when evaluating hedging accounting?
AJ: When we talk about anything related to accounting, the first question that comes up is ‘will our auditors be comfortable?’
Step one is SOC1 certification, which we have in place, and which is verified every year to ensure we comply with FASB, and the IFRS accounting guidelines.
The other concern which we hear a lot is auditability at hedge designation level. The designation set-up drives my journal entries, book of records, and so on, and hence it’s a very important component. What if someone makes any changes on the designation? Will it get captured? The answer is yes, because we have a detailed audit report from the time the designation was initiated. Any changes made will get captured so it’s very transparent from an audit perspective.