Asset Sensitive Financial Institutions – Improved Cash Flow Hedge Accounting Standard
Financial Institutions that are exposed to falling interest rates often enter into receive-fixed interest rate swaps to preserve their Net Interest Margin. These hedges are typically designated in a cash flow hedging relationship against two types of floating rate assets: (1) pools of LIBOR indexed assets and (2) pools of PRIME indexed assets. The effectiveness of these hedging relationships is directly related to what is recognized under Accounting Standards Codification (ASC) 815, Derivatives and Hedging as a benchmark interest rate. Currently LIBOR, OIS, and US Treasury are identified benchmark interest rates, which allows benchmark risk designations to ignore any credit spread variations in the hedged population. This means that for cash flow hedging relationships where a derivative is designated against floating rate assets, LIBOR indexed assets achieve superior effectiveness and financial reporting as compared to PRIME indexed assets where credit spreads cannot be ignored. This is one of the concerns the new hedging standard improvements will address that will help better align the economic results of an entity’s risk management activities with its financial reporting.