Interest Rate Swaps

December 2016

Interest rates are relatively low now, but the Federal Reserve Bank and others are predicting that interest rates may be on the rise soon. Many of our bank clients are wondering what can be done to smooth out volatility and manage interest expense in the future. Although there are several techniques that can be employed to manage interest rate risk, there are an increasing number of banks that are contemplating entering into interest rate swaps to manage interest expense on their borrowings.

Among other uses, an interest rate swap can be used to reduce an entity’s exposure to variability in interest-related cash outflows on borrowings, such as issuances and quarterly rollovers of short-term borrowings or variable rate debt. Swaps can potentially provide an economical way to convert variable rate debt into fixed rate debt. Sounds simple, but it is complex, as all derivative accounting seems to be. An interest rate swap is just one type of hedge that follows the guidance in Accounting Standards Codification 815 – Derivatives and Hedging (ASC 815).

An interest rate swap is a derivative financial instrument which must be accounted for at fair value. Assuming the criteria are met, designation of a swap as a cash flow hedge allows a bank to effectively record interest expense on its income statement at a fixed interest rate, while recording the fluctuations in fair value of the swap for the effective portion of the hedge in accumulated comprehensive income. Ineffectiveness of the swap, if any, is recorded in earnings on a current basis.

ASC 815 provides comprehensive guidance on derivative and hedging transactions, defines a derivative instrument and specifies how to account for such instruments. In addition, ASC 815 establishes when reporting entities, in certain limited well-defined circumstances, may apply hedge accounting to a relationship involving a designated hedging instrument and hedged exposure.

The full text of ASC 815 can be found in the FASB Accounting Standards Codification and should be read before any derivative is considered.

Per ASC 815-20 Hedging-General, in order to qualify for hedge accounting, the hedging relationship (both at inception of the hedge and on an ongoing basis) shall be expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge for a cash flow hedge (ASC 815-20-25-75).

In order for an entity to apply hedge accounting, the entity must, at inception, formally designate and document the objective and the strategy for the hedge; such documentation must include (per ASC 815-20-25-3b 2):

  • The hedged instrument – the derivative, in this case interest rate swap;
  • The hedged item or transaction – the asset, liability or transaction being hedged;
  • The nature of the risk being hedged – interest rate risk; and
  • The method that will be used to retrospectively and prospectively measure the hedge’s effectiveness, including the frequency of the measurement, which must be no less than quarterly.

Failure to document the above criteria at inception would preclude a bank from using hedge accounting.

There are many reasons why a hedging instrument might have some ineffectiveness, for example:

  • A difference in the basis of the hedging instrument and the hedged item such as a derivative instrument based on LIBOR and a hedged item based on the prime rate;
  • Differences in critical terms of the hedging instrument and the hedged item such as the term, principal and notional amounts, and pay or receive dates;
  • The hedged item is no longer outstanding, or no longer probable of occurring, such as in cases of quarterly rollovers of short term FHLB borrowings.

If your bank is contemplating the use of an interest rate swap, management should consider the following steps:

  • Review your derivatives policy and update as necessary.
  • Discuss your plans with your ALCO consultant.
  • Perform due diligence on your proposed swap counterparty.
  • Engage the services of a third party to assist you in determining the appropriateness of your planned hedge, completing the required documentation and performing an assessment of the effectiveness of the proposed hedge.
  • Educate your board on the risks of the transaction and potential balance sheet impact. Depending on the movement of interest rates, it is not unusual for a swap to give rise to an accumulated other comprehensive loss, which will need to be reflected as a component of equity.
  • Consult with your BNN service team to ensure that you have appropriate documentation of your planned hedge, that your proposed hedge will meet the accounting criteria for hedge accounting and that you properly understand the accounting implications.

If management decides to move forward and enter into an interest rate swap, measures should be put in place to: assess the ongoing creditworthiness of the counterparty to ensure there is no impairment to be recognized; obtain quarterly fair values of the derivative and to review the assessment of the third party prepared effectiveness test.

In summary, an interest rate swap can be an important component of interest rate management; however the accounting requirements can be complex.

If you have any questions, contact your BNN advisor at 1.800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.