Cash Flow Hedging Strategies Simplified by the New Hedge Accounting Rules

Long term interest rates falling again along with the inverted yield curve present an opportunity for financial institutions to hedge floating rate liabilities on their balance sheet. Hedging against rising rates on floating rate debt has become a simpler strategy to pursue under the simplified hedge accounting rules. Under the new rules, qualifying cash flow relationships with some basis difference no longer produce income statement volatility and allows financial institutions to focus on the economics of a hedging strategy. While a hedge may not provide a perfect offset to the hedged exposure, whether that be customer deposits or wholesale borrowings, the hedge no longer needs to be perfect to achieve full cash flow hedge accounting treatment and avoid an impact to earnings. Under the new hedge accounting rules of ASU 2017-12, hedge ineffectiveness of less than 20% can be disregarded when recording the results of the hedge in the income statement. If the hedge relationship qualifies, the change in fair value of the hedge is recorded in other comprehensive income and then reclassified to earnings as the exposure accrues. Below we review cash flow hedging strategies illustrating these opportunities with a particular focus on hedging a bank’s MMDAs — even when rates on such accounts are not being directly set using a particular index. We also consider the accounting for a strategy to hedge rolling FHLB advances — which allows a financial institution to lower their effective interest cost relative to term funding alternatives.

View Document