What Happens to Hedge Accounting During a Bank M&A Transaction?

Interest rate hedges have become indispensable for mitigating earnings volatility and safeguarding capital in today’s financial landscape. For many banks, hedge portfolios contribute meaningfully to earnings. However, when a bank is acquired, hedge accounting is typically lost due to purchase accounting. Acquirers need to make timely decisions around de-designation and, in some instances, re-designation of hedge strategies.

Below, we provide a summary of what happens to both existing fair value and cash flow hedges of an acquired bank under ASC 815.

Fair Value Hedges

If the acquired company does not liquidate the fair value hedge accounting relationships prior to the acquisition date, the new entity must decide whether or not to continue hedge accounting by re-designating the relationship and meeting all hedge accounting criteria, including the assessment that the hedge is highly effective. If the acquiring entity chooses not to re-designate, the on-going periodic changes in fair value of the hedge would be recorded in earnings.

If a new hedge accounting election is made, the assessment of hedge effectiveness would need to consider the impact of the off-market rate at the time of re-designation. The difference in fair value of a hedge with an on-market and off-market rate can be viewed as a financing or time value component. This complicates the effectiveness calculation, although in most cases, the hedge will still be considered highly effective.

Cash Flow Hedges

For hedges under cash flow hedge accounting (cash flow hedges of forecasted transactions), the new entity must also reassess the probability of the underlying exposure (i.e., forecasted transaction) occurring within the new entity. If the forecasted transaction is no longer probable of occurring, cash flow hedge accounting is not allowed.

At the time of acquisition, the hedge is revalued on the acquiror’s balance sheet at FMV, and any previously deferred amounts on the balance sheet in Other Comprehensive Income are written off to Goodwill. When re-electing hedge accounting, the new hedge relationship will need to meet all of the designation requirements, including effectiveness testing. Similar to fair value hedge redesignation, the off-market amount of the re-designated hedge can be viewed as a financing or time value component. This off-market amount can be excluded from the effectiveness assessment and straight-lined amortized into earnings, usually resulting in an effective hedge relationship.

How Derivative Path Can Help

DerivativeEDGE can provide the correct calculations for any re-designated hedge accounting relationship. Whether you are a bank being acquired or are on the acquiring side of a purchase business combination, hedge accounting should be considered prior to the acquisition date. Entities should be aware of the re-designation requirement if the hedges of the acquired entity are not terminated or do not mature before the acquisition date and there is a desire to continue the hedge accounting relationship for these positions.

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