Fair Value Macro Hedging

Transcription

1 Fair Value Macro Hedging Implementing a Highly Efficient Hedge Accounting Methodology for Fixed Rate Loan Portfolios By: Gerry Daly, Senior Solutions Consultant, Reval May 30, 2011 CONTENT Executive Summary Introduction Hedging Interest Rate Risk Economic and Accounting Mismatch Hedge Accounting Without Paragraph 81.A Hedge Accounting With Paragraph 81.A Conclusion and Benefits

2 Executive summary Macro hedge accounting is the hedge accounting methodology frequently used by financial institutions that hedge the interest rate risk arising from their deposit gathering and lending activities, and it is particularly used for high volume fixedrate loan portfolios. This paper explains the effects of fair value accounting rules on hedging interest rate risk, the application of fair value macro hedge accounting and how such a methodology can offer cost and process efficiencies. Introduction About the author Gerry Daly is a Senior Solution Consultant based in the UK. He is a certified accountant with 15 years corporate treasury and accounting experience. Prior to joining Reval, Mr. Daly was a Treasury Accountant at Shell Plc and a Treasury and Compliance Officer for Qwest Communications International, Inc. He can be reached at gerry. daly@reval.com Financial institutions that advance fixed rate loans are exposed to interest rate risk and credit risk. The economic impact of interest rate risk is typically hedged through the use of interest rate derivative instruments. However, with the advent of fair value accounting rules, which require derivative instruments to be marked-to-market, the use of such derivatives can generate volatility in the Profit & Loss statement as interest rates rise and fall. To reduce such volatility, special accounting treatment, or hedge accounting, can be applied when specified criteria and conditions are met. When the volume of loans is relatively low, hedging and hedge accounting can be applied at the individual loan level. For higher volume portfolios - particularly mortgages and personal finance loans the costs and manual effort involved with documentation, monitoring and measuring means that it is impractical to apply hedge accounting at the individual loan level.as the International Accounting Standard for the recognition and measurement of financial instruments (IAS 39) evolved, changes were made which enable a financial institution to group underlying exposures (for example, mortgages and loans with similar characteristics) and apply a more simplified and cost-effective hedge accounting process, macro hedge accounting. This process is better aligned ABOUT REVAL Reval provides an award-winning Web-based platform that auto mates corporate financial risk management for a wide range of interest rate, foreign exchange, commodity and credit derivatives. The world s leading corporations and financial institutions use this SOX-compliant Software-as-a- Service to support and execute hedging strategies from exposure capture through performance measurement and to comply with international and domestic accounting standards, including continued on next page 2011 Reval.com, Inc. All Rights Reserved 2

3 with the internal management process whereby interest rate risk is managed at the aggregated level. This paper details the methodology and approach that can be implemented under IAS 39 paragraph 81.A to achieve a highly efficient fair value macro hedging process. Once implemented, a financial institution will have a hedge accounting methodology that is aligned with the way the underlying business is managed from an economic and risk perspective. The process implemented will be cost-effective, thus ensuring that the benefits of removing P&L volatility are fully realised. Hedging Interest Rate Risk When a financial institution grants a fixed rate loan, it will be exposed to changes in market levels of interest rates and credit spreads. First, earnings may vary as funding costs rise and fall. Second, the economic value of the loan portfolio will rise when rates fall and vice versa. Interest rates risk can also affect prepayment behaviour. With fixed rate loans such as mortgages and personal lending, there is an implicit call option written by the financial institution. That is, the customer has the right to repay their loan before the contractual maturity date. If interest rates fall, customers may re-finance their loans at a lower rate (and potentially elsewhere) and the financial institution will have to re-lend the funds at a lower rate thus reducing interest income. About the author (continued) ASC 815 (FAS 133), ASC 820 (FAS 157), IAS 39 and IFRS 7. Reval deploys rapidly and integrates easily with treasury management and ERP systems. The company s SaaS platform and team of financial experts are also available on an outsourced basis through Reval Center. Reval was founded in 1999 and is headquartered in New York, with regional centers based in Philadelphia, Chicago, San Francisco, Toronto, London, Frankfurt, Graz, Sydney, Hong Kong, and Gurgaon. Financial institutions typically seek to manage their interest rate margin by converting fixed rate assets and fixed rate liabilities to floating rates, respectively. Interest rate derivatives such as interest rates swaps and swaptions are typically utilised for this purpose. For larger volume portfolios, financial institutions will hedge at the portfolio level, not at the level of an individual loan. For example, a tranche of 500 million 3 year fixed rate mortgages may be offered to the market at a rate of 3.45% for a period of time. Once drawn down, this tranche will consist of many smaller individual loans. In this example, 2011 Reval.com, Inc. All Rights Reserved 3

4 the financial institution may transact a Pay Fixed Receive Libor interest rate swap as a hedge. From an economic perspective, this transforms the tranche to a floating rate portfolio and locks in an interest rate margin (assuming floating rates funding of the same basis/tenor and no prepayments). Prepayment risk may also be hedged through the use of derivatives (for example, amortising swaps representing the expected prepayment behavior of the portfolio or through the use of swaptions). In some markets, prepayment risk is mitigated by the inclusion of prepayment penalties in the loan contract. Economic and Accounting Mismatch Under IAS 39 accounting principles, different accounting treatments apply to loans and derivatives; consequently, there may be an accounting gain or loss from a hedged portfolio in an accounting period, despite the economic hedge. In simple terms, earnings are generated for the loans on the basis of interest accrued in each period, while the derivative acting as a hedge has to be marked-to-market. By way of the above example, if interest rates rise the fixed rate mortgages will still accrue at 3.45%. However, the Pay Fixed Receive Float swap will show a mark-to-market loss in the period. Hedge Accounting Without Paragraph 81.A Handling Individual Loans If Hedge Accounting treatment is applied and the stringent criteria of IAS 39 are met, then the change in the value of the swaps in each period can be offset against the change in the value of the mortgages due to changes in the benchmark interest rate e.g Libor. One of the core tenants of IAS 39 hedge accounting, however, is that hedges need to be applied to a designated individual item. Consequently, this would mean that details of every individual fixed rate loan would have to be captured, documentation generated to link each individual loan to a hedging instrument, and the effectiveness of the hedging relationship tested for every individual loan at the point of loan origination and in each subsequent accounting period. The impact of the above is a process that becomes unworkable in practice and where the costs outweigh the benefits of smoothing out P&L. The volume and granularity of data to be captured, the systems required to link and track the hedge 2011 Reval.com, Inc. All Rights Reserved 4

5 relationships, and the manual effort within the accounting department to operate the process on an on-going basis, are key considerations. Prepayments To qualify for hedge accounting treatment, hedges have to reflect the contractual re-pricing of the underlying loans. On an economic basis, however, a financial institution manages the portfolio and risks on the basis of expected re-pricing, after applying prepayment models based on historical experience, the age and seasonality of a portfolio tranche and the interaction between the level and direction of interest rates and customer behaviour. In addition, as individual loans prepay, the hedge relationships have to be re-adjusted and other individual loans substituted into the hedged portfolio. The hedge should be de- and re-designated each time to reflect the changes to the underlying hedged items. Hedge Accounting With Paragraph 81.A How Does Paragraph 81.A Address Hedging Individual Loans? IAS A addresses this issue in a fair value macro hedge of the interest rate exposure by allowing you to designate an amount of a currency rather than individual assets as the exposure. This better aligns with the internal risk management process whereby portfolio exposures are aggregated into tranches and time buckets representing the re-pricing period. The gain or loss related to the hedged items are reported as one of two separate line items, rather than allocated across many hedged items. (Note that while a financial institution will often hedge economically on a net basis after aggregating assets and liabilities, this is not allowable under IAS 39 paragraph 81.A the amount designated will therefore represent the gross amount of loans re-pricing in a period). How Does Paragraph 81.A Address The Issue Of Pre-Payments? When aggregating individual loans into re-pricing time buckets, IAS 39 paragraph 81.A supports aggregation based on the expected, rather than contractual, re-pricing dates Reval.com, Inc. All Rights Reserved 5

6 The re-pricing date is the earlier of the dates when the item is expected to mature, or the date when the interest rate resets to a market rate. In many cases, it will be possible for an item to be prepaid - for example, a borrower might repay a bank loan early. In such cases, the entity must use the expected re-pricing date (based on its own or industry experience), rather than the contractual date. The time buckets that the company identifies must be sufficiently narrow so that all the items within a bucket are homogeneous with respect to the interest rate risk being hedge. The expected re-pricing dates can be estimated at the inception of the hedge and throughout the term of the hedge, based on historical experience and other available information, including information and expectations regarding prepayment rates, interest rates and the interaction between them. How Does Paragraph 81.A Address the Issue of Over-Hedging? There is a risk that expectation does not match reality with regard to the actual level of prepayments and that those prepayments are higher than anticipated, resulting in an over-hedged portfolio. When designating the amount of a currency as the exposure, it is recommended that some headroom is built in. That is, an amount reflecting 80-90% of the expected exposure is designated as the hedged exposure, thereby allowing similar loans to drop into the exposure in the event of a higher degree of prepayments occurring. Conclusion and Benefits Implementing this methodology and approach to fair value hedging of interest rate risk in a fixed rate loan portfolio will mitigate profit and loss volatility very efficiently when done through an automated process. Removing the requirement to track and adjust the individual items making up the portfolio ensures that it is practical in operational terms to handle large volumes of small value items. The costs associated with complying with the onerous requirements of hedge accounting will be significantly reduced. Once implemented, a financial institution will have a hedge accounting methodology that is aligned with the way the underlying business is actually managed from an economic and risk perspective Reval.com, Inc. All Rights Reserved 6

7 Applying the IAS 39 Paragraph 81.A Methodology To correctly apply this hedge accounting methodology a financial institution must comply with the procedures set out in (a) (i) below and paragraphs AG115 AG132 of IAS 39. (a) As part of its risk management process, the entity identifies a portfolio of items whose interest rate risk it wishes to hedge. (b) The entity analyses the portfolio into re-pricing time periods based on expected, rather than contractual, re-pricing dates. (c) On the basis of this analysis, the entity decides the amount it wishes to hedge. (d) The entity designates the interest rate risk it is hedging. This risk could be a portion of the interest rate risk in each of the items in the hedged position, such as a benchmark interest rate e.g. Libor. (e) The entity designates one or more hedging instruments for each re-pricing time period. (f) The entity assesses at inception and in subsequent periods, whether the hedge is expected to be highly effective during the period for which the hedge is designated. (g) Periodically, the entity measures the change in the fair value of the hedged item 1. If the hedge is highly effective the entity recognises the change in fair value of the hedged item as a gain or loss in profit or loss and in one of two line items in the balance sheet without having to change the fair value need of the individual assets or liabilities. (h) The entity measures the change in fair value of the hedging instrument(s) (as designated in (e)) and recognises it as a gain or loss in profit or loss. (i) Any ineffectiveness will be recognized in profit or loss as the difference between the change in fair value referred to in (g) and (h) Hedge Documentation Content: (a) Which assets and liabilities are to be included in the portfolio hedge and the basis to be used for removing them from the portfolio. (b) How the entity estimates re-pricing dates. (c) The number and duration of re-pricing time periods. (d) how often the entity will test effectiveness (e) the methodology used by the entity to determine the amount of assets or liabilities that are designated as the hedged item (f) Whether the entity will test effectiveness for each re-pricing time period individually, for all time periods in aggregate, or by using some combination of the two Reval.com, Inc. All Rights Reserved 7