Pub. 8 2020 Issue 4

ISSUE 4. 2020 9 the environment has certainly evolved since the start of 2020. Managing excess liquidity while planning for interest rate risk management has also become slightly more complicated on the liability side. How does a bank choose from the various funding options and hedging strategies available? The decision-making process must consid- er balance sheet composition (i.e., the availability of liabilities to hedge), impact to earnings and capital (in addition to liquidity) from the strategy, and practical applications, such as hedge accounting. It’s generally recommended for accounting simplicity and hedging flexibility to first evaluate liability hedges when attempting a shift in interest rate risk profile. Many insti- tutions took advantage of both spot-starting and forward-starting cash flow hedges over the past year. Forward-starting swaps on forecast borrowings allow the bank to purchase longer duration assets today and know they will maintain the future’s at- tractive spread. For example, offerings like IntraFi Network’s (formerly Promontory Interfinancial Network) IntraFi Network Deposits give banks the ability to launch these funding contracts six months to one year in the future, while locking in their rate now to hedge against any increase in funding costs before the launch date. This allows the bank maximum f lexibility in planning its liquidity now and well into the future. But what about banks f lush with liquidity with no future funding needs anticipated? Part of the answer arose from a surprising place: dealing with yet another source of stress — the LIBOR transition. The FASB released ASC 848 Reference Rate Reform in March 2020 to address potential con- cerns about the impact of the upcoming LIBOR transition on hedge accounting. Although LIBOR fallback is expected at year-end 2021, guidance is applicable im- mediately to help users explore potential alternative contracts and rates. It allows banks to be proactive in dealing with LI- BOR cessation and identify a new hedged exposure. The bank can then modify the hedge to match the new (non-LIBOR) ex- posure, adjusting the fixed-rate or adding a f loating rate spread to keep the transac- tion NPV-neutral. Finally, the bank can amend their hedging memo to ref lect the new exposure, and the hedge relationship continues without de-designation. There is a positive balance sheet strategy development that comes from this guidance. By allowing banks to consider a change to a non-LIBOR hedged item, it essentially provides added f lexibility to banks that have implemented strat- egies using wholesale funding paired with swaps, a strategy that many banks smartly continue to explore. The guid- ance allows those banks to consider replacing the existing funding with other sources for cheaper and more custom- izable wholesale borrowings or even deposit products, without impacting hedge accounting. These products allow a bank to replicate the previous funding instruments’ details, but at a considerably discounted cost. Banks can leverage the new accounting guidance to change the hedged exposure from wholesale fund- ing to deposits without a re-designation event, allowing the bank to pay down wholesale borrowings. For those banks that now have many more deposits than when they first implemented the strategy, reducing their current need for wholesale funding, this is a welcome change in funding source that maintains the interest rate protection they continue to need. This rule can be applied in a variety of different ways. Banks can make changes to the interest rate index, the spread to that index, the reset period, pay frequency, business day conventions, payment and reset dates, the strike price of an existing option, the repricing calculation, and may even add an interest rate cap or floor that is out-of-the-money on a spot basis. On the other hand, some aspects of the hedge are unrelated to the reference rate reform: an institution cannot effect a change to the notional amount or maturity date, change from an interest rate to a stated fixed rate, or add a variable unrelated to LIBOR. Ultimately, none of these options single- handedly solve the problem of too much liquidity with too few safe places to deploy them while earning an attractive yield and protecting against the eventuality of rising rates. Like life in 2020, the key is to deploy various creative tactics to weather the storm and emerge a stronger institution. n Managing excess liquidity while planning for interest rate risk management has also become slightly more complicated on the liability side. How does a bank choose from the various funding options and hedging strategies available? The decision-making process must consider balance sheet composition (i.e., the availability of liabilities to hedge), impact to earnings and capital (in addition to liquidity) from the strategy, and practical applications, such as hedge accounting.