FASB releases enhanced guidance on Fair Value Hedging activities – Portfolio Layer Method

On March 28, 2022, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging – Portfolio Layer Method. This new guidance further aligns risk management objectives with hedge accounting results on the application of the last-of-layer method, which was first introduced in Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The enhanced guidance further improves the last-of-layer concepts to expand to nonprepayable financial assets and allows more flexibility in the derivative structures used to hedge the interest rate risk. For entities that have already adopted ASU 2017-12 this update is available for immediate adoption. Most of the provisions in this update have prospective application with the exception of the basis adjustments changes which would have a modified retrospective application.

Highlights related to portfolio construction and maintenance:

• All financial assets are permitted to be included in a fair value hedge of a portfolio layer method regardless of contractual prepayment features.
• Contractual maturity requirements have been removed, but they do influence layering abilities and basis adjustment recognition upon breach of any hedged layers.
• A one-time transfer of securities from held-to-maturity to available-for-sale is permitted, if they are included in a portfolio layer method hedge within 30 days of transfer.
• Anticipated and actual breach events have an aligned application. Partial or full dedesignations are required for any anticipated or actual breaches in the closed portfolio.
• When a breach is either anticipated or has occurred, an accounting policy is to be developed that will determine the dedesignation method prospectively.

Highlights related to hedging strategies:

• Multiple layer hedging is permitted within the same closed portfolio. Horizontal and vertical stacking of different hedged layers are permitted within the same closed portfolio.
• Different derivative structures are permitted including spot-starting and forward-starting bullet-notional swaps as well as amortizing-notional swaps.
• Voluntary full or partial dedesignations/terminations are permitted anytime when a breach is not anticipated nor has occurred.
• The income statement effect of any breach in the closed portfolio must be reported in interest income.

Changes to accounting for basis adjustments

The FASB clarified that basis adjustments will be prohibited from being allocated to the individual assets while the hedging relationships are active but must be allocated to the appropriate balance sheet line items if more than one asset class is included in portfolio hedges. This may create an operational burden for those institutions that were previously allocating basis adjustments at the individual asset level and will require a transition adjustment which is required to be reported through retained earnings upon adoption of the guidance. Furthermore, the FASB confirmed that basis adjustments are prohibited from being included in the credit loss calculation throughout the updated guidance.

In conclusion

Chatham Financial has followed this project very closely over the years and has had a significant role in working with the FASB to help shape the new guidance. Please subscribe to our upcoming updates and webinars for more in-depth discussions on specific strategies and the impact of hedge accounting changes.