Tentative FASB decisions that can change how financial institutions hedge floating-rate exposure

On April 10, 2024, the FASB voted to approve changes to topic 815, Derivatives and Hedging, on a specific application for groups of individual forecasted transactions. The main change is a simplification of requirements to support that all hedged transactions share similar risk by softening the assessment threshold from “shared” to “similar” and removing the “same index” example from paragraph 20-55-23. Removing the example allows preparers to expand the pool of hedged transactions to include various interest rate indexes in the same hedging relationship.

This welcome change would allow financial institutions who are hedging interest rate risk – mainly floating-rate exposures on loan pools - to expand the hedgeable populations to include various indexes. Banks could have the ability to group interest receipts from loans indexed to SOFR, Term SOFR, Prime, Fed Funds, and possibly other rates in a single hedge, reducing the risk of missed forecasts and unexpected earnings impact as lending practices vary over time.

Highlights of tentative FASB decisions

• Softening of the threshold terminology for assessing risk exposure from “shared” to “similar”
• Expanding the concept of hedged risk to include more than one index for cash flow hedges of forecasted interest payments/receipts from floating-rate transactions
• Affirming previous proposed amendments to require similar risk assessments to be performed at hedge inception and on an ongoing basis
• Amend hedge assessment guidance to set quantitative thresholds consistent with highly effective threshold, enable institutions to conclude risk exposures in a group of forecasted transactions are deemed similar if the hedging instrument is highly effective against each risk individually, and permit institutions to apply qualitative assessments on a hedge-by-hedge basis, as appropriate.

Background on shared risk

The board has previously discussed the topic of shared risk assessments in 2019 during the comment letter review of proposed Accounting Standard Update, Derivatives and Hedging (Topic 815), Codification Improvements to Hedge Accounting. In this ASU, the FASB further clarified earlier changes made to hedge accounting as it relates to change in hedged risk initially introduced in ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities. Among the clarifications in the proposed ASU, the board focused on creating a distinction between hedged transactions and hedged risk as well as expanding shared risk assessment to be performed on an ongoing basis, not only at inception. The concepts were meant to work in tandem with the ability for institutions to change the hedged risk throughout the life of the hedging relationship, but due to the significant pushback provided by various stakeholders, these changes did not result in updated guidance.

Furthermore, the lack of prescribed methodology for performing a shared risk assessment has resulted in a wide diversity in practice across different users of hedge accounting. Similarly, auditor interpretation varies across firms, with some more conservative approaches pointing to similar asset testing as required in fair value hedges of multiple fixed-rate financial instruments. This test is not well suited to assess shared risk of floating-rate exposures under the cash flow hedging model.

While the proposed changes from 2019 would have provided much needed improvements to hedges of floating-rate asset pools for financial institutions, a much larger economic event overshadowed those programs. LIBOR transition consumed much of the past three years as many institutions converted cash and derivative contracts from legacy LIBOR based rates to SOFR. The concept of change in hedged risk applicable to LIBOR transition, was temporarily addressed by ASC 848, Reference Rate Reform, which allowed institutions to make changes to hedged risk and hedged transactions caused by LIBOR phaseout. The majority of financial institutions saw a close to transition activity in 2023.

Conclusion and future steps

Chatham has followed this topic closely and will continue to provide comments and feedback to the FASB on the proposed ASU as it is exposed for comment. At a minimum, this tentative FASB decision has the potential to alleviate negative earnings impacts on financial institutions caused by changes in contractual rates on various floating-rate loans. As noted by one of the FASB board members, a number of financial institutions suffered hedge accounting loss and material fourth quarter 2023 earnings impacts as a result of not having the ability to scope in various indexed loans in the same hedging relationships. With the right adoption approach, the currently proposed hedge accounting improvement can better optimize financial institutions’ ability to leverage asset pools to obtain their economic objectives.