Disruption to hedge accounting: another unintended consequence of LIBOR transition

Guidance is needed to avoid P&L impacts

Will new the new risk-free rates that replace LIBOR, such as SOFR and €STR, cause P&L volatility for banks? Their impact on hedge accounting means this could be a possibility without updated guidance from bodies such as the IASB and FASB.

In hedge accounting for loans, a bank issues a bond with a fixed interest rate, hedges it using an interest rate swap that also pays a fixed rate, and then pays out at a floating rate. The two fixed payments match one another, which means the bank can account for the bond as a floating rate bond. Otherwise, it would need to account for the bond one way and the interest rate swap by marking it to market, which means the P&L would fluctuate on a daily basis. In hedge accounting, the bonds can be accrued as if the price did not change. To do this, it's necessary to both group the transactions and carry out effectiveness testing. This means running the P&L off the fixed leg of the swap and the bond, and demonstrating that as the market moves, there is a high level of confidence that the number won’t change.

The issue is that all hedge accounting relationships for fixed income instruments include at least one LIBOR leg. And effectiveness testing depends on the asset being liquid. If an instrument’s history covers a period in which one of the new reference rates did not exist, the hedging trades may not be liquid enough.

Without new guidelines or accounting for rates such as SOFR and €STR, once LIBOR ceases to exist, so, potentially, do the hedge accounting relationships with legs that reference it. This means the P&L for the bond and swap will need to be reported separately, which could cause huge P&L volatility for banks.

The IASB discussed its “exposure draft” paper that addressed this issue in a late June 2020 meeting. However, new guidance and standards relating to risk-free rates and hedge accounting remain to be finalized. It's another of the many unintended consequences of the LIBOR transition.

At Finastra, we’re keen to be part of the discussion around how to resolve issues like this. This hedge accounting issue in particular has the potential to impact many of our treasury customers. So we're keen to hear your views. What guidance would you welcome from standards bodies? Does the LIBOR deadline give your institution enough time to respond to this? Please contact us.