UK Bank Treasurers continue to find the selection and application of hedging strategies in their risk management activities challenging as the rise in interest rates since 2022 and the continuous economic and geo-political uncertainties have resulted in increased volatility in interest rates.
This article describes some of the challenges and the initiatives or projects undertaken by Banks and Building Societies in the last two years to address them as well as the potential hedge accounting considerations.
Enhancing the risk management practice and hedging strategy
The main market shift has been the rise of interest rates, which has caused Banks to struggle in maintaining their current structural hedges whilst managing their liquidity positions. To protect Net interest Margin (‘NiM’), Banks normally use either on-market or in some cases, off-market interest rate swaps (‘IRSs’) to economically hedge interest rate risks (‘economic hedges’). The use of IRSs will result in profit and loss (‘P&L’) volatility if hedge accounting (or other forms of offsetting fair value treatment) is not applied.
The recent increased volatility in interest rate movements and increased cost of capital have resulted in increased use of economic hedges. A classic example is UK Government gilts which are generally at fixed rates and where Banks have traditionally classified at fair value through other comprehensive income (‘FVOCI’) for liquidity purposes. The low interest rate environment prior to 2022 meant that hedges using IRSs to economically hedge against interest rate mismatch between floating rate borrowing and the fixed rate gilts, were not considered and also hedge accounting was therefore not applied.
However, as interest rates rose, the fair value of the gilts effectively fell impacting the Bank’s reserves and the gap between interest income and expense also widen because the fixed rate received on the gilts that were purchased prior to 2022, would be lower than the current borrowing floating interest rates. Such events have caused Banks to find optimal ways to protect their NiM and reserves such as using off-market IRSs. Such economic hedging activities will most likely result in increased P&L volatility that is generally mitigated by applying hedge accounting.
Design, implement or replace – treasury processes and treasury management systems (“TMS”)
Banks are also seeking to either upgrade or replace existing TMSs to enable higher levels of automation to achieve better asset liability management (‘ALM’) to , to comply with the interest rate risks in the banking book (‘IRRBB’)assessment or reporting requirements in line with the Pillar 2A capital requirements, and to protect the NiM in a volatile interest rate environment.
Banks will also need to consider the extent of configuration required on the new TMS to ensure the accounting rules in the new system are calibrated to their accounting policies to ensure minimum go-live issues. In addition, Banks are also considering phased implementation of the accounting functionalities e.g. develop MS excel spreadsheets with strong end user computing governance and controls in the interim before developing a non-EUC solution either as a separate solution or within the new TMS system. As a result, the implementation of advanced TMS would require the involvement of professionals with expertise in treasury functions, financial reporting, accounting of financial instruments and hedge accounting.
As Banks embark on the TMS upgrades and / or replacement projects, it is important that the accounting functions within a TMS are considered and/or included as this is always an area of challenge particularly with fair value measurement, effective interest rate calculations, and hedge accounting.
Introduction of new products and bespoke transactions – impact on hedge accounting
Banks and building societies continue to grow despite the challenging market environment introducing new lending and deposit products. It is heartening to know that some are considering and/or introducing sustainability-related lending and deposit products. Such products may not always meet the criteria to be classified as amortised cost hence detailed assessment would be required to determine if these products can be included in a hedge relationship.
In addition, securitisation and structured products continue to be a source of additional funding. With the volatile interest rate environment, banks and building societies would need to take into consideration their abilities to apply various hedging strategies involving structural hedging, natural hedging and/ or economic hedging when using derivatives. In order to avoid P&L volatility that will occur due to derivatives in an economic hedge, banks and building societies will most likely consider applying hedge accounting. Consequently, banks and building societies will need to constantly assess their hedging positions and ensure that hedge accounting is applied effectively and efficiently.
Conclusion
The inclusion of hedge accounting consideration in treasury initiatives and projects can be a complex process. We have seen a significant uptick in requests from clients requiring inputs and assistance to help manage both general and macro / portfolio hedge accounting process. Implementing a robust hedge accounting process and solutions will help banks lay a solid foundation, to not only address the challenges due to interest rates volatility but also enable balance sheet optimisation.
This article was written by Charlotte Lo (Partner, Banking accounting advisory) and Ahmed Rizvi (Senior Manager, Banking accounting advisory).
