Interest-Rate Swaps and Floors Are Still Rare at Community Banks…But for How Long?
By Brady Nitchman
Community Bank Advisor, 2007 Winter 

Derivative instruments continue to be a hot topic for managers at our bank clients as counterparties call on them. The most common transactions involve the use of interest-rate swaps or the purchase of interest-rate floors to manage interest-rate risk. In the current interest-rate environment, we have noticed an increase in inquiries related to the accounting for such transactions. Here is a very brief summary of the more common derivative transactions:

• Interest-rate swaps—funding. As asset growth continues to be reliant on long-term fixed-rate funding from Federal Home Loan Banks and brokered CDs, some financial managers are utilizing swap contracts offered by counterparties to hedge the interest inherent in long-term fixed-rate financial instruments. This form of hedging is often treated as a fair-value hedge.
• Interest-rate swaps—loan portfolio. Contracts can also be purchased to swap the interest rate on a pool of loans to a fixed or variable rate. The hedging of the swap contracts against the loan portfolio could be considered a cash-flow hedge.
• Interest-rate floors. In the current interest-rate environment, the purchase of interest-rate floors on a pool of loans has become an item of interest. In this transaction, the buyer (financial institution) and seller (counterparty) agree upon the term, the strike rate, the notional amount (size), the amortization of the floor (“bullet”, straight line, etc.), the start date, and frequency of settlement. If the applicable index falls below the strike rate, then the counterparty pays the financial institution the difference between the strike rate and the index based on the notional amount. The floor contract is a derivative instrument and required to be carried at fair value on the balance sheet, with changes in the fair value impacting the income statement (the contract is not amortized over the life of the contract).

There are opportunities to hedge the change in the fair value of the derivative instrument (swap contract or floor contract), with changes in the fair value of the financial instrument (FHLB advances, brokered CDs, or loan pools) to reduce or eliminate income statement impact. To achieve hedge accounting, there are a series of items that must be documented upon inception and at least on a quarterly prospective basis.

While the use of derivative instruments continues to be a discussion topic in board rooms on a regular basis, only a few community banks we have worked with have taken the plunge in any significant transactions. The most common reasons for avoiding the contracts are the complexity of the accounting standards and the rigorous documentation requirements. We will continue to provide guidance and assistance in adopting the proper accounting standards related to complex transactions.

Fair-Value Option

The FASB is proposing a new accounting standard to create an option (termed the “fair-value option”) under which an entity could irrevocably elect to account initially and subsequently for certain financial assets and liabilities at fair value. If the election is made by the company, changes in fair value will be reflected in current earnings each period. One of the reasons for this proposed standard is to achieve an offset accounting effect for changes in the fair values of related financial assets and liabilities without having to apply complex hedge accounting provisions.

Mortgage-Backed Securities and FAS 133

FAS 155, Accounting for Certain Hybrid Financial Instruments, established a requirement to evaluate interests in securitized financial instruments (such as mortgage-backed securities) as derivatives. In November of 2006, a FAS 133 Implementation Issue B40 was proposed that clarified that a securitized interest in a pre-payable financial asset would not be subject to FAS 155 if the asset met certain criteria. The examples provided by Implementation Issue B40 indicated that mortgage-backed securities would not be subject to FAS 133.

Interested in Learning More?