Perspectives: Accounting

December 24, 2018
Data Needed to Comply with CECL
By Toby Lawrence, President, Lawrence Advisory Services and Owner, Platinum Risk Advisors

Having attended more than 20 different CECL seminars offered by accounting firms, software companies and industry regulators, one common question continues to come up time and time again.

What data is needed to comply with CECL?

Some of the speakers respond by listing everything except the kitchen sink to ensure they don’t leave anything out, while others state that no additional data is needed because their solution relies only on the data within an institution’s Call Report. One concern with these so-called “simple models” is that when we experience another economic slowdown, the adequacy of these models may come into question and/or may result in a small amount of losses tainting an institution’s entire portfolio – resulting in a higher provision for the allowance for loan and lease losses (ALLL) than what is actually necessary.

Many institutions likely already have the data they need to calculate CECL in their current loan subsidiary ledgers (with the possible exception of the additional information needed to calculate prepayment percentages). For the actual CECL calculation, however, you need to be thinking about the following information.

Data needed for loans that are currently outstanding
- Customer / member number
- Loan number
- Loan type
- Ability to distinguish between term loans and line of credit loans
- Date the loan was originated
- Maturity date of the loan
- Original amount of the loan
- Current interest rate
- Unpaid balance at month-end
- Additional amount that can be draw on the loan (for line of credit loans)

For CECL, you may want to use more loan types than what are currently in your loan subsidiary ledger. This will help prevent significant losses in one loan type from tainting a large portion of your loan portfolio, leading to your institution having to record a higher ALLL balance than necessary. Additionally, the more collateral types you use, the better your ability to segment the loan portfolio and truly analyze the opportunities and risks within.

Data needed to calculate prepayment percentages for term loans
- Amount of contractually due principal payments received by vintage or year of origination
- Amount of total principal payments received by vintage year

Data needed for charge-offs
- Date of the charge-off or recovery
- Loan type
- Unpaid balance of the loan at the time of charge-off
- Estimated selling costs incurred to liquidate the related collateral
- Net proceeds received from the liquidation of the collateral
- Amount of the charge-off or recovery
- Year the loan was originated
- Amount of any remaining accrued interest
- If using migration analysis, the last risk rating (commercial loans) or FICO credit score (consumer loans) and the date the loan was assigned to that risk rating / FICO credit score
- Loan officer assigned to the loan
-If using the probability of default / severity of loss method, the number of net charge-offs and number of loans originated by each loan type and vintage year (year of origination)

Additional data will be required to justify the subjective adjustments to the CECL historical charge-off percentages. To help with this, be prepared to segment your loan portfolio by:
- Collateral type
- Ranges of the loan-to-value ratio
- Ranges of the debt service coverage ratio for commercial loans and debt-to-income ratio for consumer loans
- Risk rating for commercial loans and FICO credit scores for consumer loans (assuming the institution doesn’t risk consumer rate loans)
- Separating the loans located inside and outside of the normal trade area
- Loans acquired through participation
- Loan officer responsibility codes (to determine if there are any trends in loan officers’ individually-managed portfolios)
- Delinquency status
- Spec versus presold loans for commercial construction one-to-four family loans
- Level of policy and technical exceptions
In order to segment a loan portfolio as noted above, lenders will need additional data for their loan subsidiary ledgers.

Data needed to justify subjective adjustments
- Collateral type (to do this correctly most lenders will need to add significantly more loan types to their loan subsidiary ledgers)
- Risk ratings for commercial loans
- FICO credit scores for consumer loans
- Cash flow generated from on-going operations (commercial loans)
- Principal and interest payments due to the institution (commercial loans)
- Principal and interest payments due to other lenders (commercial loans)
- Estimated market value of collateral pledged against the loan
- Debt-to-income ratio for consumer loans
- Number and type of policy exceptions
- Number and type of technical exceptions
- Zip code for real estate loans (this information is already in the loan subsidiary ledger)
- Whether the loan is on nonaccrual status or a TDR (this information is likely already in the loan subsidiary ledger)

The good news for most institutions is that their data processing systems are already set up to store this additional data. An interagency statement issued by the FDIC, OCC and the Federal Reserve Bank in 2006 required banks to segment their loans for major loan concentrations. This statement hasn’t been enforced well to date, but regulators will be expecting institutions to do a better job of segmenting their loan portfolios going forward. These same types of data will also be needed to properly stress test a loan portfolio.

Getting this data for the current year will take some effort and will require a data scrub of all the loans currently in the loan portfolio. However, after the initial data scrub tracking this additional data should be relatively painless. The most challenging issue with implementing CECL will be obtaining this same level of data for prior years. To ensure you have enough data for your CECL calculation it is strongly recommended that institutions implement whatever model they’re planning to use for CECL adoption as soon as possible, since at least 3 to 5 years of verifiable data will be needed to perform a proper CECL-compliant ALLL calculation.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Toby Lawrence is the president of Lawrence Advisory Services and the co-founder and owner of Platinum Risk Advisors.

October 22, 2018
Hedge Accounting: A Q&A with Dan Morrilll and Ryan Henley

As the FASB’s hedge accounting standard continues its march to implementation – and with early adoption permitted – many companies may be wondering exactly how the changes will impact their operations. To get a better handle on life under the new rules, FMS checked in with Dan Morrill of Wolf & Company and Ryan Henley of Stifel for a quick summary of the changes to be aware of and the opportunities that may emerge for financial institutions.

Q: Which institutions would you expect to see the greatest impact from the hedge accounting changes?
A: While the accounting changes improved upon hedge relationships of several types, predominantly the rule changes allow for much greater flexibility in hedging fixed-rate instruments (converting fixed-rate assets or liabilities to floating), otherwise known as a fair value hedge. Given the current rate environment, institutions that would benefit most are those that have a risk to shrinking net interest margins in a continued rising rate environment as funding costs increase and fixed-rate asset yields remain constant.

Q: What are some of the new opportunities that have emerged as a result of these changes?
A: There are two primary strategies currently employed as a result of the changes. First, institutions are hedging assets that typically are offered in the market in a generic fixed-rate form. Fixed-rate loans or bonds of a longer maturity can now be converted to floating-rate asset classes by entering into an interest rate swap utilizing the new hedging rules. Secondly, institutions can create funding strategies paired with these same hedging alternatives to arrive at a cheaper funding profile for a given interest rate risk position.

Q: For those institutions that were hedging under the old rules, how significant will these changes be?
A: FASB’s effort significantly simplifies the accounting results (in constructing, measuring and monitoring) of hedge relationships. For institutions with legacy hedge relationships, this would apply to both future hedging strategies they would employ, as well as the opportunity to amend existing hedging relationships upon adoption. It will simply lead to a cleaner hedging platform for the institution going forward.

Q: Which change in particular do you see as having the most impact on the operations of banks and credit unions?
A: The ability to now hedge fixed-rate assets (swap fixed-rate instruments to float) gives an institution a tremendous amount of flexibility in product offerings to its client base. If the institution’s core market desires a longer-term fixed-rate product (in the consumer or commercial space), management can originate into this demand and then subsequently adjust the interest rate risk of the product without client involvement and in a clean accounting manner.

Q: Are there any effects of these changes that might be seen as a negative?
A: Generally speaking, most accounting changes carry with them a set of considerations or consequences that are not always favorable. Importantly, ASU 2017-12 was an attempt to rectify previous issues within hedge accounting. As a result, the rule really only improves upon the legacy framework. In our opinion, there are no negative consequences, as it affords greater flexibility than before.

Q: What should institutions be doing to prepare for these changes, or to make sure they’re in the best possible position to take advantage of them?
A: It is important to note that a significant number of institutions are currently early adopting the standard to take advantage of these rules. Why is this so important? Because it is likely that a competitor will be employing the strategies mentioned above due to the added flexibility. There are considerations upon adoption that must be analyzed, such as whether the institution has any legacy hedge relationships. If so, should these relationships be amended upon adoption (leaning on the transition provisions of the rule), and does the institution have investment securities classified as held-to-maturity that are eligible to be transferred to available-for-sale as permitted by the standard? If so, does it make economic sense to do so for each eligible instrument? These are some of the questions to be asking now.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Authors

Ryan Henley is a Managing Director and the Head of Depository Strategies at Stifel. In this position, he provides ongoing analysis and balance sheet strategies to financial institutions and portfolio managers nationwide, as well as a broad variety of analysis related to economics, interest rates, investments and interest rate risk management strategies.

Dan Morrill is a Principal at Wolf & Co. and is responsible for the firm’s Professional Practice group. In addition to leading the Audit and Accounting Committee, Dan conducts training on technical issues, performs quality control reviews, participates in learning and development initiatives and conducts technical research.

January 29, 2018
Swaps: Margining And Accounting Considerations
By Ira G. Kawaller, Managing Director, HedgeStar

Due in large part to regulatory pressures, an increasing number of swap transactions undertaken by financial institutions have been – or will be – subject to margining requirements. Current industry practice is still evolving, but depending on exactly how these margining practices are implemented, different accounting treatments could follow.

The Case for Margining
In any discussion of margining, it’s useful to first distinguish between cleared swaps and non-cleared swaps. Cleared swaps are reported to clearing entities that apply well-defined and standardized margining practices that require posting of initial margin (i.e., collateral that may be in the form of cash or other qualifying assets) and variation margin that must be settled in cash, every day. Non-cleared swaps, in contrast, are bilateral contracts between two entities – often a swap dealer and an end user – where any margining practices would be carried out independently from a clearing entity.

Broadly speaking, over the next several years, virtually all financial institutions will be subject to mandatory margining for most, if not all, of their derivative positions. The rationale is that margining serves to eliminate credit risk as a function of losses being collateralized or settled in cash. Thus, the process assures that winners get paid. These margin adjustments could be stipulated with specific frequencies (e.g., weekly or daily) and/or when threshold valuation markers are breached.

Cash v. Non-cash Margin
The form of the margin is critical. Specifically, it’s important to distinguish between cash and non-cash margin. In regulated futures markets, where the most well-established margining practices have long precedent, both cash and selected non-cash securities are permissible for initial margin, but variation margin settlements must be satisfied exclusively in cash. Futures market practice further expressly distinguishes initial margin from variation margin, designating the former as collateral, while the latter is a bona fide settlement against the futures position.

For example, with an initial margin requirement of $1,000, a futures market participant would put up the $1,000 in cash or in securities at the start of the trade. This initial margin would be used only if the losing party failed to meet its variation margin obligation. In most cases, however, where variation margin adjustments occur as prescribed, this original margin would remain untouched until the trade is terminated, at which point the initial margin would be returned to the posting party.

To illustrate, let’s say Trader A enters a long futures position at a price of $50 per unit, and at the end of the day the closing futures price reaches $51. In this instance, Trader A would receive a variation settlement of $1 times the number of units per contract (the contract multiplier). It should be clear that the opposing trader (Trader B) would be the loser in this transaction, such that Trader B would be required to pay that same variation margin amount. These types of cash flows are settled at the exchange clearing house at or before the start of trading on the following business day.

In fact, in the futures environment, individual traders don’t deal directly with the clearing house. Instead, all traders are represented by clearing members and futures commission merchants (FCMs) who act as the traders’ agents – both as execution agents and as cash flow intermediaries. Thus, subsequent to settlements between clearing member firms and the clearing house, a parallel settlement between the trader and his or her FCM and then the FCM and the clearing member would be performed (note that clearing members and FCMs may be either distinct entities or the same company performing distinct functions). Initial margin amounts are intended to cover the credit risk associated with FCMs or clearing firms paying out their customers’ variation margin obligations prior to receiving reimbursement from their customers.

Under this process for futures contracts, variation margin assures that gains and losses will be settled every day, such that the value of the futures contract effectively resets to zero with each variation margin settlement. These aggregated gains or losses are considered to be unrealized until the contract is liquidated, at which point all unrealized gains or losses are redefined as realized. This terminology obscures the fact that unrealized gains or losses results are “real” in the sense that the money that moves from the loser to the winner does so without restriction – that is, any funds in excess of the initial margin requirement can be redeemed from the FCM and used for any purpose.

Contrast this margining process with one that allows for all margin adjustments to be satisfied with non-cash collateral. The trade would still involve an initial margin, but subsequent margin adjustments would be made periodically – up or down – as position values change, and securities (i.e., non-cash) may be used for this purpose. Ultimately, all collateral posted would be returned to the posting party following the termination of the contract.

Margining for Swaps
With the evolution of clearing facilities designed to handle swaps and other derivatives, a margining practice has evolved that mimics that of futures margining, with a twist. In this arena, (a) the initial margin obligation can still be satisfied with cash or securities, (b) variation margin requires a cash settlement and (c) variation margin is settled no less frequently than daily. The twist is that an extra cash flow adjustment is added into the mix – the price adjustment amount or price adjustment alignment (PAA), formerly termed the price adjustment interest (PAI).

What is the rationale behind the PAA? Prior to the advent of cleared swaps, when bilateral swaps operated with an International Swap Dealers Association (ISDA) credit support annex that required non-cash collateral adjustments, whichever party posted collateral still enjoyed the earnings that the collateral generated (e.g., dividends or accrued interest). In other words, posting collateral is purely a custodial issue, but it doesn’t alter the security’s ownership. Thus, it should be clear that a key difference between posting cash collateral and non-cash collateral is that, unless otherwise compensated, those posting cash give up the earning potential from that cash, while those posting non-cash collateral get to keep the associated incremental earnings. The PAA adjustment compensates for this difference – and thus strives to equalize the two practices – by returning an amount to the losing party (i.e., the party that pays the variation margin) roughly equal to this incremental income that would otherwise have been earned on the cash settlement.

Under existing and proposed margining rules, a single net settlement amount is calculated daily by the clearing entity, composed of the PAA netted from the variation margin. While these combined values will typically be settled with a single cash flow, if one wants to evaluate gains or losses of derivatives under different margining regimes, these two components should be differentiated. Put another way, the PAA component of an aggregate gain or loss associated with any derivatives position would more appropriately be considered to be other interest income (or other interest expense), as opposed to a component of the derivative’s gain or loss.

Different Accounting Approaches
Unfortunately, at this point, accounting practices are less than scrupulous in distinguishing between these two different margining orientations – variation margin as a settlement or variation margin as a type of collateral. While some entities account for variation margin as collateral and others account for it as settlement against derivatives values, the different treatment seems to be largely independent of underlying economics.

In fact, these two orientations foster distinct balance sheet presentations. When variation margin is treated as a settlement, gains or losses from derivatives are entirely reflected in the trading entity’s cash balance position, and simultaneously the derivatives carrying value reverts to a zero balance with each variation settlement. On the other hand, when financial reporters treat variation margin as collateral, adjustments to the value of posted collateral have no effect on the carrying value of the derivative.

Although both of these methods are widely practiced, the underlying economics should be the key to determining the proper approach – the critical factor should be whether cash is transferred to the winning party with or without restrictions. If those funds are available to be spent or used by the winning party, treating it as anything other than a settlement (i.e., treating it as a collateral adjustment) is frankly at odds with reality. Unlike traditional collateral, which is expected to be returned, the return of unrestricted cash settlements would be predicated upon a price reversal for the derivative in question – it could happen, but it certainly shouldn’t be expected.

Consider a case where cash variation margin settlements are treated as collateral. If the position generates a gain of $100 during the first accounting period – such that the entity receives $100 of cash designated as collateral – this receipt of cash must be journalized where the counter journal entity would be a payable. Assuming the position is liquidated in the next accounting period with no further value change, both the derivative position and the payable would have to be reversed. Thus, the associated journal entries (assuming no hedge accounting) would follow as in the table below.

Under this approach, at the end of the first period, the balance sheet shows assets consisting of (a) cash and (b) derivatives – both valued at $100 – while liabilities include a $100 payable account, and recognized earnings for the period are $100. In the second period, with no further market value changes, no further income is realized, and both the derivative and the cash collateral are treated as if they were cash settled, but the associated cash amounts are equal and opposite, such that no cash movement actually happens in the second period.

Cash $100
           Collateral payable $100
Cash collateral settled in period 1

Derivative $100
           Gain on Derivative $100
True-up derivative at period 1 end

Cash $100
           Derivative $100
Close-out derivative in period 2

Collateral payable $100
           Cash $100

On the other hand, if variation margin is treated as a settlement, the following journal entries would apply:

Cash $100
            Derivative $100
Variation margin during period 1

Derivative $100
           Gain on Derivative $100
True-up derivative at period 1 end

Under this second orientation, there are no derivative-related non-cash items on the balance sheet at the end of the first period or after. That is, cash is the only asset, but the same $100 of earnings arises in the first period. To be clear, the two methods yield identical reported earnings amounts, but the balance sheet presentations are different.

Note that the above journal entries ignore the treatment of the PAA amounts. When PAA is received, cash should be debited and (most likely) other interest income should be credited; when PAA is paid, other interest expense should be debited and cash should be credited.

As noted, both of these accounting methods appear to have been sanctioned by audit firms, but the indiscriminate application of the two methods is unjustified, as the “cash collateral” label is a source of confusion. The proper accounting should follow from whether cash settlements are exchanged between the derivative counterparties and, if so, whether those cash amounts are restricted in any way. Unrestricted cash settlements shouldn’t be treated the same way collateral is treated. Posting collateral is a custodial concern that generally has no impact on a firm’s balance sheet. Moreover, collateral is typically deposited with an independent party, and is something that is expected to be returned in full, assuming all associated cash flow obligations are satisfied. If a cash settlement is not handled in this restricted way, it shouldn’t be considered to be collateral, making the term “cash collateral” inappropriate.

Whether reporting entities or audit firms come to respect these economic distinctions is yet to be seen. If no consensus develops, however, resulting balance sheet presentations will be inconsistent, making it difficult to compare assorted financial ratios across institutions. When financial institutions issue debt and add an equal volume of assets, the net worth is unchanged, but such an action adds to the riskiness of the enterprise (assuming those balance sheet items are real). In the context of derivatives, when derivative positions are cash settled, credit risks pertaining to those positions evaporate. Therefore, to the extent that financial ratios fail to respect this economic reality, the associated credit risks and leverage calculations will be misstated.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

As a managing director with HedgeStar, Ira Kawaller draws on his more than 40 years of industry experience to provide hedge strategy services, training and hedge program implementation.

OCTOBER 16, 2017
Understanding discounted cash flow modeling as an option for CECL  
By Brandon Quinones, Risk Management Consultant, Sageworks

One of the main impetuses for changing the prevailing model for estimation of the allowance for loan and lease losses (ALLL) was the FASB’s view that reliance on historic information to determine “incurred-but-not-realized” losses in reserve calculations did not allow institutions to adjust reserve levels given a reasonable and supportable expectation of future events. Thus, a new standard requiring institutions to “… estimate expected credit losses over the contractual term of the financial asset(s)…” and “…consider available information relevant to assessing the collectability of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts.”1

Contractual v. Expected Cash Flows
When estimating losses using a discounted cash flow (DCF) approach, expected cash flow models are appropriate for reserve calculation under the new standard. A few material differences between the two calculations are modeling factors such as prepayment, default estimates, loss estimates and recovery activities that otherwise would not be used in a contractual cash flow calculation.

Track movement of loans by segment
to identify trends in portfolio growth
To calculate and apply these tendencies, the following inputs are critical to the calculation of discounted cash flow:

Of all the portfolio assumptions noted in the table, perhaps the most important to calculate are the Probability of Default (PD) and Loss Given Default (LGD).

PD and LGD are parameters that can be leveraged by institutions in a standalone measurement. Institutions currently using a PD and LGD approach for current GAAP may make an effort to calculate a lifetime PD and a symmetrical LGD to determine a rate for loss in an attempt to accomplish life-of-loan requirements as part of the new standard.

Long-Term Assets
Calculating and understanding the average life and/or prepayment rate of a loan/loan type (e.g., CRE, Mortgages, C&I) is mandatory when calculating the expected credit losses.

An institution calculating its life-of-loan loss experience utilizing methodologies such as Vintage Analysis, Migration, PD and LGD, and/or Static Pool analysis will require look-back periods sufficient to cover the expected life of the pool. For example, if a loan pool has an average life of four years, an institution would need four years of data to conduct a single four-year observation of losses, and such a data set would only be inclusive of loans that were on the balance sheet four years prior.

A DCF approach can employ recent, shorter-term observations for deployment in a forward-looking amortization schedule. DCF is, and will be, a preferred methodology for calculating the reserve of longer-lived assets.

Readily Available Industry/Peer Data
In instances where loan pools lack loan-counts to be statistically relevant, haven’t experienced a material amount of defaults/losses during periods where data is available and/or have new portfolios that are more analogous to industry/peer experience, a DCF best accommodates alternative measurements while maintaining institution-specific risk.

In using DCF, financial institutions may deploy industry-level PD, LGD and CPR (Conditional Prepayment Rate) toward their own loan structures for a reasonable and possibly more relevant expectation of life-of-loan loss.

The CECL standard frequently references concepts related to making adjustments based on reasonable and supportable forecasts2, concepts that are most logically addressed by using a DCF methodology. In projecting expected cash flows, each period within a forward-looking amortization schedule can/will vary slightly based on future expectations of external/economic data.

By its very nature, executing an expected cash flow schedule for each loan every month/quarter may not be practical in a spreadsheet environment. On the other hand, institutions utilizing a third-party provider may run into challenges recording the loan data required to build an accurate amortization schedule.

The process starts and ends with developing policies and procedures around the ongoing maintenance of loan-level data. Every institution should begin to define rules for storage and/or maintenance of data. By taking steps now, financial institutions will find themselves in a position to calculate a reasonable and supportable reserve.

1 ASU 326-20-30-6
2 ASU 326-20-30-7

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Brandon Quinones, Risk Management Consultant, Sageworks
Brandon Quinones is a Risk Management Consultant in the Bank Division at Sageworks, where he primarily focuses on helping community banks and credit unions manage their allowance for loan and lease loss (ALLL) provisions.

FEBRUARY 2, 2017
FOMC opts to hold steady amid improving conditions  
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

Following a two-day policy meeting in Washington, Federal Reserve officials unanimously held their benchmark rate steady in a range between 0.50% and 0.75%, while noting in a statement some recent improvements in the economy.

The Fed provided little direction on when it might next raise borrowing costs, as officials debate the impacts of policy changes with the new administration. The central bank currently projects three rate hikes for 2017, though committee members differ on how proposed tax cuts and regulatory changes may boost growth and inflation.

Looking Ahead
“Measures of consumer and business sentiment have improved of late,” the Federal Open Market Committee said in its statement Wednesday. Policy makers reiterated their expectations for moderate economic growth, “some further strengthening” in the labor market and a return to 2% inflation.

The FOMC also repeated that it anticipates interest rates will rise gradually. The statement said job gains “remained solid” and the unemployment rate “stayed near its recent low,” a tweak from December’s language that the rate “has declined.”

“Inflation increased in recent quarters but is still below the committee’s two percent longer-run objective,” the Fed said. Market-based measures of inflation compensation are “still low,” the central bank said, after suggesting in December that such measures had “moved up considerably.”

The committee left unchanged its stated intention to continue reinvesting its maturing debt holdings until “normalization” of the benchmark rate is “well under way.” The Fed’s balance sheet stands at about $4.5 trillion.
Fed Chair Janet Yellen, who didn’t have a press conference scheduled after this meeting, will have the opportunity to discuss the decision further during her semiannual monetary-policy testimony to Congress in mid-February. The FOMC next meets on March 14-15.

Before the latest statement, investors saw a roughly 38% chance that the first rate increase of 2017 would come at the Fed’s March meeting, based on trading in federal funds futures. The odds rose to about 52% for the subsequent gathering in early May and 75% for mid-June. The market forecast is currently calling for two hikes in the next two years and one in 2019. This would bring the overnight rate to 1.12% for December 2017, 1.62% at year-end 2018 and 1.87% for 2019. 

Tough Decisions
With bond yields still near historic lows, investors in fixed-income securities face a dilemma. Short-term bonds offer sub-par yields, but provide reinvestment opportunities in a rising rate environment. On the other hand, longer-term bonds secure a higher yield, but present larger losses if market rates rise.
Ten-year Treasury notes currently yield about 2.50%, not a great return given the interest rate risk in holding the security over the next decade. If yields were to climb 100 basis points to 3.50%, the price would drop almost 9%.  In this scenario, a five-year Treasury issue yielding 1.9% would lose 4.6%, and a 1.2% two-year note would drop 2%.  Even if bonds are held to maturity, experiencing price losses only on paper, the investor still foregoes the opportunity to earn higher returns if yields rise. 

The opposite would occur if rates fall, resulting in a sharp rally and producing sizeable unrealized gains. If this were to happen, the investor benefits from having locked in above-market yields. The investor is faced with the challenge of managing a portfolio structured to perform in either scenario.

One solution is to create a “bond ladder.” A laddered portfolio consists of securities that mature in successive years, starting in a few years and extending out to five years or longer. Assembling a stable basket of cash flows avoids locking in all of one’s funds at “low” yields, while enabling the investor to pick up some additional income. 

The benefit of a ladder is that as rates move higher, bonds coming due in the near term can provide funds for reinvestment when the alternatives may be more attractive. Depending on the investor’s preference and individual situation, the principal can be put to work at the desired maturity. If current yields are higher than the bonds rolling off, the investor is able to increase overall returns and boost portfolio performance.

At the close of every year, it seems the market prognosticators predict higher rates for the ensuing twelve months. Heeding these warnings, many investors flock to ultra-short-term bonds, sacrificing income. According to academic studies, by investing the bulk of the portfolio in short-term, low-yield bonds, investors are exposed to a different risk over time: earning low yields. There is an opportunity cost of sitting at near zero and waiting for higher rates, as the conventional wisdom about bonds does not always play out. Just as a well-balanced portfolio consists of several types of investments, so too should it contain a well-structured schedule of maturities.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Robert B. Segal, CFA, Founder/CEO, Atlantic Capital Strategies, Inc.
Robert B. Segal, CFA is founder and chief executive officer with Atlantic Capital Strategies, Inc. Bob has been in the banking industry since 1982, having worked in several community banks with roles in mortgage banking, sales and trading, and asset liability management. He is a frequent speaker at industry events and contributes to many regional and national finance publications. His firm provides investment advisory services to community-based institutions. Bob can be reached at or 781-276-4966.

OCTOBER 26, 2016
Three Approaches to Small Business Lending that Drive Growth
By Mary Ellen Biery, Research Specialist, Sageworks

Business lending has been an important source of growth for banks and credit unions since the financial crisis, and it will continue to be a critical driver in the quarters ahead. In a September 2016 survey of bankers, 81% indicated that CRE and C&I will be their focus for growth.

Given the current market’s pressure to ‘grow or go,’ many banks will look toward loan growth, which is seen by many banks as a way to scale, helping them outpace rising costs of compliance while expanding their reach into their communities. Financial institutions effectively growing their business loan portfolios are tapping into an underutilized opportunity for loan growth – loans to smaller businesses – and are implementing changes that transform the customer experience.

Loans to operating businesses have historically tended to flow toward larger institutions. But financial institutions focused solely on large commercial loans are missing an immense opportunity to grow the loan portfolio and retain or attract customers. Large enterprises make up less than 1% of the nearly 29 million businesses in the U.S. Most businesses are actually sole proprietorships or small businesses.

“Small businesses don’t want to go to online lenders, but it’s easier for many of them and they often can get the money quickly,” says Peter Brown, a senior consultant at Sageworks. “There’s a huge opportunity because those small businesses need funding, perhaps more than many other businesses.”

Common Approaches Driving Growth
Institutions already growing their commercial loan portfolios profitably are doing so by taking action to upend some of the traditional pain points – for the borrower and the lender – related to business lending. These three approaches, often driven by technology, can offer a better customer experience.

1. Speed of application
Technology is helping institutions make the application process faster and easier for borrowers while streamlining the underwriting process for the financial institution. For example, file-hosting technology allows applicants to share electronic files of supporting documentation for loan applications, and electronic signatures also move the process along more quickly. A new technology for banks and credit unions can automatically import financial data from electronic tax returns directly into the loan application. This saves the borrower from time-consuming and error-prone data entry while simultaneously transferring the necessary information into the bank’s system for credit analysis, loan administration and life-of-loan management.

2. Faster decisions and transparency
The search costs involved in small business lending are high for both borrowers and lenders. In recent years, financial institutions have streamlined loan approval processes by implementing technology that automates credit analysis, decisioning and the annual updates to financial statements of current borrowers. Even if the application process has been streamlined as described above, the decisioning stages can also be expedited to increase turnaround times for borrowers.

With loan decisioning technology, the institution can choose how much of the process to automate while still maintaining and supporting the human element provided by experienced analysts. For example, with the right technology and process in place, lenders can be responsible for much of the application process, and with that information in the system technology can make a recommendation for approval, rejection or further review. For smaller exposure loans, these efficiency gains mean the institution’s trained analysts are focused on the loans or borrowers that most demand their attention, and business borrowers benefit from faster loan decisions and a more transparent process.

3. Competitive rates
Pricing a loan to match a competitor’s rate may win the new business, but financial institutions understand that doing so can come at a huge cost if the institution doesn’t take into account the risk level and whether the loan will meet the institution’s profitability goals. Technology makes lending operations more efficient and scalable and can provide greater insight into which changes to rates, fees or terms are advantageous to both the borrower and lender.

Financial institutions growing their commercial portfolios profitably use technology to provide superior customer experiences while fundamentally changing the risks and costs associated with lending to businesses. These institutions that have the ability to underwrite smaller loans to businesses efficiently and accurately stand to tap into important growth markets while more effectively meeting the needs of current members and clients.

Technology in these cases doesn’t replace the relationship that a financial institution has with a business borrower; rather, the goal is to replace the administrative touches. In doing so, lenders, relationship managers and portfolio managers can spend more time talking to customers about their needs rather than the administrative requirements for the institution.

After all, the customer doesn’t care about the institution’s administrative requirements – that small business just wants its money.

1 “Sageworks Summit Poll: CRE loans top focus in loan portfolio”, 10/4/2016.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Mary Ellen Biery, Research Specialist, Sageworks
Mary Ellen Biery is a research specialist at Sageworks, where she produces accounting and banking content for the company’s blogs and websites, as well as for other outlets. She is a veteran financial reporter whose work has appeared in The Wall Street Journal and on Dow Jones Newswires,,, and other sites.

NOVEMBER 10, 2016
A Review of Swap Hedge Accounting 
By Brian Matochik, Senior Vice President, FTN Financial Derivative Products Group

Hedge accounting is a set of accounting rules established by FASB that standardizes and governs the way swap transactions are accounted for. To those of us who are not accountants (and maybe even to some of us that are), this term may seem daunting and complicated. However, hedge accounting is actually very beneficial for financial institutions that are looking make longer-term loans and hedge the risk by using interest rate swaps.

The purpose of hedge accounting is to not only establish guidelines and consistency for how swaps should be accounted for, but also to reduce the potential earnings volatility in derivative transactions that qualify for this type of accounting treatment. Because interest rate swaps are required to be marked to market, income volatility could arise if their market value changed significantly and had to be taken into earnings. For example, the market value of a pay-fixed swap will move similarly, but inversely, to the market value of a bullet bond with similar par amount and term. Therefore, a swap’s price volatility can be substantial, which is why hedge accounting is certainly worth considering.

There are two types of hedge accounting treatment, as outlined in the table below:

Fair Value Hedge
For a fair value hedge, the swap will be recorded as an asset or liability on the balance sheet with an offsetting value adjustment to the hedged asset or liability. As long as the structure of the hedge and the item being hedged are closely matched, there is little to no earnings impact. This is especially useful for institutions that use swaps to hedge long-term fixed-rate commercial loans (loan swaps executed with individual borrowers, i.e. back-to-back swaps, do not require hedge accounting treatment).

Cash Flow Hedge
For a cash flow hedge, the swap will be recorded as an asset or liability on the balance sheet with an offsetting value recorded in OCI (Other Comprehensive Income). Cash flow hedge accounting is comparable to how banks account for AFS securities, where the value of a hedge is offset as a component of equity. Similar to a fair value hedge, as long as the structure of the hedge and the item being hedged are closely matched, there is little to no earnings impact. Cash flow hedges are useful for hedging trust preferred securities, FHLB advances and other floating-rate liabilities.

Some institutions choose to bypass hedge accounting treatment and simply mark swaps to market in earnings, which is the alternative option to hedge accounting. In these cases, institutions will often move an asset to a trading account to help offset swap market values. However, since hedge accounting reduces the potential earnings volatility that would come from changes in the swap’s market value, it is beneficial for institutions to consider this approach first when exploring any hedge strategies.

There are, of course, certain documentation requirements and steps involved in order to be able to elect hedge accounting treatment, and it is important for institutions to partner with a knowledgeable counterparty for full accounting support to ensure compliance. However, when used properly, hedge accounting is an important tool that institutions can use to reduce earnings volatility from hedging instruments.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Brian Matochik, Senior Vice President, FTN Financial Derivative Products Group
As a Senior Vice President in the Derivative Products Group at FTN Financial, Brian is responsible for customer hedging strategy development and hedge accounting support, as well as derivative trade execution, management and implementation, with a focus on hedging strategies for community banks.  He is involved in all aspects of FTN Financial’s Hedging Program including loan structuring, pricing, trade execution and client support. Mr. Matochik graduated summa cum laude from the University of Memphis with a B.A. in International Studies and also holds an M.B.A. from the University of Memphis Fogelman College of Business and Economics.