Perspectives: Accounting

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.

Conclusion
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
Approach
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.

BENEFITS
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.

Forecasting
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.

CHALLENGES
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 bob@atlanticcapitalstrategies.com 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.

Conclusion
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. https://www.sageworks.com/datareleases.aspx?article=396&title=Sageworks-Summit-Poll:-CRE-loans-top-focus-in-loan-portfolio&date=October-5-2016

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, CNN.com, MarketWatch.com, CNBC.com 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.  






OCTOBER 17, 2016
FMS Quick Poll: Social Media
By Financial Managers Society

What constitutes a “community?”

Whereas a clear designator such as geographic proximity might have definitively answered that question in the past, the notion isn’t quite as clearly cut these days. The explosive growth of social media has redefined both what a community is and where it is – shifts that are proving profound for personal and business relationships alike.

What is the impact on a community institution, for example, if the community it serves begins to migrate to the virtual world of social media? How does a bank or credit union continue to reach out to its community to connect, communicate and engage when those customers are more likely to log on than walk in? We were curious as to how FMS members were using social media and how it was affecting engagement with their customers. With close to 125 responses in our latest Quick Poll, it certainly appears as though members are attempting to reach out to their customers via social media, but the details lie in the degree to which they are committed to that effort.

Of the 122 respondents in the poll – 104 from banks and 18 from credit unions – 56% consider their institution to be either a highly active (multiple posts per week, dedicated staff, regular interaction with customers) or somewhat active (a post at least every week, occasional interaction with customers) social media user (see Figure I). Meanwhile, 21% of poll participants maintain a social media presence but don’t consider themselves particularly active, and 23% aren’t on social media at all, for reasons ranging from compliance concerns to lack of resources to a belief that their customers just aren’t interested.

FMS Quick Poll

For those who have chosen to maintain a social media presence, has the effort proven fruitful in terms of engaging their communities? The answer is somewhat, but perhaps not as much as they would like. Only 7% of respondents describe the level of interaction with their customers via social media as vibrant, while 36% consider their social media efforts worthwhile but not a terribly high priority, and another 30% note that their customers rarely engage with the institution on social media (see Figure II).

FMS Quick Poll

In terms of where FMS members spend their time and resources on social media, Facebook is far and away the most frequently utilized platform at 44% among poll respondents (see Figure III), followed by LinkedIn (24%) and Twitter (19%). Members see far less value, however, in posting photos to Instagram or videos on YouTube (6% each).



Across these and other platforms, poll respondents are clearly trying to highlight their standing in their communities, with 36% frequently sharing local news and events (see Figure IV). Another common social media use is posting basic announcements regarding branch hours, closings, etc. (29%), while less common uses include product promotions (20%) and personal finance advice/articles (14%).

FMS Quick Poll

Responses across asset sizes were fairly consistent, though larger institutions ($500 million and up) reported greater levels of social media interaction with their customers than their smaller peers. It is interesting, however, that even among the larger institutions a “vibrant” level of engagement was hard to come by.

Thanks again to everyone who participated in our latest FMS Quick Poll. If you didn’t have a chance to complete the poll, be sure to weigh in with your views on social media in the comments section below or on FMS Connect!




SEPTEMBER 22, 2016
Fed Elects to Punt: Eyeing the End of the Year, FOMC Leaves Rate Unchanged Again
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

The Federal Reserve left its policy rate unchanged for a sixth straight meeting, saying it would wait for more evidence of progress toward its goals, while projecting that an increase is still likely by year-end.

“Near-term risks to the economic outlook appear roughly balanced,” the FOMC said in its statement after a two-day meeting in Washington. “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”

Three officials, meanwhile, dissented in favor of a quarter-point hike. Esther George, president of the Kansas City Fed, voted against the decision for a second straight meeting. She was joined by Cleveland Fed President Loretta Mester and Eric Rosengren, head of the Boston Fed.

The central bank’s “dot plot” showed that officials expect one quarter-point rate increase this year. Officials scaled back expectations for hikes in 2017 and over the longer run. Policymakers see two rate hikes next year, down from their June median projection of three. They see the Fed funds rate settling in at 2.9%, down from a 3% guess in June.

“Our decision does not reflect a lack of confidence in the economy,” Fed Chair Janet Yellen said at the press conference. “Since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future.” She noted that a “cautious” approach is all the more appropriate given that short-term rates are still near zero, and therefore the Committee can more effectively respond to inflation pressures by raising rates than to falling inflation by cutting rates.

At this time, markets place the chance of a rate increase by year-end at 60%, down slightly from 65% after the Fed’s April 27th meeting. This compares with only 10%, however, at the end of June. The yield on the benchmark 10-year Treasury note traded recently at 1.65%, compared with 1.85% at the end of May.

In its latest banking profile, the FDIC said community banks reported net interest income of $17.5 billion during first quarter 2016, up $1.3 billion (8.2 percent) from the prior year. Net interest margin of 3.56% was up two basis points from the year earlier, as asset yields increased two basis points and funding costs were unchanged. Going forward, however, margins are projected to trend downward as asset yields are under pressure while funding costs remain near floors.

In this environment, some institutions may wish to consider a more active investment style. A number of organizations limit their investment allocation to a few areas in which they are comfortable, such as mortgage securities or agencies. With this approach, however, the institution may be sacrificing income as well as increasing balance sheet risk.

In fact, portfolio managers at many banks have been busy realigning their investment distributions. With the decline in rates in recent quarters, portfolio cash flow has spiked and according to industry reports, the destination for this cash has largely been municipal and other non-agency bullet securities.

This shift should not come as a surprise, as organizations continue to struggle with margin challenges in the face of a flatter yield curve. Depositories choose these types of securities to provide additional yield and position the portfolio more appropriately for the current rate environment. The predictable cash flow feature makes them an attractive alternative even with the longer duration.

Investment sectors often become overvalued. Investors concerned about rising rates have flocked to short-duration mortgages and floating-rate notes, driving up prices and pushing down yields. At the same time, the market tends to punish entire sectors during times of stress. In these cases, investment officers should consider selling the “rich” securities and moving into the undervalued ones.

Earlier this year, corporate bond spreads widened dramatically as energy prices fell and the stock market plunged. This affected most corporate issuers regardless of credit quality. Apple Inc., for example, issued five-year notes at a spread of 100 basis points to Treasuries, about double the normal spread. This happened in spite of Apple’s strong balance sheet, consistent profitability and ample liquidity.

Investors moving out of short-duration mortgage securities and into high-quality corporate bonds at this time could have realized higher levels of current income and more stable portfolio cash flow characteristics. While corporate bonds are not appropriate for all investors, the same strategy can be utilized with other securities that offer favorable total return potential.

Maintaining flexibility for managing the investment portfolio can reduce overall rate sensitivity through a range of tactical and strategic transactions. An active manager tends to spread exposures to a variety of higher-returning sectors, while moving out of market segments that become expensive.  Successful active management also entails a willingness to think independently in terms of position and sector weightings. When properly implemented, active management strategies can lessen an institution’s exposure to declining margins, helping to offset the impact of a challenging investment landscape.

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 bob@atlanticcapitalstrategies.com or 781-276-4966.

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.