The Financial Accounting Standards Board has dropped a plan that would have made it harder for banks to use a popular tool for managing the interest rate risk of prime-rate-based loans.
In deliberations at its first two weekly meetings in May, the board put aside a proposed interpretation of its derivatives standard that would have explicitly excluded prime-rate-based hedges from qualifying for hedge accounting treatment.
Risk managers are awaiting a revised draft, which they expect to provide a way for banks to hedge pools of prime-rate-based loans and qualify for the treatment laid out in the derivatives standard.
“I think the board has already made its decision,” said Paul Laurenzano, a practice fellow with the FASB. “It’s just a function of the staff drafting it in a manner that they are comfortable with based on the decision made.”
Bankers were concerned that the initial draft of the interpretation — known as G25 — would have made even the simplest prime-rate-based swaps impractical, leaving earnings especially vulnerable to rate fluctuations.
The decision to recast G25 “was just great news,” said Clark Maxwell, the director of the financial institutions practice at Chatham Financial Corp., a Kennett Square, Pa., advisory firm. The industry’s lobbying effort against the plan “helped the board recognize that this was very important, and the way G25 was originally written was really pretty punitive.”
Board staff members initially wrote the interpretation to address what they called a misapplication of an earlier interpretation, G13, which was itself intended to clarify the standard on derivatives and hedges, FAS 133. Notorious for its complexity, FAS 133 inspired the creation of the Derivatives Implementation Group to address its specific practice ambiguities.
The group has issued almost 200 interpretations of FAS 133. It has not met formally for over two years, but board staff members continue to circulate proposals to members for comment. And the FASB’s Web site says it “remains a consultative group available to serve” as needed.
The initial position in FAS 133 was that rates on Treasuries were the only appropriate, risk-free benchmarks for hedging against interest rate changes. The board eventually allowed London interbank offered rate-based hedges after the industry complained it needed a more practical, risk-free rate for its swaps.
But the board argued that a prime-based swap was a hedge against total variability (incorporating credit risk as well as rate risk).
The staff’s first crack at G25 would have explicitly excluded prime-based hedges unless banks specifically identified every loan in the pool it was hedging. Banks said that method would have created substantial volatility and a maintenance burden that would make the hedges a practical impossibility.
Banks could have continued to use the swaps for economic protection, but they would not have qualified for hedge accounting. That would have resulted in a cash-flow mismatch between hedge and hedged asset that would also lead to earnings volatility.
In meetings on May 5 and May 12, board members instructed the staff to rewrite the standard in a way that let banks hedge the first payments received on a pool of prime-based loans.
For instance, a bank might set up a swap with a notional amount of $10 million on a $50 million pool, with the first payments received on $10 million of the loans counting toward the swap — effectively eliminating credit risk from the swap equation.
The heart of the technical complication is that prime is not a single rate, though market forces tend to drive a consensus. The board decided that a bank’s own prime rate, the prime rate as calculated in The Wall Street Journal, and the prime rate as calculated by the Federal Reserve Board were all acceptable and more or less interchangeable. A bank could therefore set up a swap tied to the Journal’s prime to hedge a pool of loans bearing its own prime rate.
Though banks could use the first-payments-received technique for prime and other nonbenchmark rates, they wanted another alternative.
“Our suggestion was to expand the concept of benchmarks to include prime and fed funds and other indexes,” said Gwen Ritter, an accounting expert at the American Bankers Association. “We think that allowing the first-payments-received approach is moving in the right direction, but taking it one step further would provide more hedging opportunity. Our main concern is that banks will be able to hedge interest rate risk.”
George Darling, the president of Darling Consulting Group in Newburyport, Mass., offered another suggestion: Using an international standard that “basically says it doesn’t matter what index you are hedging as long as you can prove correlation” between the cash flows of the pool and the hedge.
“Nobody who knows banking at all would ever argue that just because a loan rate is indexed to Libor that there’s less credit risk than if it were indexed to prime,” he said. “It just happened to be what the borrower chose for the index they wanted to be priced to.”
But Mr. Maxwell at Chatham said FASB’s solution “works out in everybody’s best interests” and the initial read on G25 would have been “a hard answer to swallow.”
The best estimate for when the revised interpretation will be released is two to four weeks from now, but insiders warn that, as usual, that time frame could change.
