Guest blog by BSA Associate member, ALMIS International

In the hedge accounting context, the portfolio approach is designed to assist banking firms with the accounting challenges associated with hedging for IRRBB (interest rate risk in the banking book).

Many firms are being strongly encouraged by the PRA to move hedging policy from 3-month LIBOR to SONIA swaps.  Accounting issues have become a stumbling block.

To achieve hedge accounting the hedge item risk must be documented at inception.  To be eligible for hedge accounting, the hedge and designated hedge item must be documented and demonstrated to be effective. 

A yield curve is used to measure the fair value of the hedged item and the movement in fair value from time to time.  This movement relative to the fair value movement of the hedge is the measure of effectiveness, where ineffectiveness must go to P/L.

Historically firms in our experience use the 3-month LIBOR curve for measuring the fair value movement of the hedged item.  We believe the reason for this is NOT because the underlying risk is 3-month LIBOR but is because this curve has been regarded as a reasonable proxy for the underlying risk (the underlying risk being movements in risk free interest rates).

So, using a SONIA swap is not the result of any change in hedging objective.  It is likely because SONIA is now deemed a better, more representative benchmark of the underlying risk.  The policy is changing but the objectives are the same, as the underlying risk is the same.

As we see it, 3 fair value portfolio hedge accounting approaches are being adopted in practice.  There is no perfect solution to all this, but some of the pros and cons of each approach are as follows:

1. Maintain 2 portfolios, one for SONIA swaps and another for LIBOR swaps. 

The advantage is no P/L volatility due to shifts between SONIA and LIBOR rate spreads from time to time.  The swap fair value movements are aligned to the underlying movements as the underlying can be valued using a LIBOR curve for loans matched against LIBOR swaps, and a SONIA curve for loans matched against SONIA swaps. 

The disadvantage is the need to manage and maintain two separate portfolios.  Ineffectiveness can arise in smaller portfolios as there is less opportunity for offset within the portfolio.  Also, there is potential future audit challenge that the firm is being inconsistent with its documented objectives of hedging.  How can it justify using two different techniques for measuring the same risk in circumstances where the objective also remains the same?

2. A single portfolio with the hedge item measured using 3 month LIBOR regardless of swap

This will not require a change in policy documentation.  However, the loans matched against a SONIA swaps will at the outset be valued lower, as the SONIA curve is lower than the LIBOR curve.  Ineffectiveness will arise from SONIA swaps where the change in fair value will not fully offset the change in fair value of the designated loans that use the LIBOR curve.  Eg a LIBOR increase over SONIA of 2bp with result in the loan value falling, but the swap value staying the same.  This volatility will increase over time as the proportion of SONIA hedges increase.

3. A single portfolio with the hedged item measured using SONIA, regardless of swap

This will require a change in policy and some auditors have expressed a view this therefore requires a de-designation.  In any event some adjustment needs to be made for the increase in hedge item value when using a fixed LIBOR designated hedged rate measured against a SONIA curve.  There will also be ineffectiveness as the loans matched with LIBOR swaps will not always move perfectly in line with SONIA curve, i.e. when the LIBOR / SONIA spread changes.  However, this ineffectiveness will reduce over time, as the proportion of SONIA swaps increase.  Finally, this method is likely to be consistent with the objectives of hedging where the underlying risk is the same regardless of hedge. 

Conclusion

There are clearly a number of considerations.  Our company’s view is that the SONIA curve is now a far better proxy for risk free interest rates and therefore should be used for measuring and monitoring interest rate risk.  Whichever conclusion a firm comes to, the accounting should never be an impediment to best hedging practice and currently regulators and treasury experts are advising firms to transition away from LIBOR as soon as possible.