Hedge accounting may gain a fifth benchmark interest rate

The FASB decided on Dec. 20, 2017, to consider adding an interest rate to the list of accepted benchmark rates for hedge accounting in U.S. GAAP.

If the board agrees to add the Secured Overnight Financing Rate for Overnight Index Swaps (SOFR OIS) to Topic 815, Derivatives and Hedging, it plans to release the proposed change for public comment in February. The board wants to set the deadline for public comments no later than March 30, 2018, so that it can finalize the change by the time the Federal Reserve authorizes the SOFR OIS for use by banks.

Adding the SOFR OIS to Topic 815 is considered a crucial step toward banks’ willingness to use the interest rate.

“The staff believes it meets the criteria to be a benchmark rate; it’s close to risk free and is indicative of high-quality borrowing rates,” FASB assistant project manager Julie Um said in reference to the SOFR OIS.

The benchmark interest rate is typically an important component for pricing the derivatives contracts businesses use to hedge their exposure to spikes in interest rates. When hedge accounting is effective, it can keep fluctuations in interest rates or other financial market measurements out of reported earnings and help companies avoiding fluctuations in their income.

Topic 815 allows businesses to hedge interest rate risk using a benchmark interest rate, which is defined in U.S. GAAP as an interest rate that is widely used in the financial markets and associated with an issuer or instrument that has virtually no risk of default. Topic 815 lists three rates as benchmarks: London Interbank Offered Rate (LIBOR), the rate on direct Treasury obligations of the U.S. government and the Fed Funds Effective Swap Rate (Overnight Index Swap Rate). A fourth rate, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate, is scheduled to join the list in 2019, when the changes from Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, become effective. The FASB said the hedge accounting amendments can be adopted ahead of the effective date.

Derivatives priced with LIBOR as their benchmark are the most common hedging instruments in the market, the FASB said. LIBOR also is used for many other financial transactions, including mortgages and loans. But LIBOR’s credibility was tarnished by the 2012 rate-rigging scandal. In 2014, the Financial Stability Oversight Council (FSOC), the interagency panel of financial regulators chaired by the Treasury Department, recommended that U.S. regulators cooperate with foreign financial authorities, international bodies, and market participants to produce alternative benchmarks.

The Federal Reserve responded to the FSOC’s recommendations by empaneling its Alternative Reference Rate Committee (ARRC) to identify new reference rates that are “more firmly based on transactions from a robust underlying market” and can replace LIBOR.

The new rate “will be derived from the deepest, most resilient funding market in the U.S. As such, it represents a robust rate that will support U.S. financial stability,” Federal Reserve Board Governor Jerome Powell said in an August statement to propose the new rate.

The FASB has no plans to remove LIBOR from U.S. GAAP, a FASB spokesperson said.

“After the new rate has taken effect and the transition in the market is complete, the FASB will address any changes that need to be made to the hedging standard,” the spokesperson wrote in an email to Accounting & Compliance Alert. “At this point, though, there are no plans to make any changes with respect to LIBOR.”

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