The appeal of Balance Guaranteed Swaps

For treasury professionals managing dynamic portfolios of fixed-rate loans, a Balance Guaranteed Swap (BGS) often presents an attractive alternative to a traditional vanilla Interest Rate Swap. A BGS is a sophisticated derivative designed to mitigate the risk of a portfolio's balance falling below a specified level. Typically, one party (the lender) guarantees a continuously updated notional balance to another (the borrower) over a set period, with payoffs linked to variations in the underlying portfolio.

These swaps offer significant commercial advantages, making them popular in specific applications:

• Reduced volatility: BGS can significantly reduce the volatility of a company's balance sheet and key financial metrics. They offer economic protection against both interest rate risk and prepayment risk with added flexibility to grow a loan portfolio under the umbrella of a single swap contract.
• Improved credit rating: By mitigating financial risks, a BGS can potentially enhance a company's creditworthiness, leading to better borrowing terms and lower interest rates.
• Enhanced financial stability: The guaranteed balance can provide a crucial safety net, particularly during shifts in the underlying loan portfolio, contributing to overall financial stability.
• Automation: The balance guarantee feature reduces the need for manual rebalancing and trading processes compared with traditional dynamically managed swap portfolios.

However, these benefits often come with some less obvious drawbacks;

• High cost: The guarantee provided by the swap will likely come at a significant cost. The counterparty will charge a premium for bearing the risk, a cost that needs to be carefully weighed against the benefits.
• Complexity: Structuring and implementing a BGS can be complex, requiring specialized expertise and potentially leading to higher transaction costs. Understanding the terms and conditions is crucial to avoid unforeseen liabilities.
• Accounting challenges: The complex nature of these derivative transactions means they do not easily fit into existing accounting frameworks such as IFRS 9, 13 and IAS 39 when it comes to valuing and measuring the contracts particularly with regard to hedge accounting requirements.

In this blog, we will focus on those critical accounting considerations and highlight potential pitfalls to be aware of.

Valuation considerations: Beyond the mid-market rate

The valuation of Balance Guaranteed Swaps (BGS) is inherently complex, with no single, universally applicable formula. A precise valuation typically necessitates sophisticated financial modelling software and expert knowledge, primarily due to the unique pricing factors involved:

Unlike a vanilla swap which has entirely observable inputs (Level 2 in the Fair Value Hierarchy) these BGS have inputs which are Level 3 in nature such as the assumptions around the projected notional balances. Entities should be aware of this in terms of financial disclosures.

A less frequently considered aspect is the impact on IFRS 13 and the definition of “Fair Value”. While swaps are valued under IFRS 13 at ‘transaction price,’ and typical models use interest rate curves to price the derivative instruments, BGS introduce a unique challenge.

Vanilla swaps are typically valued on a “mid-market” basis using prevailing rate curves (e.g SONIA curves in the UK).  However, BGS include spreads in the fixed leg to compensate the originating swap counterparty for the additional costs of managing the balance guarantee. As a practical example, if the prevailing five-year swap rate is 3%, a similar BGS might have a rate of 3.2%, providing 20 basis points of additional margin on the swap to fund the guarantee.

This difference means that pricing a BGS on its trade date (and at subsequent rebalances), using mid-market swap rates can give rise to so called “Day 1 fair value” considerations because they tend to have significant Day 1 liabilities when priced as ordinary swaps using mid-market inputs – and yet no value is “created” on Day 1! This anomaly arises because, in the inter-banking market where BGS are priced, these swaps reflect the market rate, it is the pricing models that feature this shortcoming as they rely on observable mid-market rate curves.

Hedge accounting considerations under IAS 39/IFRS 9: The operational gap

Applying hedge accounting under IAS 39 (still relevant for entities using portfolio hedging, though superseded by IFRS 9) to Balance Guaranteed Swaps is intricate. It demands meticulous consideration of the swap's specific terms and the nature of the risk being hedged, as IAS 39's strict criteria for hedge accounting must be rigorously met.

A common pitfall is the disconnect between front-office perception and back-office reality. From a front office perspective, the BGS offers a convenient, one-stop solution to economically hedging the underlying loans, with both interest rate and prepayment risk continuously updating to mirror the portfolio. In theory, this should make hedge accounting straightforward.

However, this is rarely the case, portfolio hedging as outlined by IAS 39 was designed for hedging a dynamic loan portfolio with a continual rebalancing of basic interest rate swaps. This means to implement hedge accounting and meet the effectiveness requirements of the accounting standard, a sufficient model must be implemented to model, value and account for the loan portfolio as represented in the Fair Value Hedge Adjustment (FVHA).

This can leave entities with an operational gap: a strong economic hedge but an insufficient treasury accounting function to properly designate, measure and account for the hedged portfolio. The BGS requires the exact same amount of accounting work as any ordinary portfolio hedge, with several added complexities including;

How Deloitte can help: Bridging the gap

While BGS offers an attractive solution for the economic hedging of open portfolios of rate-sensitive loans and deposits, its implementation often overlooks the wider accounting considerations and complexities. It is a solution marketed by banks to front offices that seldom need to consider the intricate technical accounting implications.

Deloitte can provide assurance to clients around these potential pitfalls and considerations, helping entities develop effective valuation and hedging models that will withstand the scrutiny of auditors and associated users of financial statements. Our services include:

• Identifying and assessing risks
• Developing a hedging strategy
• Implementation and monitoring
• Technology and data analytics
• Regulatory compliance

If you would like to discuss your company’s specific BGS challenges, please get in touch with one of the team.