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How banks can balance risks with results through hedge accounting
Listen to the EY India Insights podcast on hedge accounting, risk management and financial reporting, and how banks can navigate volatility effectively.
In the latest episode of the EY India Insights podcast, Hemal Shah, Partner, Consulting Services, EY India, explores the evolving role of hedge accounting in helping banks align risk management strategies with financial reporting outcomes. He explains why effective hedging can result in earnings volatility, the challenges posed by hedge effectiveness testing and the importance of stronger governance across treasury, risk and finance functions. Tune in to gain relevant insights into how banks can better reflect the economic intent of their hedging strategies in an increasingly volatile environment.
Key takeaways
Effective hedging may still cause earnings volatility due to accounting timing and valuation mismatches in banks despite sound risk management.
Hedge accounting helps banks align financial reporting with economic reality, reducing artificial volatility and improving transparency for investors and stakeholders.
Hedge effectiveness testing, basis risk and valuation differences remain key challenges in achieving consistent and reliable accounting outcomes.
Strong documentation, governance and ongoing monitoring are essential, as hedge accounting requires operational discipline beyond risk management.
Closer collaboration between treasury, risk and finance functions enables banks to better reflect hedging objectives in financial statements.
A hedge may successfully mitigate risk, yet accounting mismatches can create earnings volatility that masks its true economic effectiveness.
Hemal Shah
Partner, Consulting Services, EY India
For your convenience, a full text transcript of this podcast is available on the link below:
Welcome to the latest episode of EY India Insights podcast. I am Pallavi, your host for today. In this episode, we are discussing hedge accounting in banks – how they are managing risk versus managing outcomes. Joining us is Hemal Shah, Partner, Consulting Services, EY India, to share his insights on the challenges and opportunities in aligning risk management with accounting outcomes.
Hi, Hemal. Thank you for joining us today and welcome to the podcast.
Hemal
Hi, Pallavi. Thank you.
Pallavi
What is the fundamental difference between managing risk and managing accounting outcomes? And why has this become a critical issue for banks in today's volatile interest rate environment?
Hemal
If you look at banking as a business, at its core, risk management is all about protecting the bank from adverse movements in interest rate, currencies and any other market variables. Banks use instruments such as interest rate swaps or other derivatives to reduce their economic risk and stabilize earnings over a period of time. However, accounting outcomes focus on how those hedging activities are reflected in the financial statements.
The challenge arises because a hedge can be economically effective but may not always produce the desired accounting result. In today's environment of interest rate volatility, central bank policy shifts and geopolitical conditions, balance sheet management for banks has become very common.
Banks are increasingly focused not only on whether a hedge reduces risk, but also whether accounting treatment accurately reflects the economic reality. In simple terms, managing risk is about reducing exposures, while managing outcomes is about ensuring that the financial statements tell the same story as the risk management strategy.
When these two diverge, unexpected earning volatility can occur, even though the hedge is doing exactly what it is designed to do.
Pallavi
Why do banks sometimes experience earnings volatility, even when their hedging strategies are working effectively from a risk management perspective?
Hemal
This is one of the most common misconceptions around hedge accounting. A bank may have successfully reduced its economic exposure through derivatives but accounting rules often require different valuation approaches for the hedging instrument and the underlying exposure.
As a result, gains and losses may be recognized in different periods or measured using different assumptions. For example, an Interest Rate Swap (IRS) may offset the risk of a loan portfolio from a treasury perspective. Economically, the bank is protected. However, if the accounting treatment of the swap and the hedged item is not perfectly aligned, profit and loss statements may still show fluctuations. So, the volatility which investors see in the reported earnings does not necessarily indicate ineffective risk management. Instead, it may reflect limitations in the hedge accounting framework and complexity of matching accounting recognition with economic reality. The key objective of hedge accounting is therefore to reduce these artificial mismatches and improve transparency.
Pallavi
What are the key challenges such as hedge effectiveness testing basis risk, valuation differences and documentation requirement that can create inconsistencies in hedge accounting outcomes?
Hemal
There are several practical challenges that banks face.
1. Hedge effectiveness assessment: Banks must demonstrate that there is a strong economic relationship between the hedge instrument and the risk which is being hedged. Even small deviations can create accounting ineffectiveness.
2. Basis risk: This occurs when a derivative does not move exactly in line with the underlying exposure. Even though the hedge reduces most of the risk, slight differences can affect accounting results and generate residual volatility.
3. Valuation differences: The derivative and the hedged items may be valued using different methods, different market data sources or assumptions. These differences can create accounting mismatches despite a successful economic hedge.
4. Documentation and governance requirements: Hedge accounting is not automatic. Banks need very clear documentation of risk management objectives, hedge designations, their methodologies and ongoing monitoring. If documentation is incomplete or at a high level or not maintained consistently, hedge accounting treatment may not be available even when the underlying hedge strategy is sound.
Together, these challenges explain why hedge accounting is often viewed as both a risk management exercise and also an operational discipline.
Pallavi
Looking ahead, how can banks strengthen governance and better align treasury, risk and finance functions to ensure hedge accounting reflects the true economic intent of their risk management strategy?
Hemal
The key is to move away from siloed decision making. Treasury teams typically focus on managing funding and interest rate risk exposures. The risk teams focus on measuring and monitoring risk, while the accounts and finance teams focus on the accounting and the reporting objectives.
To achieve successful hedge accounting, all these three functions need to operate from a common framework and shared objectives. Banks can strengthen governance by establishing clear hedge accounting policies, enhancing documentation standards, investing in integrated technology platform, maybe even create a bespoke technology platform and conducting ongoing effectiveness monitoring – all these ensure that risk management decisions are reflected accurately in financial reporting.
Another important step is embedding hedge accounting considerations earlier in the hedging lifecycle rather than treating them as a reporting exercise at the end of the process. When treasury, risk, finance and accounting (F&A) collaborate from the outset, banks can reduce surprises, improve transparency and better demonstrate the economic rationale behind their hedging activities. Ultimately, the goal is simple – financial statements should reflect the true economic effect of the risk management decisions. Enabling stakeholders to understand how effectively the bank is managing uncertainty in a volatile market environment is a pure imperative.
Pallavi
Thank you, Hemal. Now that brings us to the end of this episode. Thank you so much once again for sharing all your perspectives to our listeners.
Hemal
Thank you, Pallavi. Thank you so much.
Pallavi
And to all our listeners, thank you so much for tuning in to the EY India Insights podcast. Stay connected for more conversations on the trends shaping business risk and transformation.
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