Critically, by engineering the bank/dealer swap to provide for an initial day-one cash flow to the benefit of the bank, the bank is able to accelerate the earnings recognition under the strategy, realizing the lion’s share of these earnings in the first reporting period (ending March 31, 2016, in this example). After that first period, some earnings volatility arises, again, as a consequence of the differences in the two swap valuations due to credit considerations (see table below).
This strategy allows community banks to use swaps to provide fixed-rate financing to their customers, while at the same time carrying variable rate loans on their balance sheet. However, the same issues are equally applicable to money managers who choose to layoff derivative exposures with offsetting contracts, rather than liquidating those derivatives with their original counterparties. Even when the offsetting derivatives are designed to have identical cash flow features, the quirks of accounting rules will likely foster unanticipated earnings volatility. While the magnitudes of these earnings impacts may be relatively minor, users of this strategy should not be surprised by these results.
This article was originally published in the September 2017 issue of Bank Asset/Liability Management.
Ira Kawaller is the founder of Kawaller & Co., LLC – a consulting organization that assists commercial enterprises in connection with their use of derivatives. He can be reached at firstname.lastname@example.org.