Hedging the banking book

RiskAtoms Bank holds two sets of interest rate swaps that point in opposite directions: £19.2bn that pay a fixed rate and £16bn that receive one. A visitor might ask why the treasury does not just cancel them and save the fees. Take away the receive-fixed swaps and a 275bp fall in rates costs the bank £604.3m of net interest income in the first year instead of £263.3m, and its economic value test goes from a pass to a fail. Take away the pay-fixed swaps instead and it fails the same test from the other side. Each hedge answers a different question, and the answers only make sense together.

A swap exchanges a fixed rate for a floating one on a notional amount (L1.7.04: Interest rate swaps). In the banking book it is ALM's main tool because it changes the rate behaviour of a block of the balance sheet without touching the customers. A pay-fixed swapPay-fixed swap: the bank pays a fixed rate and receives a floating rate (SONIA). It gains when rates rise. turns fixed-rate assets into floating ones; a receive-fixed swapReceive-fixed swap: the bank receives a fixed rate and pays a floating rate. It gains when rates fall. turns floating income into fixed. The book holds each swap as a fixed leg and a SONIA leg, so swaps add up like any other position in the gap, NII and EVE.

The macro hedge: fixed-rate mortgages

The bank lends £24bn of two- and five-year fixed-rate mortgages and funds them with deposits that reprice much sooner. The macro hedgeMacro hedge: swaps that hedge a whole portfolio of similar items, such as fixed-rate mortgages, against its expected repricing profile rather than loan by loan. pays fixed on 80% of the mortgages' expected repricing profile, quarter by quarter: £19.2bn at 3.9% and 3.0%, the swap rates when the loans were written. It stops at 80% because borrowers prepay (L3.6.08: Optionality in loans): if they prepay faster, the swaps stay and the bank is over-hedged. In parallel up the mortgages lose £1,069.6m of value and the swaps gain £755.6m.

The structural hedge: deposits and equity

The other side of the bank has money that does not reprice: the core current accounts of L3.6.09: Non-maturity deposits, paying about 0.5% whatever happens, and the equity, which pays no interest at all. Invested overnight, their income would rise and fall with Bank Rate one for one. The structural hedgeStructural hedge: receive-fixed swaps that turn the income on stable, rate-insensitive funding (core current accounts and equity) from overnight into a rolling multi-year fixed rate. invests £12bn of the core current accounts and the £4bn of equity in receive-fixed swaps, arranged as a five-year rolling ladderRolling ladder: a hedge split into equal tranches with staggered maturities; each month one matures and is replaced at that day's rate, so the average rate moves slowly..

The price of that stability is that the hedge lags the market both ways. When rates rose from near zero, ladders built in the low-rate years held income down for years; in a fall they hold it up. The table shows the second case: Bank Rate drops 275bp at once, but the ladder's yield drifts down over five years.

What the hedges do together

Run the book with each hedge on and off. Year-1 and three-year ΔNII are for the parallel shocks of 275bp; the outlier test is the worst of the six EVE shocks against 15% of Tier 1.

• No hedges. The fixed-rate mortgages and the slotted deposits roughly offset in value: the worst ΔEVE is only 2.3% of Tier 1. But NII swings with rates because the deposits earn whatever Bank Rate pays.
• Macro hedge alone. The mortgages now earn a floating rate, the natural offset is gone and the bank holds only the deposits' behavioural length. A fall of 275bp costs £604.3m in year 1 and the bank is an outlier, at 22.0%.
• Structural hedge alone. Fixed income on top of fixed mortgages: the bank is long fixed-rate assets twice over and fails in parallel up, at 28.9%.
• Both. The bank passes at 7.35%, and its NII still rises with rates (+£254.7m at +275bp) and falls with them, by less than half the macro-only swing.

Netted, the two hedges leave a pay-fixed position of about £3.2bn, at different tenors. In practice a treasury nets such flows internally and trades only the difference with the market. Each hedge is still sized on its own block, because each protects something different: the margin on fixed-rate lending from the day it is priced, and the income on stable funding over the cycle. L3.6.11: Funds transfer pricing shows how transfer pricing hands each result to its owner.

Hedge accounting in outline

A swap is a derivative, measured at fair value with changes in profit and loss. Mortgages and deposits are held at amortised cost and show no change at all. In parallel up the macro hedge would book a gain of £755.6m and the structural hedge a loss of £932.2m, while the items they hedge stay still: an accounting mismatchAccounting mismatch: when a hedge is measured at fair value through profit and loss but the item it hedges is held at amortised cost, so profit swings although the bank's economic position does not. that makes profit swing although the bank's economic position barely moved. Hedge accounting realigns the timing.

• Fair value hedgeFair value hedge: hedge accounting in which the hedged item's change in value for the hedged risk is also recognised, so it offsets the derivative's change in profit and loss.. The hedged item is also revalued for the hedged risk, so the two changes offset in profit and loss and only ineffectivenessHedge ineffectiveness: the part of the derivative's change in value that the hedged item does not offset. It goes to profit and loss. is left. For a portfolio such as the mortgages, IAS 39's portfolio fair value hedge of interest rate risk lets the bank analyse the portfolio into repricing time periods by expected repricing dates, designate an amount of assets (not a net amount) in each, and show the hedged item's revaluation as a separate line.
• Cash flow hedgeCash flow hedge: hedge accounting in which the effective part of the derivative's change in value goes to other comprehensive income (the cash flow hedge reserve) and reaches profit and loss when the hedged cash flows do.. The derivative hedges variable future cash flows, such as interest on floating-rate assets. The effective part of its change in value waits in other comprehensive income, the cash flow hedge reserve, and moves to profit and loss as the hedged interest does.
• Deposits are the hard part. IAS 39 does not let a liability repayable on demand be a hedged item in a fair value hedge for any period beyond the earliest date it can be withdrawn, so core deposits cannot be designated for their behavioural life. Banks in the European Union can use the EU carve-outEU carve-out: the European Union's 2004 endorsement of IAS 39 without certain hedge accounting requirements, so banks can include core deposits in portfolio fair value hedges and need not book ineffectiveness when under-hedged., which lets them include core deposits in portfolio fair value hedges and does not treat under-hedging as ineffectiveness. Others have to find a different hedged item.
• IFRS 9 and what comes next. IFRS 9 brought a new general hedge accounting model in 2013, but banks may keep applying the IAS 39 portfolio hedge model for macro hedging. In December 2025 the IASB published an exposure draft, Risk Mitigation Accounting, a model for dynamically managed repricing risk, with comments due by 31 July 2026.

The structural hedge has $N = 60$ tranches of notional $A$, tranche $k$ maturing at $t_k$ with fixed rate $r_k$. A tranche that matures is replaced at the new five-year rate $r^{\text{new}}$. The ladder's average rate $t$ years from now, and the swaps' net income over year one, are:

With today's ladder $\bar r(0) = 3.60\%$ and $r^{\text{new}} = 4.29\%$. After a 275bp fall the fixed leg still earns $\text{£}580.6\text{m}$ in year 1 while the SONIA leg costs much less, so the swaps add $\text{£}325.6\text{m}$ to NII. For hedge accounting, with $\Delta V$ the change in fair value:

Move rates, resize the structural hedge and switch the mortgage hedge on or off. The chart shows the ladder rolling month by month; the readouts are the whole bank's NII and outlier test.

Risk management first. The EBA's 2022 guidelines on IRRBB say banks using derivatives to mitigate IRRBB need the knowledge and expertise to do so, should understand the accounting effects of their hedges but that “the accounting treatment should not drive their risk management approach”, and should monitor how hedging strategies evolve. The standard's NII and EVE measures include the hedges, as this book does. The supervisory detail is M4.5: Liquidity and IRRBB regulation.

Accounting. Hedge accounting sits in IAS 39 and IFRS 9; the EU endorsed IAS 39 with the carve-out by Commission Regulation (EC) No 2086/2004 of 19 November 2004. IFRS 9 in depth comes in M4.7: Accounting for risk.

• ALM hedges the banking book with swaps: pay fixed to turn fixed-rate loans floating, receive fixed to turn the income on stable funding fixed.
• The macro hedge pays fixed on 80% of the mortgages' expected profile (£19.2bn); it stops short because borrowers prepay.
• The structural hedge invests £16bn of core current accounts and equity in a five-year ladder of 60 tranches; its yield (3.60% today) moves a sixtieth a month.
• Each hedge alone fails the outlier test (22.0% and 28.9%); together 7.35%, with the year-1 NII loss at −275bp cut from £604m to £263m.
• Hedge accounting fixes the timing mismatch: fair value hedges for value, cash flow hedges for cash flows; core deposits need the EU carve-out or another hedged item.

Macro hedge

Macro hedge: swaps that hedge a whole portfolio of similar items, such as fixed-rate mortgages, against its expected repricing profile rather than loan by loan.

Structural hedge

Structural hedge: receive-fixed swaps that turn the income on stable, rate-insensitive funding (core current accounts and equity) from overnight into a rolling multi-year fixed rate.

Rolling ladder

Rolling ladder: a hedge split into equal tranches with staggered maturities; each month one matures and is replaced at that day's rate, so the average rate moves slowly.

Pay-fixed swap

Pay-fixed swap: the bank pays a fixed rate and receives a floating rate (SONIA). It gains when rates rise.

Receive-fixed swap

Receive-fixed swap: the bank receives a fixed rate and pays a floating rate. It gains when rates fall.

Accounting mismatch

Accounting mismatch: when a hedge is measured at fair value through profit and loss but the item it hedges is held at amortised cost, so profit swings although the bank's economic position does not.

Fair value hedge

Fair value hedge: hedge accounting in which the hedged item's change in value for the hedged risk is also recognised, so it offsets the derivative's change in profit and loss.

Cash flow hedge

Cash flow hedge: hedge accounting in which the effective part of the derivative's change in value goes to other comprehensive income (the cash flow hedge reserve) and reaches profit and loss when the hedged cash flows do.

Hedge ineffectiveness

Hedge ineffectiveness: the part of the derivative's change in value that the hedged item does not offset. It goes to profit and loss.

EU carve-out

EU carve-out: the European Union's 2004 endorsement of IAS 39 without certain hedge accounting requirements, so banks can include core deposits in portfolio fair value hedges and need not book ineffectiveness when under-hedged.