2023 was a wild ride. Many banks experienced stress after 500 basis points of interest rate increases. Investors and depositors worried about unrealized losses and withdrew their capital and liquidity, leading to a small number of banks that failed.
Management teams reacted quickly and began hedging their balance sheets. For many banks, it was their first time using derivatives.
You may be asking yourself, what now? How do I optimize this solution now that I have it? What are hedging best practices?
1. Strategic Tool Versus Last Resort
Some bankers employed derivatives because they felt compelled to hedge and now hope they won’t need to do it again. This mentality misses the strategic tool that derivatives are for balance sheets and customers. Derivatives allow banks to optimize customer requests, investment decisions and funding choices. In some cases, they provide significant cost savings or bring forward future income. In other cases, they allow leadership to meet market demands without taking interest rate risk.
2. Hedging Versus Trading
Well-meaning brokers may suggest a derivative because it is a good trade that may make money for the bank but exacerbates its risk relative to rising or falling rates. The best practice considers derivatives as hedges, not trades — risk management, not investment.
In application, this means starting from the balance sheet. What is the risk position? Where is it trending? Would a derivative help change that direction? And lastly, industry best practices measure the proposed transaction’s impact on earnings in different rate environments before executing.
3. Proactive Versus Reactive
Sometimes, when a balance sheet’s risk position is lopsided, management turns to derivatives to reinstate balance. But derivatives are not a silver bullet. They can’t unwind what has already occurred. Instead, the best practice is a proactive approach that considers unlikely outcomes and looks at the opportunities that the market presents, keeping in mind what the balance sheet needs.
For example, throughout 2023, banks used pay-fixed swaps to ease margin pressure and to hedge against losses on fixed-income portfolios. The yield curve was inverted, i.e.- short-term rates were higher than long-term rates, allowing banks to hedge against rising rates while also receiving income from the swap.
4. Consistent Versus Sporadic
The best practice is to make derivatives part of every asset/liability committee (ALCO) meeting so that it becomes muscle memory. ALCO should review existing positions and determine whether to leave them in place or unwind early. It means considering derivatives alongside ALCO’s tools — the bond portfolio, wholesale funding and loan and deposit products.
For example, say a bank’s ALCO wants to extend the duration of the balance sheet because it is too asset-sensitive and is concerned about the possibility of falling rates. Using the bond portfolio, running a loan special or using a derivative can all accomplish the same outcome, with derivatives having the added benefit of using less capital and having an immediate impact on the balance sheet.
5. Holistic Versus Micro and Macro
When a bank installs native hedging tools versus outsourcing to a third party, it opens doors to both balance sheet and customer hedging. A holistic hedging program allows banks to hedge at the balance sheet level and introduce customer swaps. Customer swaps offer a means to meet fixed-rate debt requirements without taking rate risk, giving the customer a lower all-in rate versus traditional fixed-rate loans and providing the bank with fee income. And there is no conflict between balance sheet and customer hedging; the two are complementary.
For example, a bank generates $100 million of floating-rate loans to customers and offers swaps to those who want a fixed rate. If the balance sheet becomes too asset-sensitive, a swap can be used to hedge the risk of falling rates. In the process, the bank generates fee income, provides the customer with a lower fixed rate and hedges against the unlikely but unfavorable possibility of falling rates.
Hedging interest rate risk with derivatives is an essential tool in every ALCO’s tool kit. Applying these best practices on when and how to use that tool will help management teams optimize their balance sheets.