Hedging in the Spotlight After Banks Failed to Mitigate Interest Rate Risk

Even as progressively higher interest rates throughout 2022 caused increasingly large unrealized losses on banks’ books, they rarely hedged that risk.

In fact, banks with fragile funding, like high concentrations of uninsured deposits, sold or reduced their hedges in 2022 as interest rates climbed, according to a new paper from university researchers. Rising interest rates have caused long-term assets, such as bonds and loans that pay a fixed rate, to decline in value. One way for banks to mitigate that risk is to use interest rate swaps, contracts that banks can purchase to turn fixed rate assets into floating rate assets. That eliminates the potential for unrealized losses to increase if rates continue to increase.

Banks are weighed down by the declining value of their assets. Ninety-seven percent of 435 major exchange listed U.S. banks reported that the fair value of their loans was below their carried value at the end of 2022, according to The Wall Street Journal citing data provided by S&P Global Market Intelligence. The difference was a $242 billion loss, reversing a paper gain of $96 billion at year-end 2021. The unrealized loss equated to 14% of those banks’ total equity and 21% of their tangible common equity.

“In some ways, the cake is baked. If I own a bunch of fixed rate bonds or I’ve made a bunch of fixed rate loans that are below market [interest rates] … there’s not a lot you can do,” says Ben Lewis, managing director and global head of sales for financial institutions at Chatham Financial. “But one of the things that’s super interesting about the current environment is that you can actually get paid to hedge.”

Only about 6% of aggregate assets at U.S. banks are hedged by swaps, according to the April research paper “Limited Hedging and Gambling for Resurrection by U.S. Banks During the 2022 Monetary Tightening?” Researchers calculated the swap coverage using call report data from the first quarter of 2022, and quarterly and annual filings.

Companies that offer a way to hedge against interest rate risk say swaps are even more attractive for banks right now given the inverted yield curve: long-term bonds have a lower yield than short-term bonds. That tends to indicate a recession is more likely.

“Regardless of when banks hedge, they’re eliminating future rate risk,” says Isaac Wheeler, head of balance sheet strategy at Derivative Path. “But if a bank didn’t do it a month ago and it hedged today instead, it now gets 100 basis point higher spread on a floating rate basis, which is a lot better.”

Interest rate risk is a concern because banks face rising funding costs, resulting in net interest margin compression. Both Derivative Path and Chatham Financial help banks with hedges and report a pickup in activity since the March banking crisis. Wheeler says concerns about NIM compression are driving banks to focus on hedging loans; hedging activity at his firm is now split equally between loans and securities.

Lewis says the community banks he’s working with are using hedging to avoid the impact of worst-case rate scenarios on their long-term assets. “They’re willing to give up some income today or potentially future income tomorrow to manage that risk,” he says.

But one reason why banks may hesitate to add swaps now is because the swap locks in whatever unrealized loss the bank already has on the asset. While the asset’s market value won’t further erode, the swap means there’s no ability to reverse the unrealized loss if rates fall. A bank that believes rates will begin falling in 2023 may decide to wait for the unrealized loss on the asset to reverse.

In either case, it’s a good idea for bank boards to be skeptical about interest rate predictions. Directors should ask management about contingency plans if rates move in a way they didn’t model and should explore how different rate environments impact their margin and earnings. They may decide to hedge a portion of their longer-term assets to reduce pressure on their NIM without locking in too many of their unrealized losses.

“Banks get to choose what risks they can take, and I think now more than ever, the idea of taking interest rate risk isn’t appealing,” Wheeler says. “A lot of banks eventually realize that they don’t want to be in the business of taking rate risk, or that’s not how they want to generate earnings. They want to lean into the other things that they’re better at, while trying to reduce rate risk.”