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

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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.”

Why It’s Not Too Late for Interest Rate Swaps

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“Has the train left the station? Are we trying to bolt the door after the horse has left the stable?”

These are the types of questions community bank directors are asking in the aftermath of the largest single-year interest rate increase since 1980. Playing catch-up in its fight to control inflation, the Federal Reserve’s rate hikes in 2022 were both unexpected and larger than any previous decades. One year later, some industry observers have begun to argue that an overly aggressive Fed may soon need to reverse course to prevent a recession. If the worst is truly behind us, this line of argument goes, why should a bank executive invest time in 2023 to install interest rate hedging capabilities?

Because, we argue, there will always be uncertainty regarding the direction and speed of change in interest rates. Swaps give institutions enormous power because they have the ability to exchange that uncertainty (floating rate) for certainty (fixed rate).

Here are three strategies we think banks with direct access to interest rate derivatives will deploy in 2023. These ideas are timeless but are particularly relevant based on where we are today in the economic cycle:

1. Individual Loans
A borrower hedging program enables a bank to retain a floating-rate asset while the borrower secures fixed-rate financing via a swap. With on-balance sheet loan rates jumping from the mid-3% range to as high as 6% to 7%, booking the fixed-rate loan seems like the best thing to do. But weak or negotiable prepayment language often means that a fixed-rate loan really behaves like a one-way floater. For example, a loan booked at 6.5% today will never move higher — but if the market corrects lower, you can expect a call from the borrower looking for a downward rate adjustment.

Some banks without access to hedging tools have placed their borrowers into loan-level interest rate swaps by involving an outside party in the loan agreement. These indirect swaps are designed as a convenience product for small banks to get their toe in the water and accommodate larger borrowers with a long-term fixed rate. By keeping the community bank swap-free, indirect programs also prevent the bank from considering the following two balance sheet strategies that protect and enhance net interest margin.

2. Securities Portfolio
Perhaps the greatest pain point related to interest rates that banks experience in 2022 was marking the securities portfolio to market prices and booking the resulting unrealized losses in the accumulated other comprehensive income, or AOCI, account. Banks without swaps installed were forced to choose between two bad options during the excess liquidity surge of 2020: hold onto cash that earned virtually nothing or purchase low-yielding long-term bonds to pick up maybe 100 basis points. Institutions with access to swaps had a third choice: keep the first two years of the higher-yielding asset and then swap the final eight years to a floating rate. Swaps used to fine-tune the duration of a bond provide the double benefit of converting to a higher floating yield today (handy when the fed funds is around 4.33%) and creating a gain in the AOCI account to offset the losses booked on the bond.

While a swap today cannot erase past unrealized losses, it is a game changer for the CFO and treasurer to have the ability to take control of portfolio duration.

3. Wholesale Funding
Higher interest rates have also led depositors to move their funds, leading banks to grow their wholesale funding from sources such as FHLB advances. Banks without access to swaps will often ladder out term fixed-rate advances to longer maturity dates, using a product that includes both a yield curve premium and a liquidity premium. A bank with hedging capabilities can accomplish the same objective by keeping the actual funding position short and floating. From there, the funding manager can conserve the liquidity premium and achieve a more efficient all-in borrowing cost by using pay-fixed swaps to create the ladder. Additionally, the swap always provides a two-way make-whole, where a traditional fixed-advance includes a down-rate penalty but no benefit when rates rise.

While some bankers still view interest rate derivatives as risky, the rapidly changing conditions experienced in 2022 suggest that the greater risk may be attempting to manage the balance sheet without access to these powerful tools. Today, more than 40 years since their creation, one thing is certain: it’s not too late for any bank to start using interest rate derivatives.

Strengthening Financial Performance in a Rising Rate Environment

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Interest rate volatility has been a dominant theme this year and inflation worries have begun morphing into recession fears.

For banks, rising rates are generally a positive trend; they tend to result in higher deposit franchise values and higher net interest margins. While unrealized losses in the available for sale bond portfolio also typically increase during rising rate environments, adhering to a disciplined investment framework can help bank leaders avoid knee-jerk reactions and put unrealized losses into the right context (discussed previously here).

As rates continue to rise, it’s time to check the pulse on your institution’s pricing model. In addition to pricing assets accurately, a successful bank also focuses on funding cheaply, using a number of models to identify relative value and hedging interest rate risk when necessary. Here, we’ll dive deeper into three principles that can help institutions strengthen their financial performance.

Principle 1: Disciplined Asset Pricing
Capital requirements mean that a bank has a finite capacity to add assets to its balance sheet. Each asset going on the balance sheet must be critically evaluated to ensure it meets your institution’s specific performance goals and risk mandates.

Using a risk-adjusted return on capital (RAROC) framework for asset pricing and relative value assessment helps establish a consistent, sustainable decision-making framework for capital allocation. Clearly, different assets have different risks and returns. An effective financial manager ensures that the bank is meeting its hurdle rates, or return on capital, and that the model and assumptions are as accurate as possible.

A mispriced asset isn’t just a risk to margin. It also represents liquidation risk, as assets priced incorrectly to market perceptions of risk have a higher likelihood of poor sale performance, such as losses on sale or failure to sell. The value of the institution can also be impacted if the bank consistently — even marginally — misprices assets. Overall, if an asset is not appropriately priced for the risks and costs associated with it, then a bank should critically evaluate its role on the balance sheet.

Principle 2: The Value of Deposit Funding
Banks benefit from low-cost, sticky funding. Core deposits typically comprise the largest and cheapest funding source, followed by term and wholesale funding and all other, generally short-term, funding sources.

Understanding your funding’s beta is a key first step to unlocking better financial performance.

In this application, beta is a measurement of the relationship between a funding source’s interest rate and an observable market rate; it is the sensitivity of funding cost relative to a change in interest rates.

As rates rise, low beta funding results in greater growth in franchise value compared to high beta funding. As assets reprice to the higher rate environment, balance sheets with low beta funding will see margins steadily widen. Banks with high beta funding tend to exhibit margin compression and declining valuations. Conversely, low beta funding results in more stable valuation as rates rise.

Principle 3: Risk Management in an ALM and RAROC Framework
Borrowers and depositors maximize their own utility, which often presents a dilemma for the financial institutions that serve them. When interest rates are low, borrowers typically want long-term, fixed-rate loans and depositors keep their deposits shorter term.  When interest rates are higher, we typically see the opposite behavior: depositors begin to consider term deposits and borrowers demand more floating rate loans. This dynamic can cause mismatches in asset and liability duration, resulting in interest rate risk exposure. Banks must regularly measure and monitor their risk exposure, especially when rates are on the move.

Significant divergence from neutral rate risk — a closely aligned repricing profile of a bank’s assets and liabilities — exposes a bank’s return on equity and valuation to potential volatility and underperformance when rates move. That’s where hedging comes in. Hedging can assist a bank by reducing asset-liability mismatches, enhancing its competitiveness by locking in spread through disciplined asset pricing and stabilizing financial performance. After all, banks are in the business of lending and safekeeping funds, but must take on risk to generate return. Hedging can reduce discomfort with a bank’s existing or projected balance sheet risks and improve balance sheet strategy agility to better meet customers’ needs.

There are opportunities for banks all along the yield curve. But institutions that don’t hedge compete for assets in the crowded short duration space — often with significant opportunity costs.

Rising rates generally result in stronger margins and valuations for well-funded depositories; disciplined asset pricing in a risk-adjusted framework is critical for financial performance. As a financial professional, it’s important that the board has a firm understanding of what drives deposit franchise value. Take the time to ensure that the entire leadership team understands potential risk in your bank’s ALM composition and be prepared to hedge, if needed.

Navigating the Turbulence of Rising Rates, Inflation and Volatility

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Financial markets have been rocked by significant volatility in 2022.

Over the first six months of 2022, the 10-year U.S. Treasury rate jumped from 1.52% to 3.2%. A confluence of events is driving that volatility: increased inflation expectations led to more significant and sooner-than-expected increases in the Federal Funds rate, uncertainty of the first military conflict in Europe since World War II, and the economy. Financial institutions are finding themselves in very turbulent waters.

Banks that prepared for this possibility are navigating across these choppy waters with greater ease. They’re using prudent risk management tools, like interest rate swaps, to smooth earnings and protect against continued increases in long-term rates. Swaps create more flexibility for banks: they can be quickly and easily implemented and allow institutions to bifurcate the rate risk from traditional assets and liabilities.

Most banks use hedging strategies that aim to smooth earnings. For example, banks use an interest rate swap to convert a portion of their floating-rate assets to fixed. They lock in the market’s expectations for rates and bring forward future expected income.

The benefits of this strategy:

  • Synthetically converting pools of floating-rate assets via a swap extends the duration of assets, reduces asset sensitivity and increases current earnings.
  • This helps banks monetize the shape of the yield curve by bringing forward future interest income and producing smoother net income.

When it comes to hedging floating rate loans, we see a mix of Fed Funds (to hedge loans tied to Prime), SOFR, LIBOR, and a handful of banks using that Bloomberg Short-Term Bank Yield (BSBY) index.  Additionally, hedging floating rate loans with floors requires special considerations.

On the other side of the spectrum, those banks hedging for rising rates primarily use swap and cap strategies to reduce duration risk in the loan and bond portfolio. Notably, the Financial Accounting Standards Board recently introduced the portfolio layer method, which allows banks to swap pools of fixed-rate assets like loans or securities to floating.

The benefits of this strategy:

  • Synthetically converting fixed-rate assets via a swap shortens the duration of a bank’s balance sheet and hedges rising rates.
  • Create more capacity for a bank to do more fixed-rate lending.
  • Swaps can start today or in the future, allowing banks to customize the risk mitigation to its risk profile.

In the turbulent seas of this current moment, banks prepared to use hedging strategies enjoy the benefits of smoother income and mitigated rate volatility. They also benefit from their flexibility: Banks can quickly execute swaps, allowing it to bifurcate the rate risk from traditional assets and liabilities. Finally, derivatives have low capital requirements, resulting in minimal impact to capital ratios.

Adding hedging tools to the tool kit now allows your bank to get ready before next quarter’s volatility — and potential rate change — is best practice that can be accomplished quickly and efficiently.

Why Community Banks Should Use Derivatives to Manage Rate Risk

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As bank management teams turn the page to 2022, a few themes stand out: Their institutions are still flush with excess liquidity, loan demand is returning and the rush of large M&A is at a fever pitch.

But the keen observer will note another common theme: hedging. Three superregional banks highlighted their hedging activity in recent earnings calls.

  • Birmingham, Alabama-based Regions Financial Corp. repositioned its hedging book by unwinding $5 billion of receive-fixed swaps and replacing them with shorter-term receive fixed swaps. Doing so allowed the $156 billion bank to lock in gains from their long-term swaps.
  • Columbus, Ohio-based Huntington Bancshares increased its noninterest income in a scenario where rates increase 100 basis point from 2.9% to 4%. The $174 billion bank terminated certain hedges and added $6 billion of forward starting pay fixed swaps.
  • Providence, Rhode Island-based Citizens Financial Group executed $12 billion of receive fixed swaps in 2021, including $1.25 billion since June 30, 2021. The $187 billion bank’s goal is to moderate their asset sensitivity and bring forward income.

These banks use derivatives as a competitive asset and liability management tool to optimize client requests, investment decisions and funding choices, rather than be driven by their associated interest rate risk profile.

Why do banks use derivatives to hedge their balance sheet?

  • Efficiency. Derivatives are efficient from both a timing and capital perspective. In a late 2021 earnings call outlining their hedging strategy, Citizens Financial’s CFO John Woods said, “We think it’s a bit more efficient to do that (manage interest rate risk) off-balance sheet with swaps.”
  • Flexibility. It’s more flexible than changing loan and deposit availability and pricing.
  • Cost. It’s often less expensive when compared to cash products.

Why are some banks hesitant to use swaps?

  • Perception of riskiness. It’s easy for a bank that hasn’t used derivatives to fall into the fallacy that swaps are a bet on rates. In a sense, though, all the bank’s balance sheet is a bet on rates. When layered into the bank’s asset-liability committee conversations and tool kit, swaps are simply another tool to manage rate risk, not add to it.
  • Accounting concerns. Community banks frequently cite accounting concerns about derivatives. But recent changes from the Financial Accounting Standards Board have flipped this script:  Hedge accounting is no longer a foe, but a friend, to community banks.
  • Fear of the unknown. Derivatives can bring an added layer of complexity, but this is often overdone. It’s important to partner with an external service provider for education, as well as the upfront and ongoing heavy lifting. The bank can continue to focus on what it does best: thrilling customers and returning value to shareholders.
  • Competing priorities. Competing priorities are a reality, and if something is working, why bother with it? But growth comes from driving change, especially into areas where the bank can make small incremental adjustments before driving significant overhauls. Banks can transact swaps that are as small as $1 million or less.

For banks that have steered clear of swaps — believing they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help separate facts from fears and make the best decision for their institution. The reality is community banks can leverage the same strategies that these superregional banks use to enhance yield, increase lending capacity and manage excess liquidity.

Are Fixed-Rate Loans the Quick Fix?

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Commercial fixed-rate loans can be an alluring quick fix for the net interest margin pressure that many banks face today, but could expose banks to several risks while providing tepid returns.

Future earnings are largely out of the bank’s control. While the current yield of a fixed-rate loan can look attractive relative to the historic lows of short-term funding costs, its long-term return is highly dependent on the future path of short-term interest rates. When interest rates increase, the spread between the yield earned on a fixed-rate loan and the ongoing funding cost for a bank decreases — and could even go negative.

While banks have some control over funding costs, the largest factors that influence short-term funding rates are external: central bank monetary policy, inflation expectations and the overall business cycle. None of these factors are controlled by any individual bank, which means the ongoing net yield of a fixed-rate loan depends on factors outside your bank’s control.

Prepayment penalties often do not protect banks. Bank executives should temper expectations that prepayment penalties protect bank income or influence borrower behavior for fixed-rate loans. Many borrowers negotiate limited prepayment provisions in advance, or ask that prepayment penalties be fully or partially waived when refinancing. Additionally, fixed-rate borrowers are most likely to prepay when refinancing lowers their borrowing cost. These realities mean borrower prepayments often result in the loss of higher-yielding loans with little or no compensation to banks.

Interest rates and prepayments have a unique relationship that can reduce returns. Higher interest rates generally mean higher funding costs and lower prepayments, while lower interest rates result in lower funding costs and higher loan prepayments. In other words, a fixed-rate loan is most likely to remain on-balance sheet when interest rates are high and a bank would prefer it go away, but pay off quickly when interest rates are low and a bank would prefer it stay. This inverse relationship between interest rates and prepayments can significantly reduce the lifetime earnings of a fixed-rate loan.

There are tools to help. Below are some strategies that banks can use to reduce the risks of fixed-rate loans:

  • Consider a customer swap program. Banks can offer borrowers a pay-fixed interest rate swap paired with a floating-rate loan instead of originating a traditional fixed-rate loan. The borrower ends up with a fixed rate; the bank books a floating rate asset that is less sensitive to future interest rate movements. These programs can also be a significant source of non-interest fee income. Modern capital markets technology and advisory companies enable banks of all sizes to offer loan-level hedging programs to qualifying commercial clients.
  • Hedge large deals on a one-off basis. Banks can use an interest rate swap to transform the return of an individual loan from fixed to floating. The borrower maintains a conventional fixed-rate borrowing structure. Separately, the bank executes a pay-fixed swap that effectively converts the loan interest to a variable rate that aligns more closely with its funding costs. While this strategy can be used on any fixed-rate loan, it can be particularly prudent for larger and longer-term transactions.
  • Use longer-duration funding. Banks can borrow for longer terms to match fixed-rate loan maturities, or “match fund,” to reduce interest rate risk. Banks can either issue new longer-term funding vehicles or use interest rate swaps to synthetically convert the maturity of existing short-term funding instruments to longer-duration liabilities. While match funding does not address fixed-rate loan prepayment risks, it does help mitigate some of the earnings risk associated with fixed-rate loans.

How does your bank evaluate fixed-rate loans? Fixed-rate loans are not inherently bad. A well-diversified balance sheet will include a mix of fixed- and floating-rate loans. But originating an outsized portfolio of commercial fixed-rate loans comes with risks that banks should properly evaluate. How is your bank managing the risks associated with fixed-rate loans? Are you booking deals as a quick fix to get through this quarter, or building a safe balance sheet with steady earnings for the future?

Avoiding Pitfalls of Covid-19 Modifications for Swapped Loans

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Many banks are modifying commercial loans as they and their commercial borrowers grapple with the economic fallout of the Covid-19 pandemic.

Payment relief could include incorporating interest-only periods, principal and interest payment deferrals, and/or loan and swap maturity/amortization extensions. While modifications can provide borrowers with much-needed financial flexibility, they also risk creating unintended accounting, legal and economic consequences.

Don’t forget the swaps
Lenders need to determine whether there is a swap associated with loans when contemplating a modification. Prior to modification, lenders should coordinate efforts with their Treasury or swap desk to address these swapped loans, and ensure that loan and swap documentation are consistent regarding the terms of the modification.

Develop realistic repayment plans
Lenders need to consider how deferred obligations will be repaid when creating a temporary payment deferral plan. The lender may need to offer an interest-only period so a borrower can repay the deferred interest before principal amortization resumes, or deferred interest payments could be added to the principal balance of the loan. Lenders also should consider whether the proposed modification will be sufficient, given the severity of the borrower’s challenges. The costs associated with amending a swapped loan may convince a lender to offer a more substantive longer-term deferral, rather than repeatedly kicking the can down the road with a series of short-term fixes.

Determine whether swap amendment is necessary
The modified loan terms may necessitate an amendment of the associated swap. It may be possible to leave the swap in place without amendment if you are only adding an interest-only period, as long as the borrower is comfortable with their loan being slightly underhedged. But if you are contemplating a full payment deferral, it typically will be desirable to replace the existing swap transaction with a new forward-starting transaction commencing when the borrower is expected to resume making principal and interest payments.

Understand bank or borrower hedge accounting impact of loan modifications
Lenders often hedge the value of their fixed-rate loans or other assets through formalized hedging programs. A popular strategy has been to designate these swaps as fair value hedges using the shortcut method.

This method requires that the economic terms of the asset, such as amortization of principal and timing of interest payments, precisely match those of the hedge. A mismatch due to a loan payment deferral would cause the lender to lose the hedge’s shortcut status. The lender’s hedging program potentially could maintain hedge accounting treatment using the more cumbersome long-haul method if that mismatch scenario was contemplated in the hedge inception documentation.

Borrowers who have taken variable rate loans may have entered into swaps to gain synthetic rate protection. Restructuring  a hedge to defer payments alongside the loan’s deferred payments could jeopardize an accounting-sensitive borrower’s hedge accounting treatment. It is possible for the borrower to reapply hedge accounting under the amended terms, although the restart has additional considerations compared to a new un-amended hedge. If hedge accounting is not restarted, the derivative’s valuation changes thereafter would create earnings volatility per accounting rules. While borrowers should be responsible for their own accounting, lenders’ awareness of these potential issues will only help client relationships in these uncertain times.

Take stock of counterparty derivative exposure
As interest rates plunge to record lows, many lenders have seen their counterparty exposure climb well above initially-approved limits. Hedge modifications may further exacerbate this situation by increasing or extending counterparty credit exposure. We recommend that lenders work with their credit teams to reassess their counterparty exposure and update limits.

Accounting guidance also requires the evaluation of credit valuation adjustments to customer swap portfolios. Lenders should ensure that their assumptions about the creditworthiness of their counterparties reflect current market conditions. These adjustments could also have a material impact on swap valuations.

Hope for the best, plan for the worst
Hopefully, loan modifications will give borrowers the opportunity to regain their financial footing. However, some may face continued financial challenges after the crisis. Lenders should use the modification process to prepare for potential defaults. Loan deferments or modifications should provide for the retention of the lender’s rights to declare a default under the loan documents and any swap agreements. The lender, through consultation with its credit team, may want to take this opportunity to bolster its position through the inclusion of additional guarantors or other credit enhancements.

The economic fallout from the global pandemic continues to have a profound impact upon borrowers and lenders alike. Adopting a thoughtful approach to loan modifications, especially when the financing structure includes a swap or other hedge, may make the process a little less disruptive for all.  

When Rates are Zero, Derivatives Make Every Basis Point Count

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It’s been one quarter after another of surprises from the Federal Reserve Board.

After shocking many forecasters in 2019 by making three quarter-point cuts to its benchmark interest rate target, the data-dependent Fed was widely thought to be on hold entering 2020. But the quick onset of the coronavirus pandemic hitting the United States in March 2020 quickly rendered banks’ forecasts for stable rates useless. The Fed has acted aggressively to provide liquidity, sending its benchmark back to the zero-bound range, where rates last languished from 2008 to 2015.

During those seven years of zero percent interest rates, banks learned two important lessons:

  1. The impact of a single basis point change in the yield of an asset or the rate paid on a funding instrument is more material when starting from a lower base. In times like these, it pays to be vigilant when considering available choices in loans and investments on the asset side of the balance sheet, and in deposits and borrowings on liability side.
  2. Even when we think we know what is going to happen next, we really don’t know. There was an annual chorus in the early and mid-2010s: “This is the year for higher rates.” Everyone believed that the next move would certainly be higher than the last one. In reality, short-rates remained frozen near zero for years, while multiple rounds of quantitative easing from the Fed pushed long-rates lower and the yield curve flatter before “lift off” finally began in 2015.

The most effective tools to capture every basis point and trade uncertainty for certainty are interest rate derivatives. Liquidity and funding questions have taken center stage, given the uncertainty around loan originations, payment deferrals and deposit flows. In the current environment, banks with access to traditional swaps, caps and floors can separate decisions about rate protection from decisions about  funding/liquidity and realize meaningful savings in the process.

To illustrate: A bank looking to access the wholesale funding market might typically start with fixed-rate advances from their Federal Home Loan Bank. These instruments are essentially a bundled product consisting of liquidity and interest rate protection benefits; the cost of each component is rolled into the quoted advance rate. By choosing to access short-term funding instead, a bank can then execute an interest rate swap or cap to hedge the re-pricing risk that occurs each time the funding rolls over. Separating funding from rate protection enables the bank to save the liquidity premium built into the fixed-rate advance.

Some potential benefits of utilizing derivatives in the funding process include:

  • Using a swap can save an estimated 25 to 75 basis points compared to the like-term fixed-rate advance.
  • In early April 2020, certain swap strategies tied to 3-month LIBOR enabled banks to access negative net funding costs for the first reset period of the hedge.
  • Swaps have a symmetric prepayment characteristic built-in; standard fixed-rate advances include a one-way penalty if rates are lower.
  • In addition to LIBOR, swaps can be executed using the effective Fed Funds rate in tandem with an overnight borrowing position.
  • Interest rate caps can be used to enjoy current low borrowing rates for as long as they last, while offering the comfort of an upper limit in the cap strike.

Many community banks that want to compete for fixed-rate loans with terms of 10 years or more but view derivatives as too complex have opted to engage in indirect/third-party swap programs. These programs place their borrowers into a derivative, while remaining “derivative-free” themselves. In addition to leaving significant revenue on the table, those taking this “toe-in-the-water” approach miss out on the opportunity to utilize derivatives to reduce funding costs. 

While accounting concerns are the No. 1 reason cited by community banks for avoiding traditional interest rate derivatives, recent changes from the Financial Accounting Standards Board have completely overhauled this narrative. For banks that have steered clear of swaps — thinking they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help a board and management team separate facts from fears and make the best decision for their institution.

With the recent return to rock-bottom interest rates, maintaining a laser focus on funding costs is more critical than ever. A financial institution with hedging capabilities installed in the risk management toolkit is better equipped to protect its net interest margin and make every basis point count.

A Fresh Look At Derivatives Under New Hedging Rules

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A new accounting standard could make hedging with derivatives a more-viable risk management strategy for banks that had previously avoided them.

The Financial Accounting Standards Board sought to remove some barriers that previously discouraged many banks from using derivatives to hedge exposure to fluctuating interest rates. Now is an appropriate time for board members at banks of all sizes to ask their executive teams about their risk management strategies, and whether derivatives should play a larger role.

The standard — Accounting Standards Update (ASU) 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities” — went into effect for publicly traded institutions in the fiscal year beginning after Dec. 15, 2018. It takes effect for privately held banks in the fiscal year beginning after Dec. 15, 2020, though early adoption is permitted.

In theory, using derivatives such as interest-rate swaps should be an effective way for banks to fine-tune portfolios and offset risks that come with having a mix of fixed rate and floating rate assets and liabilities. In practice, however, many banks chose not to hedge with derivatives because of complicated accounting and financial reporting practices required by generally accepted accounting principles.

Old hedging rules required banks to separately measure and report hedge ineffectiveness, or any amounts by which a derivative did not perfectly mirror the instrument being hedged —even if the hedge was effective overall. Separately reporting ineffectiveness was confusing for investors and often conveyed a misleading impression of a bank’s derivatives-based hedging practices.

The new standard eliminates that requirement, resulting in hedge accounting that more accurately reflects a bank’s risk management activities and provides financial statement users more worthwhile information about the effect of hedging activities.

When initially establishing a hedge, banks must document how they will evaluate its effectiveness in offsetting the changes in the fair value or cash flow of the hedged instrument. This evaluation must be performed quarterly.

In the past, when a bank chose the “shortcut” method for evaluating hedge effectiveness, it was bound to that method throughout the life of the hedge. If management later determined that the more complicated “long-haul” method would be more appropriate, they could not simply start using that method prospectively. Rather, they would also have to evaluate for a possible restatement of previous financial statements, as if hedge accounting had never been applied.

The new standard changes that. Banks now may specify a long-haul method in their documentation to be used as a fallback method if they later determine that the shortcut method is no longer appropriate.

Things also have gotten simpler for banks that choose the long-haul method at inception. Previously, banks using the long-haul method were required to perform a quantitative assessment (such as a regression analysis) every quarter for the life of a hedge. The new standard still requires a quantitative assessment at inception, but now in certain circumstances banks can perform subsequent quarterly assessments using only qualitative methods, validating that the terms and conditions of the hedged transaction and hedging derivative have not changed.

The new guidance also revises how a bank may measure the change in a hedged item’s fair value due to changes in its benchmark interest rate. Instead of calculating fair value based on all the cash flows of the instrument’s coupon, banks now can calculate the change in fair value based solely on the benchmark interest rate component, which is a more targeted and appropriate measure.

Under old hedging rules, hedging the change in fair value of an instrument (such as a fixed-rate loan) generally required the life of the hedged instrument and the life of the hedging derivative (such as an interest-rate swap) to match. The new standard removes that burden and allows for partial-term fair value hedges. For example, a bank can hedge a 10-year fixed rate loan for only two years, using a two-year interest-rate swap.

Another new opportunity known as the “last-of-layer” technique lets banks hedge the change in fair value of a pool of long-term fixed rate assets such as loans or securities — a hedge that generally was not possible in the past. Upon adoption of the standard, banks are permitted to transfer eligible held-to-maturity securities to available for sale, even if the bank eventually chooses not to hedge the securities at all.

Bank directors should familiarize themselves with the ways the new standard simplifies hedge accounting and enables new hedging techniques before engaging management to decide if it’s time to introduce or expand derivatives as risk management tools.

Five Derivatives Safety Tips: Accessing Power While Maintaining Peace of Mind

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derivatives-8-20-19.pngWe don’t buy products; we “hire” products to get a job done. For banks, interest rate swaps are often just the thing they need to accomplish their most important work.

As Harvard Business School Professor Theodore Leavitt famously said, “People don’t want to buy a quarter-inch drill. They want a quarter-inch hole!” For banks needing to balance the blend of fixed- and floating-rate loans and deposits on their books, no product gets the job done more effectively than an interest rate swap.

Yet, because swaps carry the label of derivative, many community banks are hesitant to engage them — similar to a first-time homeowner on a DIY project avoiding power tools due to fear of injury or lack of knowledge. To maintain peace of mind while accessing the power of interest rate derivatives, community banks should keep these five safety tips in mind:

1. Finding the Derivative
The most-compelling benefit of an interest rate swap is that everyone gets what they want: the borrower enjoys a 10-year fixed rate, the bank maintains a floating yield. If a program offers this benefit in a “derivative-free” package, there is likely an interest rate swap hiding beneath the surface.

Transparency is essential in creating a safe work environment. Maybe my bank is not a party to a derivative, but what about my Main Street borrower? Safety begins with understanding the mechanics and the parties to any rate swap that might be present.

2. Understanding Derivative Pricing
Because the parties that assist community banks with swaps are typically compensated by building extra basis points into the final swap rate, it is important to have a basic understanding of derivative pricing to remain injury-free. When it comes to swap rates, not all basis points are created equal.

Just like the price/yield relationship with a fixed-income security, the “price value” of each basis point in an interest rate swap is a function of both notional amount and maturity term. So, while an extra five basis points would amount to $2,250 on a $1 million swap for a 5 year/25-year commercial mortgage, the value of fees would grow to $40,000 if the five extra basis points were embedded into a $10 million loan with a 10 year/25-year structure. Community banks should understand the amount of compensation built into each transaction in order to remain out of harm’s way.

3. Documenting with ISDA
The International Swaps and Derivatives Association has been standardizing over-the-counter derivatives market practices for the past 40 years, since the infancy of swaps. One of its first projects was designing the document framework known today as the ISDA Master Agreement, or “The ISDA” for short. Sometimes maligned for its length and complexity, the ISDA is often overlooked as a valuable safety shield for community banks who value simplicity.

Although originally built “by Wall Street for Wall Street,” the ISDA is carefully designed to protect both parties in a derivative relationship, defines key terms and sets forth remedies for a non-defaulting party should the other party fail to perform. Since it is recognized across the globe as the industry-standard, engaging in swaps without the protection of the ISDA can be hazardous.

4. Determining Collateral for Counterparty Risk
Counterparty risk, or the risk that an interest rate swap provider will fail to honor its obligations in the contract, can be mitigated by holding cash or securities as collateral. Before 2008, large banks and dealers required community banks to post collateral to secure their risk but were unwilling to reciprocate. The resulting damage caused by the failure of Lehman Brothers Holdings led to a self-imposed shift in market practices, whereby collateral terms in most swap relationships today are bilateral. Community banks considering using derivatives should seize this opportunity to hold collateral as a precautionary measure for the unexpected.

5. Utilizing Hedge Accounting
Embracing the recently updated hedge accounting standard is the final key to reducing the risk and volatility associated with these tools. With recent changes, the Financial Accounting Standards Board has succeeded in delivering what it promises on the cover of its now-mandatory update to ASC 815: “Targeted Improvements to Accounting for Hedging Activities.” One key improvement that helps protect community banks is the added ability to hedge portfolios of fixed-rate assets. That, when paired with more flexibility in application, has transformed hedge accounting from foe to friend for banks.

By taking heed of these five safety tips, community banks and their boards of directors can confidently consider adding interest rate derivatives to their risk management tool kits.