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


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.

Community Banks and Derivatives: Debunking the Four Biggest Myths


derivatives-4-8-19.pngThose of us who were in banking when Ronald Reagan entered the White House remember the interest rate rollercoaster ride brought about by the Federal Reserve when it aggressively tightened the money supply to tame inflation. It was during this era of unprecedented volatility that interest rate swaps, caps and floors were introduced to help financial institutions keep their books in balance. But over the years, opaque pricing, unnecessary complexity and misuse by speculators led Richard Syron, former chairman of the American Stock Exchange, to observe, “Derivative. That’s the 11-letter four-letter word.”

As community banks bought into Syron’s “D-word” conclusion and resolved to avoid their use altogether, several providers fed these fears and designed programs that promise a derivative-free balance sheet. But many banks are beginning to question the effectiveness of these solutions.

Today, as commercial borrowers seek long-term, fixed-rate funding for 10 years and longer, risk-averse community banks want to know how to solve this term mismatch problem in a responsible and sustainable manner. The fact that Syron voiced his opinion on derivatives in 1995 suggests that now might be a good time to examine the roots of “derivative-phobia,” by considering what has changed in the past quarter-century and challenging four frequently heard biases against community banks using swaps.

1. None of my community bank peers use interest rate derivatives.
If you are not hedging with swaps, and your total assets are between $500 million and $1 billion, then you are in good company: More than nine out of ten of your peers have also avoided their use.

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But if your bank is larger, or your growth plans anticipate crossing the $1 billion asset level, more than one in four of your new peers use swaps.

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Once your bank crosses the $2 billion mark, more than half of your peers manage interest rate risk with derivatives, and institutions not using swaps become a shrinking minority.

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Community banks should consider their growth path and the best practices of their expected peer group before dismissing out-of-hand the use of derivatives.

2. The derivatives market is a big casino, and swaps are always a bet.
While some firms (AIG in 2008, for example) have used complex derivatives to speculate, a vanilla swap designed to neutralize a bank’s natural risks operates as a hedge. Post-crisis, the Dodd-Frank Act brought more transparency to swap pricing, as swap dealers are now required to disclose the wholesale cost of the swap to their customers. In addition, most dealers are now willing to operate on a bilateral secured basis, removing most of the counterparty risk that the trading partners of Lehman Brothers experienced firsthand when that company collapsed. These changes in market practices have made it much more practical for community banks to execute simple hedging transactions at fair prices with manageable credit risk.

3. Derivatives accounting always results in unwanted surprises and volatility.
Derivatives missteps led to FAS 133—regarding the measurement of derivative instruments and hedging activities—being issued in 1998, bringing the fair value of derivatives out of the footnotes and onto the balance sheet for the first time. But the standard (now ASC 815) proved difficult to apply, leading to some notable financial restatements in the early 2000s. Fast forward nearly twenty years, and the Financial Accounting Standards Board has issued an overhaul to hedge accounting (ASU 2017-12) that is a game-changer for community banks. With mandatory adoption in 2019, there are more viable ways to solve the age-old mismatch facing banks. And the addition of fallback provisions, combined with improvements to “the shortcut method,” greatly reduces the risk of unexpected earnings volatility.

4. ISDA documents should always be avoided.
While admittedly lengthy, the Master Agreement published by the International Swaps and Derivatives Association was designed to protect both parties to a derivative contract and is the industry standard for properly documenting an interest rate swap. Many community banks seeking an ISDA-free solution for their customers are actually placing the borrower into a lightly-documented derivative with an unknown third-party. If a borrower is not sophisticated enough to read and sign the ISDA Master Agreement, they have no business executing a swap in the first place. A simpler solution is to make a fixed-rate loan and execute a swap behind the scenes to neutralize the interest rate risk. This keeps the swap and the agreement between two banks, and removes the borrower from the derivative altogether.

For community banks that have been trying to solve their mismatch problem in a manner that is derivative-free, it is worth re-examining the factors that have led to pursuing a derivatives-avoidance strategy, and counting the costs and hidden exposures involved in doing so.

FASB Update Removes Roadblock to Hedging With Derivatives


derivatives-11-13-17.pngComplex hedge accounting rules are high on the list of reasons that community banks have chosen to avoid derivatives as risk management tools. But the Financial Accounting Standards Board (FASB) created a stir a little over a year ago, when it promised to improve accounting for hedging activities. That stir turned into a wave of fanfare from community banks in August 2017, when the final Accounting Standards Update (ASU 2017-12) was issued for ASC 815 – Derivatives and Hedging, the standard formerly known as FAS 133. In order to appreciate the excitement surrounding the new hedging guidance from FASB, it helps to take a quick look at the history behind the accounting standard that is widely considered to be the most complex the accounting organization has ever issued.

When derivatives were introduced in the mid-1980s, they were known as “off-balance sheet” instruments because there was not a neat way to fit them onto a firm’s financial statements. Derivatives were instead relegated to the footnotes. As derivative structures became more complex and began to be used more aggressively by treasurers who often viewed derivatives as profit centers, a sharp unexpected rate hike in 1994 led to large derivative losses at Procter & Gamble and others. With speculative trades buried deep in the footnotes, demands for transparency from the investor community led to FAS 133 which, starting in 2000, required for the first time that derivatives be carried at fair value on the balance sheet.

In order to prevent having on-balance sheet derivative values lead to wild swings in earnings, hedge accounting rules were created as a shock absorber. But while the original intent of hedge accounting was to be helpful, in practice it was difficult to apply and unforgiving when applied incorrectly. It also lacked viable solutions for some of the most common challenges facing community banks.

With that as a backdrop, here are three changes included in ASU 2017-12 that will make hedging with derivatives much more practical and worry-free for community banks.

1. Portfolio Hedging of Fixed-Rate Assets
What made hedging a portfolio of fixed-rate mortgages impractical under the original standard was the caveat that almost every loan in the pool needed to be homogeneous with regard to origination date, maturity date and prepayment characteristics. Some banks would occasionally hedge larger commercial loans one at a time, but this very common source of interest rate risk was either hedged in a different manner or ignored in the past. The newly introduced “last-of-layer” designation eliminates this unattainable caveat and will enable liability-sensitive banks to hedge a portion of an identified closed portfolio of prepayable assets. As a result of this new strategy, banks will have a one-time opportunity to reclassify held-to-maturity securities as available for sale if they are eligible for the last-of-layer designation. Mitigating interest rate risk in both the loan and securities portfolios will now be squarely on the table for community banks’ consideration.

2. Impact of Hedging on NIM
Most banks undertaking a derivative strategy are looking to protect or enhance the bank’s net interest margin (NIM). The original standard required that hedge ineffectiveness be measured, which sometimes created unwanted accounting surprises. By eliminating the concept of ineffectiveness from the hedging framework, FASB will reduce complexity associated with interpreting hedging results. Hedge mismatches will no longer need to be separately measured and reported in financial statements. The economic impact from mismatches between the hedge and the hedged item will be reported in the same income statement line item when the hedged item affects earnings. For banks, this will enable typical hedging activities to impact NIM as intended.

3. Reduced Restatement Risk
In the past, some banks attempted to reduce the burden of hedging through the use of the “shortcut method,” where the assumption of a perfectly effective hedge was permitted by FASB when specific conditions were met. But the breach of any shortcut criterion, due to a minor missed detail or an unexpected change in business conditions, led to a loss of hedge accounting privileges and sometimes an embarrassing accounting restatement. The new ASU introduces an improvement to the shortcut method of assessing effectiveness by allowing for a fallback, long-haul method to be documented at the time of designation. This change will significantly reduce the risk of a restatement, and banks will be able to pursue prudent hedging activities with less fear of an accounting misstep.

By reducing complexity and making more hedging strategies viable, the new guidance is expected to be adopted prior to the mandatory 2019 deadline by most banks who actively hedge. In addition, more community banks are likely to consider installing hedging capabilities for the first time thanks to FASB clearing this long-time roadblock.

Derivatives Education for Boards: Weighing the Whys Along With the Why Nots


swaps-7-12-17.pngWell-documented stories of speculators using derivative structures to gamble and lose their firms’ capital, along with Warren Buffett tagging them as “financial weapons of mass destruction” have made interest rate swaps a non-starter for many community banks. It seems that the preponderance of evidence against derivatives has led many community bank boards to view the issue as an open and shut case, rather than carefully considering all of the facts before passing judgment on these instruments. But questioning the four most common objections to swaps uncovers some overlooked truths that may motivate your board to take a fresh look at derivatives.

1. I know someone who lost money on a swap…but why?
Putting aside situations where derivatives were sold inappropriately, the claim, “I know a customer who got burned using a swap,’’ is simply the banker stating that the borrower utilized an interest rate swap to lock in borrowing costs. A borrower who chose the certainty offered by a swap over uncertain variable interest payments ultimately paid more because interest rates went down instead of up, and then stayed low. In reality, the borrower was burned by the falling rate environment while the interest rate swap performed exactly as advertised, providing known debt service, albeit higher than the prevailing rates. It looked like a bad deal only with 20-20 hindsight.

With the Federal Reserve now moving short-term rates higher while market yields remain close to historic lows, the odds begin to favor the borrower who uses a swap to hedge against rising rates. Whether or not the swap pays off, the certainty that it delivers becomes more attractive as rates become volatile and their future path remains uncertain.Federal-Funds-Rate.png

2. Regulators don’t want community banks using swaps…or do they?
When looking at the topic of interest rate risk, regulators began sounding alarm bells for banks in the years following the crisis on the premise that there was nowhere to go but up for rates. In a 2013 letter to constituents, the Federal Deposit Insurance Corp. (FDIC) re-emphasized the importance of prudent interest rate risk oversight and issued this warning:

“Boards of directors and management are strongly encouraged to analyze exposure to interest rate volatility and take action as necessary to mitigate potential financial risk.”

When it came to outlining mitigation strategies in this letter, rather than banning derivatives as intrinsically risky, the FDIC specifically mentioned hedging as a viable option. They did, however, sound a note of caution:

“…institutions should not undertake derivative-based hedging unless the board of directors and senior management fully understand these instruments and their potential risks [emphasis our own].”

Compared with other risk management tactics, derivatives offer superior agility and capital efficiency along with new avenues to reduce funding costs. Accordingly, it may behoove banks to heed the FDIC’s exhortation and implement derivatives education for directors and senior management.

3. My peers don’t use swaps…why should I?Swaps.PNG

If you are not hedging with swaps and your total assets are between $500 million and $1 billion then you are in good company; seven out of eight banks your size have also avoided their use. But if your growth plans anticipate crossing the $1 billion asset level, more than one in four of your new peers will be using swaps. Once you cross the $2 billion mark more than half of your peers will be managing interest rate risk with derivatives, while institutions not using swaps become a shrinking minority. For the many institutions serving small communities and not expecting to cross the $500 million asset level in the foreseeable future, derivatives are not typically a viable solution. But if your growth will soon push you into a new group of peers with more than $2 billion in assets on the balance sheet, then having interest rate swaps in the risk management tool kit will become the norm among your competitors.

4. Our board doesn’t need derivatives education…or do we?
After digging below the surface we learn that most of the instances where derivatives left a bad aftertaste were caused by an unexpected drop in rates rather than a product flaw. We also learn that in urging banks to take action to mitigate interest rate risk, the regulators are not anti-derivative per se; they simply lay out the reasonable expectation that the board and senior management must fully understand the strategy before executing. Taking the time to educate your board on the true risks as well as the many benefits provided by interest rate hedging products may help to distinguish them as powerful tools rather than dangerous weapons.

Proposed Accounting Changes Should Make Hedging More Attractive to Community Banks


interest-rate-risk-3-31-17.pngIn the regular course of business, banks are exposed to market risks from movements in interest rates, foreign currencies and commodities. Many banks respond by utilizing over the counter derivative instruments to hedge against volatility. Under current accounting standards, banks must account for derivatives under the ASC 815 (formerly FAS 133) models.

There are three hedge accounting “models” under ASC 815: 1) cash flow, 2), fair value, 3) and net investment hedging. There are specific times when one model is required over the others, and the mechanics of each are different in many ways. Because of its breadth, hedge accounting could be seen as intimidating and difficult to understand. There have been instances where banks made mistakes in their adherence to hedge accounting which resulted in income statement volatility. As a result, the perception hedge accounting is difficult and fraught with potential danger has discouraged many banks from entertaining derivative solutions

On September 8, 2016, the Financial Accounting Standards Board (FASB) submitted a proposed draft to update hedge accounting. Specifically, the draft seeks to better align a bank’s economic results with its financial reporting and simplify hedge accounting.

The proposed changes appear to better align the accounting rules with a bank’s risk management objectives and simplifies some important items of ASC 815. Many of the existing rules remain unchanged, but the proposed changes should produce greater interest in the use of derivative solutions among community banks.

Specifically, the proposal for improving how economic results are portrayed on financial statements includes:

  • Expanding the use of component hedging for both nonfinancial and financial risks.
  • Adding the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate as an eligible benchmark interest rate for fair value accounting in the United States.
  • Eliminating the separate measurement and reporting of hedge “ineffectiveness,” a concept that has been difficult for companies to explain and for readers of financial statements to understand.
  • Requiring for cash flow and net investment hedges that all changes in fair value of the hedging instrument included in the hedging relationship be deferred in other comprehensive income and released to the income statement in the period(s) when the hedged item affects earnings.
  • Requiring that changes in the fair value of hedging instruments be recorded in the same income statement line item as the earnings effect of the hedged item.
  • Requiring enhanced disclosures to highlight the effect of hedge accounting on individual income statement line items.

Highlights of the Proposed Changes Most Likely to Affect Financial Institutions

The proposal also includes some ways to simplify hedge accounting, including the following:

  • Providing more time for the completion of initial quantitative assessments of hedge effectiveness.
  • Allowing subsequent assessments of hedge effectiveness to be performed on a qualitative basis when an initial quantitative test is required.
  • Clarifying the use of what’s known as the critical terms match method for a group of forecasted transactions.
  • Allowing an institution that erred in using the shortcut method to continue hedge accounting by using a “long-haul” method.

Why Every Basis Point Matters Now


derivatives-2-17-17.pngAfter eight years of waiting for interest rates to make a meaningful move higher, the fed funds rate is making a slow creep towards 2 percent. With a more volatile yield curve expected in the upcoming years and continued competition for loans, net interest margins (NIM) may continue to compress for many financial institutions. The key to achieve NIM expansion will involve strong loan pricing discipline and the full toolkit of financial products to harvest every available basis point.

Where to look on the balance sheet? Here are some suggestions.

Loan Portfolio
The loan portfolio is a great place to look for opportunities to improve the profitability. Being able to win loans and thus grow earning assets is critical to long-term success. A common problem, however, is the mismatch between market demand for long-term, fixed rate loans and the institution’s reluctance to offer the same.

Oftentimes, a financial institution’s interest rate risk position is not aligned to make long-term, fixed rate loans. A few alternatives are available to provide a win-win for the bank and the borrower:

  • Match funding long-term loans with wholesale funding sources
  • Offer long-term loans and hedge them with interest rate swaps
  • Offer a floating rate loan and an interest rate swap to the borrower and offset the interest rate swap with a swap dealer to recognize fee income upfront

With the ability to offer long-term fixed rate loans, the financial institution will open the door to greater loan volumes, improved NIM, and profitability.

How much does a financial institution leave on the table when prepayment penalties are waived? A common comment from lenders is that borrowers are rejecting prepayment language in the loan.

How much is this foregone prepayment language worth? As you can see from the table below, for a 5-year loan using a 20-year amortization, the value of not including prepayment language is 90 basis points per year.

Swap-chart.PNG

At a minimum, financial institutions should look to write into the loan at least a 1- to 2-year lock out on prepayment, which drops the value of that option from 90 basis points to 54 basis points for a 1-year lock out or 34 basis points for a 2-year lock out. That may be more workable while staying competitive.

Investment Portfolio
The investment portfolio typically makes up 20 percent to 25 percent of earning assets for many institutions. Given its importance to the financial institution’s earnings, bond trade execution efficiency may be a way to pick up a basis point or two in NIM.

A financial institution investing in new issue bonds should look at the prospectus and determine the underwriting fees and sales concessions for the issuance. There are many examples in which the underwriting fees and sales concessions are 50 to 100 basis points higher between two bonds from the same issuer with the same characteristics, with both issued at par. To put that in yield terms, on a 5-year bond, the yield difference can be anywhere between 10 and 20 basis points per year.

If you are purchasing agency debentures in the secondary market, you can access all the information you need from the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE) to determine the mark up of the bonds you purchased. Using Bloomberg’s trade history function (TDH), in many cases, it is easy to determine where you bought the bond and how much the broker marked up the bond. Similar to the new issue example above, a mark-up of 25 to 50 basis points more than you could have transacted would equate to 5 to 10 basis points in yield on a 5-year bond.

For a typical investment portfolio, executing the more efficient transactions would increase NIM by 1.5 to 5 basis points. For many institutions, simply executing bond transactions more efficiently equates to a 1 percent to 3 percent improvement in return on assets and return on equity.

Wholesale Funding
A financial institution can use short-term Federal Home Loan Bank (FHLB) advances combined with an interest rate swap to lock in the funding for the desired term. By entering into a swap coupled with borrowing short-term from the FHLB, an institution can save a significant amount of interest expense. Here is an example below:

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Derivatives
As you can see from a few of the previous examples, derivatives can be useful tools. Getting established to use derivatives takes some time, but once in place, management will have a tool that can quickly be used to take advantage of inefficient market pricing or to change the interest rate risk profile of the institution.

Number of Community Banks Using Derivatives, by Year

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Conclusion
In a low interest-rate environment and with increased volatility in rates across the yield curve, net interest margins are projected to continue to be under pressure. The above suggestions could be crucial to ensuring long-term success. Offering longer-term loans and instilling more efficient loan pricing is the start to improved financial performance.

Contingent Hedging Plans: How Community Banks Can Approach Hedging


A contingent hedging plan should be unique to every bank and developed in concert with internal modeling and management’s rate expectations. Like a captain adding ballast to a ship to provide a smoother ride, hedging allows a bank to reduce volatility and limit the impact of sudden interest rate changes. (See BMO’s previous article on this topic.) The goal is not to eliminate risk, but proactively mitigate or control risk at a suitable cost.

Derivative use among community banks has increased over the last several years. The graphs below illustrate the growth in the number of banks with swap and gross balances. Interestingly, after the Dodd Frank Act was enacted in 2012, at a time when using derivatives was expected to be more onerous, the year-over-year growth in derivative use among community banks has accelerated rather than declined.Swap chart.PNG

One possible explanation with the migration of bankers from larger institutions to smaller community banks is they bring with them an understanding of derivatives and their benefits. The sustained flat curve and low rate environment may have compelled banks to evaluate and use derivatives.

How To Create a Contingent Hedging Plan
Regulators require banks to establish contingent funding plans. Developing a contingent hedging plan could follow the same approach. The plan can include description of roles, responsibilities and action plans where applicable. It should also allow management to act quickly when rate assumptions change. Among the items one can include:

Determine Economic Goals with Quantitative Guidance: What are the economic risks the bank is trying to mitigate? The more quantifiable the risk, the more specific you can be with your dealer and the more targeted the recommended solution.

List of Approved Transaction Types: Keep definitions broad enough to allow management to act opportunistically without waiting for approval at the monthly board meeting. Learn the basic mechanics of these trades today, so when you look to execute in a volatile market you will already have some understanding on which trades are most suitable for the risk.

Cost and Timing: There is usually a trade off or “cost” to do a hedge–nothing is for free. Get on someone’s rate sheet distribution, remain aware of current hedge levels and determine a range of acceptable cost. When one waits too long to trade, the hedge cost may become prohibitively expensive.

Understand Accounting Treatment: Derivatives are subject to FAS133 / ASC815 accounting treatment. Develop a familiarity of which accounting model is required and under which hedging circumstance.

Transaction Mechanics: Know who to call and how to execute a trade. Develop familiarity with terminology and swap nomenclature in order to accurately communicate intent.

Counterparty Selection: This may be the most important ingredient. Without access to a dealer counterparty to help provide solutions, creating a contingent hedging plan could be a moot point.

The Dodd-Frank Act provides advantages for hedgers if they transact with a registered swap dealer (RSD). The act defines swap dealers as entities who “hold themselves out as dealers in swaps; make a market in swaps; regularly enter into swaps with counterparties in the ordinary course of business for their own accounts; or engage in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.”

These entities are required to register with the Commodity Futures Trading Commission and are held to higher business conduct standards. A list of provisionally registered swap dealers can be found here

Hedgers Can Expect the Following Benefits From RSDs
Price transparency: The act requires all RSDs to quote mid + bid/offer spread on every trade. The hedger knows exactly what the dealer is making.

Liquidity / Cost: By trading directly with a market maker, the hedger crosses one bid or offer spread rather than two which normally happens when going through an intermediary.

Fair Credit Terms: You get fair credit terms with bi-lateral collateral posting for uncleared trades.

Expertise: RSDs can provide direct market color, trade recommendations and regulatory guidance. The level of expertise will be much higher given the critical mass and scale required to be a market maker in this regulatory environment.

Hedgers should consider that the regulatory burden on RSDs is significant, so dealers have responded by recalibrating business lines. While there are still RSDs willing to face small banks, many other dealers have exited the community bank space entirely. When evaluating a swap partner, you may want to ask about their commitment to your asset class.

“Whatcha Gonna Do When the Fed Raises Rates on You?”


interest-rate-9-9-16.pngThe elephant in the room: What happens to earnings, funding costs and liquidity if the Fed aggressively tightens? It’s time to acknowledge the need for contingent hedging plans and evaluate how to manage risk while remaining profitable in a flat or rising rate environment.

For the past several years, the banking industry has faced significant earnings challenges. Profitability has been under pressure due to increases in nonaccruals, credit losses, new regulatory costs and the low rate environment. Some banks have responded by cost cutting, but community banks do not have as much flexibility in this regard, especially if they are committed to a level of service that distinguishes community banks from larger banking institutions. Among the risks community banks face today are:

Margin compression from falling asset yields and funding costs that are at their lowest.

Interest rate risk. Borrowers are seeking fixed rates at longer and longer terms. The fixed term necessary to win the loan often may create unacceptable interest rate risk to the bank.

Irregular loan growth has often lead to increased competition for available borrowers with good credit.

To meet the challenge of generating positive earnings at more desirable levels, most community banks lengthened asset maturities while shortening liabilities. This resulted in some temporary margin stabilization, provided short term rates stay where they are, in exchange for higher risk profile if rates rise. The strategy has generally worked for approximately the last five years, but the question is for how much longer can we expect this to continue to work? In my opinion, community banks need more robust risk management programs to manage these risks and, in response, many have increasingly turned to swaps and other hedging solutions.

One competitive solution commercial lenders are employing is loan level hedging. This is a program where the bank will use an interest rate swap to hedge on a loan by loan basis. An interest rate swap is a hedging instrument that is used to convert a fixed rate to floating or vice versa. Loan level hedging allows the borrower to pay a fixed rate, and the bank to receive a floating rate. There are two simple models:

  1. Offer a fixed rate loan to the borrower and immediately swap the fixed rate to floating with a dealer. The loan coupon would be set at a rate that would swap to a spread over LIBOR that would meet the bank’s return target.
  2. Offer a floating rate loan and an interest rate swap to the borrower. The borrower’s swap would convert the floating rate on the loan to fixed. Simultaneously, the bank would enter into an offsetting rate swap with a dealer. This model is usually referred to as a “back to back” or “matched book.”

In my view, these solutions help the community bank compete with dealers, regional banks, and rival community banks. These models have been around for decades and their acceptance and use among community banks has increased dramatically over the last several years. Their benefits include:

They protect margins by improving asset/liability position through floating rates on commercial assets. They may enhance borrower credit quality by reducing borrower sensitivity to rising rates.

They diversify product lines and level the playing field versus larger commercial lenders and community banks in your market who offer hedging alternatives.

They are accounting friendly. Banks should always be aware of accounting treatment before entering any hedging strategy. The accounting treatment for loan level hedges is normally friendly and often does not create any income statement ineffectiveness.

They create fee income. When properly administered, a swap program may provide the bank a good opportunity to generate fee income with no additional personnel or systems costs.

Swaps and other derivatives may provide an immediate solution without the need for restructuring the balance sheet or changing your lending and funding programs. If you haven’t considered interest rate hedging before, you should consider contacting a dealer you trust for a discussion.