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.

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.

Proposed Accounting Changes Should Make Hedging More Attractive to Community Banks

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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.