Mitigating Commercial Lending Rate Reset Risk Through Hedging

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Today’s elevated interest rate environment is challenging banks with managing their interest rate risk while meeting the needs of their customers, especially commercial borrowers. With interest rates constantly fluctuating, navigating these complexities to stay competitive and protect relationships may seem difficult. But combining loan hedging and forward rate lock (FRL) strategies can allow banks to mitigate rate-reset risk, protect against unexpected rate fluctuations and stabilize debt expense for their borrowers.

A forward rate lock is an agreement between a borrower and a bank to set a fixed rate for future financing. The FRL eliminates the risk of the borrower’s rate changing before financing begins, while incorporating a forward rate hedge preserves the bank’s loan pricing spread. Banks use FRLs most often to fix rates on permanent financing following construction and to fix future rates on existing resettable loans, which span up to 36 months or longer into the future. These strategies, often called “swaps,” are particularly useful when the yield curve is inverted or when rates have risen — both of which conditions currently exist.

The Federal Reserve has expressed a commitment to continue its tight monetary policy until inflation declines to its 2% target. Fed Governors have stated that rates will likely be higher for longer. However, bond market activity implies that the Fed will deviate from its current policy path sooner rather than later. This current disconnect between the bond market and Fed projections is reflected in an inverted yield curve, where short-term rates for floating rate loans are higher than fixed rates for mid- to longer-term structures. The market is ripe for lenders and borrowers to take advantage of this irregular trend. Here are three primary benefits of FRLs for both borrowers and banks:

1. Eliminating future rate uncertainty. Banks typically mitigate interest rate risk stemming from longer-term loans by adjusting the fixed rate every 5 years. However, with rates rising by 500 basis points in the last 16 months, these resets pose significant credit risk for the bank and market risk for the borrower. A FRL allows the borrower to set their rate today, but it’s not effective until the loan’s repricing date. This solution gives the borrower time to prepare for the higher debt service through cutting costs or increasing rents. Regulators will appreciate banks having a strategy in place to manage their reset risk.

2. Protecting banks and borrowers from credit stress due to higher reset rates. Although most banks stress test their loan portfolios, the magnitude of rate hikes over the last year means that some loans may be approaching debt service covenant limits or will at least create credit stress for both the bank and the borrower. Fixing the rate with an FRL before rates increase further helps the bank reduce credit stress for customers and itself. Regardless of what happens to rates in the next 12 to 24 months, borrowers are guaranteed a fixed rate they can budget around.

3. Preventing net interest margin (NIM) compression. In recent years, when interest rates were low, cost of funds didn’t become a significant issue for banks. This time, as rates have risen rapidly and higher than expected, banks are increasing the rates on their deposits to remain competitive. The substantially higher cost of funds has compressed NIM. Without hedging, banks have to wait for the reset period (e.g. a 5-year reset on a 10-year term loan) to reprice their loans, while paying higher rates on their deposits in the meantime. An FRL can help reduce that risk by essentially converting conventional loans that reprice at longer intervals to loans that reset every month, effective at their next reset. As rates go up, deposit costs increase, but they are matched by rising interest income on the loan — with the borrower still benefiting from the fixed rate.

Mitigating rate-reset risk is crucial for lenders in today’s financial landscape. Implementing the right commercial hedging strategy and utilizing forward rate locks can safeguard a bank and its borrowers from the impact of interest rate fluctuations. These solutions provide borrowers with stability and lenders with risk mitigation, ensuring long-term success and financial well-being.

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.”

3 Ways to Help Businesses Manage Market Uncertainty

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Amid mounting regulatory scrutiny, heightened competition and rising interest rates, senior bank executives are increasingly looking to replace income from Paycheck Protection Program loans, overdrafts and ATM fees, and mortgage originations with other sources of revenue. The right capital markets solutions can enable banks of all sizes to better serve their business customers in times of financial uncertainty, while growing noninterest income.

Economic and geopolitical conditions have created significant market volatility. According to Nasdaq Market Link, since the beginning of the year through June 30, the Federal Reserve lifted rates 150 basis points, and the 10-year Treasury yielded between 1.63% and 3.49%. Wholesale gasoline prices traded between $2.26 and $4.28 per gallon during the same time span. Corn prices rose by as much as 39% from the start of the year, and aluminum prices increased 31% from January 1 but finished down 9% by the end of June. Meanwhile, as of June 30, the U.S. dollar index has strengthened 11% against major currencies from the start of the year.

Instead of worrying about interest rate changes, commodity-based input price adjustments or the changing value of the U.S. dollar, your customers want to focus on their core business competencies. By mitigating these risks with capital market solutions, banks can balance their business customers’ needs for certainty with their own desire to grow noninterest income. Here are three examples:

Interest Rate Hedging
With expectations for future rate hikes, many commercial borrowers prefer fixed rate financing for interest rate certainty. Yet many banks prefer floating rate payments that benefit from rising rates. Both can achieve the institution’s goals. A bank can provide a floating rate loan to its borrower, coupled with an interest rate hedge to mitigate risk. The bank can offset the hedge with a swap dealer and potentially book noninterest income.

Commodity Price Hedging
Many commercial customers — including manufacturers, distributors and retailers — have exposure to various price risks related to energy, agriculture or metals. These companies may work with a commodities futures broker to hedge these risks but could be subject to minimum contract sizes and inflexible contract maturity dates. Today, there are swap dealers willing to provide customized, over-the-counter commodity hedges to banks that they can pass down to their customers. The business mitigates its specific commodity price risk, while the bank generates noninterest income on the offsetting transaction.

International Payments and Foreign Exchange Hedging
Since 76% of companies that conduct business overseas have fewer than 20 employees, according to the U.S. Census Bureau, there is a good chance your business customers engage in international trade. While some choose to hedge the risk of adverse foreign exchange movements, all have international payment needs. Banks can better serve these companies by offering access to competitive exchange rates along with foreign exchange hedging tools. In turn, banks can potentially book noninterest income by leveraging a swap dealer for offsetting trades.

Successful banks meet the needs of their customers in any market environment. During periods of significant market volatility, businesses often prefer interest rate, commodity price or foreign exchange rate certainty. Banks of all sizes can offer these capital markets solutions to their clients, offset risks with swap dealers and potentially generate additional income.

FASB Update Removes Roadblock to Hedging With Derivatives

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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

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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.

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

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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.