An Effective Way to Combat Cyber Breaches

Banks have always been in the business of risk management, but the risks they face aren’t stagnant; they migrate with time.

Traditionally, banks have faced two types of risk: interest rate and credit risk. Today, however, given the growth of digital banking and transactions, these two risks have been supplanted by another: cybersecurity.

The biggest challenge when it comes to cybersecurity risk is that it constantly evolves, as the threats, actors and attacks increase in sophistication. Banks that prepare for one method of intrusion may find themselves the victim of a different strategy.

Earlier this year, H. Rodgin Cohen, a partner at Sullivan & Cromwell and one of the industry’s most trusted advisors, commented on this change.

“I think the biggest risk in the [financial] system today is a successful cyberattack,” Cohen said. “That is a very serious risk, but I think the more likely [danger] is that a single bank — or a group of banks — are hit with a massive denial of service for a period of time, or a massive scrambling of records.”

Banks of all sizes feel pressure to keep their systems secure from intruders, according to Bank Director’s 2019 Risk Survey, which found that cybersecurity concerns among bankers have increased over the previous year.

Twenty percent of survey respondents say they address cybersecurity as a full board rather than delegating it to a committee, and slightly more than a third say at least one director is a cybersecurity expert.

The concern is ever present, and for some banks, very real: 18% of respondents, excluding chief lending officers and chief credit officers, reported that their bank experienced a data breach or other cyberattack within the last two years.

Concerns like these are why Bank Director created the “Best Solution for Protecting the Bank” category for its 2019 Best of FinXTech Awards. Judges selected winners from the most innovative solutions found in the FinXTech Connect platform.

The finalists for this year’s award were Rippleshot, which helps banks to identify credit and debit card fraud; IDEMIA, which  works to prevent card-not-present fraud; and Illusive Networks, which helps banks detect when their networks have been infiltrated.

This year’s winner was Illusive Networks, based in part on its work to secure the network of Israel Discount Bank, the third biggest bank in Israel.

Illusive approaches cybersecurity from a hackers’ point of view in order to beat them at their own game. Its strategy isn’t to stop an intrusion per se — a feat that seems increasingly impossible with the number of entry points into a system and the scores of malicious actors.

Rather, it detects and remediates an attack once it has happened. Intruders breaking into a bank’s system must persistently monitor the network for bits of information or credentials that will help them move from machine to machine and gradually close in on the data they want. Illusive plants false information across the bank’s network so that, when attackers act on it, the bank can catch them red-handed.

Illusive calls this “endpoint-focused deception.” The deceptive information is only visible to malicious actors and triggers an alert within Illusive. The technology then captures details about the bad actor directly from the machine they were using, which the bank then uses to track and stop the attack.

One of the main selling points of Illusive’s solution is the short implementation period. In Israel Discount Bank’s case, it took a matter of weeks to implement the solution. The net result is that, not only is the solution harder to detect for potential cyber criminals, but it’s also fast and easy to implement.

Addressing the Top Three Risk Trends for Banks in 2019



As banks continue to become more reliant on technology, the risks and concerns around cybersecurity and compliance continue to grow. Bank Director’s 2019 Risk Survey, sponsored by Moss Adams LLP, compiled the views of 180 bank leaders, representing banks ranging from $250 million to $50 billion in assets, about the current risk landscape. Respondents identified cybersecurity as the greatest concern, continuing the trend from the previous five versions of this report and indicating an industry-wide struggle to fully manage this risk.

Other top trends included the use of technology to enhance compliance and the potential effect of rising interest rates. Here’s what banks need to know as they assess the risks they’ll face in the coming year.

Cybersecurity
Regulatory oversight and scrutiny around cybersecurity for banks seems to be increasing. Agencies including the Securities and Exchange Commission are focused on the cybersecurity reporting practices of publicly traded institutions, as well as their ability to detect intruders. The Colorado legislature recently passed a law requiring credit unions to report data breaches within 30 days. It’s no surprise that 83 percent of respondents said their concerns about cybersecurity had increased over the past year.

Most of the cybersecurity risk for banks comes from application security. The more banks rely on technology, the greater the chance they face of a security breach. Adding to this, hackers continue to refine their techniques and skills, so banks need to continually update and improve their cybersecurity skills. This expectation falls to the bank board, but the way boards oversee cybersecurity continues to vary: Twenty-seven percent opt for a risk committee; 25 percent, a technology committee and 19 percent, the audit committee. Only 8 percent of respondents reported their board has a board-level cybersecurity committee; 20 percent address cybersecurity as a full board rather than delegating it to a committee.

Compliance & Regtech
Utilizing technological tools to meet compliance standards—known as regtech—was another prevalent theme in this year’s survey. This is a big stress area for banks due to continually changing requirements. The previous report indicated that survey respondents saw increased expenses around regtech. This year, when asked which barriers they encountered around regtech, 47 percent responded they were unable to identify the right solutions for their organizations. Executives looking to decrease costs may want to consider whether deploying technology could allow for fewer personnel. When this technology is properly used, manual work decreases through increased automation.

Other compliance concerns for this year’s report included rules around the Bank Secrecy Act and anti-money laundering. Seventy-one percent of respondents indicated they implemented or plan to implement more innovative technology in 2019 to better comply with BSA/AML rules.

Compliance with the current expected credit loss standard was another area of concern. Forty-two percent of respondents indicated their bank was prepared to comply with the CECL standard, and 56 percent replied they would be prepared when the standard took place for their bank.

Interest Rate & Credit Risk
The potential for additional interest rate increases made this a new key issue for the 2019 report. When asked how an interest rate increase of more than 100 basis points, or 1 percent, would affect their banks’ ability to attract and retain deposits, 47 percent of respondents indicated they would lose some deposits, but their bank wouldn’t be significantly affected. Thirty percent indicated an increase would have no impact on their ability to compete for deposits.

However, 55 percent believed a severe economic downturn would have a moderate impact on their banks’ capital. In the event of such a downturn, deposits and lending would slow, and banks could incur more charge-offs, which would impact capital. This fluctuation can be easy to dismiss, but careful planning may help reduce this risk.

Assurance, tax, and consulting offered through Moss Adams LLP. Investment advisory services offered through Moss Adams Wealth Advisors LLC. Investment banking offered through Moss Adams Capital LLC.

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.

Feeling the Flat Yield Curve Squeeze?


interest-rate-6-26-18.pngInvestors have always sought better returns for greater risk. Longer investment horizons are associated with a higher amount of risk driven by uncertainty. In the fixed income markets, this translates to higher yields for longer maturities to compensate investors for the risk, thus creating what is called the yield curve. The yield curve has a positive slope in a normal market. The curve can also be flat or even inverted, which typically indicate transitionary periods in the market. That said, interest rate troughs usually do not last more than seven years, and central banks normally do not pump trillions of dollars into global markets as they have over the last several years. With protracted recovery and extreme monetary policy measures, this dreaded flat yield curve seems to be here for a while.

Banks’ primary earning power is largely driven by net interest margin, which is impacted by the shape of the yield curve and the ability to manage interest rate risk. It is prudent to perform non-parallel rate simulations on a regular basis, and regulators require this type of analysis. These simulations should be reviewed with management and saved for future use. Given the protracted flat yield curve environment, banks are feeling margin compression. If you have not done so, it may be time to retrieve these reports, understand if and where risk is impacting your balance sheet and manage your margin accordingly.

There are a number of ways a flat yield curve can negatively impact interest rate margins. Liquidity pressure is often at the top of the list in a rising rate environment. We have seen seven upward moves in the target fed funds rate since the bottom of the recovery, a total of 175 basis points. Depositors are hungrily pursuing newfound interest income. Most banks have had to follow suit and raise deposit rates. On the asset side of the balance sheet, fixed-rate loan yields have remained relatively stagnant. A typical rate on a 20-year amortizing 5-year balloon, owner-occupied commercial real estate loan in the $1-million to $5-million range was priced around 4.75 percent during the bottom of the rate trough.

As deposit rates have risen, banks have had difficulty in pricing the yields on loans of this type much above 5 percent. A third pressure point is the investment portfolio. During a normal yield curve environment, institutions with asset-sensitive balance sheets could earn income by borrowing short-term liabilities and investing at higher yields further out on the curve. Given the tightness of spreads along the curve where typical banks invest, there is minimal advantage to implementing this type of a strategy.

Since the issue of margin compression driven by the flat curve is a top concern for those who manage interest rate risk, the better question is what to do about it. Most bankers know it is present but many avoid the potential ramifications. The non-parallel simulation is an important exercise to understand the implications over the next year or so. The bank may even want to consider running a worst-case scenario simulation around an inverted curve as well. From there some strategic deposit pricing can be implemented.

One strategy may be either maintaining a short duration, and hopefully, inexpensive deposit or locking in funds for longer terms, pending balance sheet needs. Locking in longer term funding will come at a cost to the net interest margin unless the curve inverts. The interest rate risk simulation will help answer those types of questions. It is also a good time to look at a loan pricing model. This would help determine whether to continue to compete on price or pass on deals until margins improve. There is even a level that where banks should turn down business. It is important to understand the price point that becomes dilutive to earnings. Finally, there is a point that one stops taking duration risk in the investment portfolio, stays short and prepares to take advantage of future opportunities while reducing price risk.

Although a flat yield curve is not a new market phenomenon, it is currently impacting bank margins and may continue to for the next year or longer. Our Balance Sheet Strategies Group recommends banks consider the use of a detailed, non-parallel simulation to assess the current market and how to position the balance sheet moving forward. In addition to optimizing the interest rate position going forward, this will also help preserve and potentially enhance the interest margin. Every five basis points saved or earned on a $250-million balance sheet will equate to $125,000 in interest rate margin.

Cybersecurity & Regtech: Defending The Bank



How can financial institutions proactively combat the risks facing the industry today? The 2018 Risk Survey—presented by Bank Director and Moss Adams LLP—compiled the insights of directors, chief executive officers and senior executives of U.S. banks with more than $250 million in assets. According to the survey, the worries keeping top executives awake at night align with the key priorities that banks commonly hear from banking regulators: cybersecurity, compliance and strategic risk.

Cybersecurity
Cybersecurity was the biggest concern by far, reported by 84 percent of respondents.

The survey addressed the confidence that executive and directors have in their institutions’ cybersecurity programs, with an emphasis on staffing and overall effectiveness. Access to the proper talent—in the form of a chief information security officer (CISO) or a strategic partner with the necessary skill set—and associated costs are key to a successful program, and 71 percent of respondents revealed their bank employs a full-time CISO.

While technical skills are valuable in today’s business environment, financial institutions must overcome their dependence on skilled technicians who don’t necessarily have the ability to strategically look at the changing technological landscape. The CISO should build an appropriate plan by taking a full view of the bank’s technology and strategy. Without this perspective, a bank could provide hackers with an opening to breach the institution, regardless of size or location.

Institutions building the foundation of a robust cybersecurity program should also focus on three key areas:

  • Assessment tools: Is the institution leveraging the proper technologies to help maximize the detection and containment of potential issues?
  • Risk assessments: Has management identified current risks to the organization and implemented proper mitigation strategies?
  • Data classification: Has management identified all critical data and its forms, and addressed the protection of this data in the risk-assessment process?

Compliance
Compliance was the second biggest area of concern, identified by 49 percent of respondents. It’s an area that continues to evolve as new regulators have been appointed to head the agencies that regulate the industry, and technological tools—dubbed regtech—have entered the marketplace.

More than half of survey respondents indicated that the introduction of regtech has increased their banks’ compliance budgets, demonstrating that the cost of solutions and staff to evaluate, deploy and support these efforts in an effective manner is a growing challenge.

Because the volume of available data and the ability to analyze that data continues to grow, respondents may have felt this technology should have effectively decreased the cost of operating a robust compliance program.

Executives looking to decrease costs may want to consider the staffing required to operate a compliance program and whether deploying technology would allow for fewer personnel. When technology is properly used and standards are developed to help guarantee efficient use of it, the dilemma of acquiring technology versus adding staff can often be more easily solved.

Strategic Risk
Strategic risk was the third largest area for concern, identified by 38 percent of respondents. Many directors and executives are wrestling with what the future holds for their institutions. The debate often boils down to one question: Should they continue to build branches or invest more in technology—either on their own or by partnering with fintech companies?

Fintech companies are a growing player in lending and payments segments, areas that were historically handled exclusively by traditional institutions. That, coupled with clients who no longer value personal relationships and instead prioritize being able to immediately access services via their devices, increases the pressure to deliver services via technology channels.

Financial institutions have entered what many would call a perfect storm. Every institution will need to make hard decisions about how to address these issues in a way that facilitates growth.

Assurance, tax, and consulting offered through Moss Adams LLP. Wealth management offered through Moss Adams Wealth Advisors LLC. Investment banking offered through Moss Adams Capital LLC.

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.

SBICs: A Unique Way to Comply With CRA



Small business investment companies have been growing in popularity since the financial crisis, as these can help banks comply with the Community Reinvestment Act and manage interest rate risk, as Dory Wiley, CEO at Commerce Street Capital, explains in this video.

  • How SBICs Benefit Banks
  • Addressing Due Diligence Concerns
  • Making the SBIC a Success for the Bank

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.

How to Reduce Bank Risk and Improve Overall Returns with SBICs


bank-risk-8-19-16.pngMany banks operate under the false pretense that because they are deemed a “conservative bank,” there isn’t a lot of risk in their business model. I often remind boards of directors that they sit on a highly leveraged, regulated hedge fund. Would they lend money to a finance company leveraged 10 times or more, while trying to manage a 3.5 percent spread? That’s your average bank. So it might be a good idea to consider an opportunity to reduce risk, even by an incremental amount.

The first thing to do is identify the area with the greatest risk. Most banks view it as credit risk, and vigorously address this with underwriting, loan committee, loan reviews, regulatory exams, reserves, limits and diversification. Banks do a great job of this. However, in our experience, the greatest area of risk, receiving the least amount of attention, is a bank’s “bond-like risk,” which shows up in the structure of securities, loans and deposits.

This risk is basically interest rate risk, and the devil is in such details as yield curves, repricing risk and maturities. While asset/liability management strategies may help, they don’t reduce the problem banks have with their dependence on duration (which is the measurement of the sensitivity of a bond to interest rate fluctuations) in exchange for a decent return. Over 80 percent of risk factor contribution to the price volatility on a bank’s balance sheet is caused by nominal duration. What this means is loans, securities and deposits all have the same structured risk which is caused by maturities and cash flows. In light of this enormous risk concentration, pension funds, endowments, foundations and other institutions diversify this risk via stock and private equity allocations. For example, private equity allocations can reduce risk and increase returns through:

  • Lower volatility of returns over time compared to duration-based assets like loans and bonds. Yes, private equity has a lower volatility risk than a two-year Treasury note.
  • Higher Sharpe Ratios than bonds or loans, which means higher returns per unit of risk. (William F. Sharpe first introduced returns-based style analysis in the late 1980s, hence the name “Sharpe Ratio.”)
  • Very low correlation coefficients to bonds and loans, meaning the returns don’t track those of bonds or loans which will help your bank diversify its earnings stream. Banks currently try to do this through non-interest income.
  • Economic cycle diversification benefits for banks that can only lend money even when pressed by market forces on pricing and structure. Private equity mitigates this by investing in different parts of the capital structure than loans, and by less stringent investing periods than banks. Banks need to lend or invest their depositors’ funds immediately. Private equity funds can be more patient because they typically have a three- to five-year window in which to put their investors’ money to work.

Banks aren’t allowed to invest in private equity funds, so why am I telling you this? While banks are prohibited from investing in private equity funds, there is an exception in the Dodd-Frank Act’s Volcker Rule for Small Business Investment Companies (SBICs), which are funds that invest in small businesses and private companies. Hundreds of banks have taken advantage of this program since 1958. There are several benefits to these investment vehicles. Banks can:

  • Help create jobs and expand the economy.
  • Get Community Reinvestment Act (CRA) credit.
  • Get CRA service credit by serving on an advisory board.
  • Create opportunities for senior C&I loans.
  • Create opportunities for commercial deposits.
  • Offer solutions to customers who need a liquidity event, more equity in their business or support for a senior loan.
  • Earn a nice return.

SBICs, like private equity, also help reduce the aforementioned risks of volatility, duration, correlations, Sharpe Ratios, economic cycle timing and diversification, which theoretically should increase portfolio returns. SBICs can make a bank safer and more profitable. Top quartile returns (returns in the top 25 percent) for SBICs from 1998 to 2010 were higher than 15 percent, while even the bottom quartile was 6.3 percent. So even a poor performing SBIC has produced higher returns than most any other asset opportunity available to a bank during this time frame. To reduce the risk of investing in a poor performing SBIC, a bank can do the following:

  1. Develop underwriting practices, like a bank does on loans, tailored to SBICs, targeting top quartile returns.
  2. Create a portfolio of multiple SBICs based on the 5 percent capital limit for bank investments to diversify company and fund manager exposure.
  3. Seek the advice of financial advisory firm.

Being conservative doesn’t mean not doing anything new, it means constantly trying to find ways to decrease risk. Any time one can reduce risk and increase profitability, it should be strongly evaluated.