Managing Interest Rate Risk With Stronger Governance

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Many banks were caught off guard by the rapid pace of interest rate hikes over the past year. Now that the initial shock has hit, bank directors are questioning how to manage interest rate risk better and prepare for disruptions.

While rising rates are part of market cycles, rates rarely increase at their recent velocity. Between March 2022 and June 2023, the federal funds rate rose from 0.25% to 5.25%, a 500-basis point increase in less than 15 months.

A High Velocity Rise Caught Bank Leaders Off Guard
Not since the 1970s have rates increased at this pace in such a short time frame. Even in the cycle preceding the 2008 financial crisis, rates rose from 1% in 2004 to 5.25% in 2006 over 24 months. The latest interest rate hikes are steeper — and come at a time when banks were already awash in cash and liquidity. With excess cash, less loan demand and no place to park their money in recent years, many banks purchased securities, which historically have been a safe bet in such times.

But few boards were prepared for rates to increase so quickly. Since March 2022, continual increases in the federal funds rate have reduced the value of banks’ fixed-rate assets and shortened the maturity of their deposits. Two bank collapses in March 2023 demonstrated how quickly interest rate risk can grow into a liquidity risk and reputation risk.

Bank Directors Can Focus on Strong Governance, Risk Mitigation
Now that they have experienced an unprecedented event, bank directors are questioning what they can do to prepare for future interest rate shocks. But banks don’t necessarily need new risk management strategies. What they should do now is use the risk-mitigating levers available to them and act with strong governance.

Most banks already have asset-liability management committees that meet quarterly to stress test the balance sheet with instantaneous shocks, ramps and nonparallel yield curves. While going through the motions every quarter might appease regulators, it won’t prepare banks for black swan events. Banks need to hold these stress-testing meetings more frequently and make them more than compliance exercises.

In addition, bank directors should review assumptions used in their asset-liability management report packages. Some directors take these assumptions at face value without questioning how they were calculated or if they reflect reality. Yet the output of a model is only as good as the integrity of its underlying conventions or specifications.

Additional Strategies Require a Focus on Execution
Repricing products, changing product mix or employing derivatives can be other effective tools for managing risk. But again, the key is in execution. Some banks fear alienating customers or the community by repricing or changing products that are safer for the bank but might not be preferred by the customer. For example, some institutions prefer to book fixed-rate loans to meet customer demand, even though floating-rate loans might help the bank better manage risk.

While derivatives can add risk if not properly understood and managed, they can be a highly effective tool to manage interest rate risk if used early in the cycle. Once rate changes are underway, a derivative might no longer be helpful or might be cost-prohibitive.

Even as the Federal Reserve contemplates its next move, bank directors can look at the recent past as a learning experience and an opportunity to better prepare for the future.

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.