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 2022 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.

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.

Going Up? Elevating Loan Yields With Swaps

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What a difference a year makes. Spring 2020 was like nothing we had ever seen: scheduled gatherings were cancelled and economic activity came to a screeching halt.

Yet today, after a year highlighted by social distancing, lockdowns and restrictions, there is a sense of anticipation that feels like a wave of pent-up demand ready to break-out, much like the buds on a flowering tree. Loans last year saw the prime rate plunge to 3.25% from its recent peak of 5%, as the Federal Reserve pushed its target back to zero to help keep the economy afloat. Banks and credit unions that built up significant portfolios of variable-rate loans experienced the pain of this unexpected rate shock in the form of margin compression.

But as flowers begin to bloom this spring, there is very little hope that short-term rates will follow suit. The Federal Open Market Committee signaled at its mid-March meeting that it expects to maintain a near-zero Fed Funds target all the way through 2023 with a goal of seeing inflation rise to more normal levels. For lenders holding floating-rate assets, waiting until the 2024 presidential primary season to experience any benefit from higher yields might seem unbearable. And with the sting of last year’s free fall still fresh, the prospect of slow and steady quarter-point bumps thereafter is not appealing.

Interestingly, there is a different story playing out when we examine the yields on longer-dated bonds. Because inflation erodes the future value of fixed-income coupon payments, bond market investors have grown nervous about the Fed’s increased desire and tolerance for rising prices. Consequently, while short-term rates have remained anchored, 10-year bond yields have surged by a full percentage point in less than six months, creating a sharply steeper yield curve. This is excellent news for asset-sensitive institutions that have interest rate hedging capabilities in their risk management toolkits. Rather than simply accepting their fate and holding onto low-yielding floating-rate assets in hopes the Fed will move earlier than expected, banks with access to swaps can execute a strategy that creates an immediate positive impact on net interest margin.

To illustrate, consider an asset-sensitive institution with a portfolio of prime-based loans. Using an interest rate swap, the lender can elect to pay away the prime-based interest payments currently at a 3.25% yield and receive back fixed interest payments based on the desired term of the swap. As of March 23, 2021, those fixed rates would be 3.90% for 5 years, 4.25% for 7 years, and 4.50% for 10 years. So, with no waiting and no “ramp,” the loans in question would instantly increase in yield by 0.65%, 1% or 1.25% for 5, 7 and 10 years, respectively, once the swap economics are considered.

The trade-off for receiving this immediate yield boost is that the earning rate remains locked for the term of the swap. In other words, when prime is below the swap rate (as it is on Day One) the lender accrues interest at the higher fixed rate; when prime exceeds the swap rate, the lender sacrifices what is then the higher floating-rate yield.

This strategy uses a straightforward “vanilla” interest rate swap, with a widely used hedge accounting designation. For banks that have avoided balance sheet hedging due to complexity concerns, an independent advisor can help with the set-up process that will open the door to access this simple but powerful tool.

In the days following March 2020 we often heard that “the only thing certain in uncertain times is uncertainty.” With swaps in the toolkit, financial institutions have the power to convert uncertain interest flows to certain, taking control of the margin and managing exposure to changing interest rates in a more nimble and thoughtful manner.

The Three C’s of Indirect Swaps

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Twenty years ago, there were 8,000+ banks; today there are less than 5,000, but competition hasn’t slowed.

Not only are banks competing with other banks for loans, they are also competing for investor dollars. There’s pressure to grow and to do so profitably. It is more important than ever that banks compete for, and win, loans.

Competing for the most profitable relationships requires banks to meet borrower demand for long-term, fixed-rate debt. But that structure and term invites interest rate risk. What can banks do? What are their competitors doing?

Banks commonly use derivatives to meet customer demand for fixed-rate loans, but opt for different approaches. The majority of banks choose a traditional solution of offering swaps directly to borrowers; however, some community banks choose to work with correspondent banks that offer indirect swaps to their borrowers.

With indirect swaps, the correspondent bank enters an interest rate swap with the borrower — sometimes called a rate protection agreement. The borrower is party to a derivative transaction with the correspondent bank; the community bank is not a direct party to the swap.

Indirect swaps are presented as a simple solution for meeting customer demand for long-term fixed-rates, but community bankers should consider the three C’s of indirect swaps before using this type of product: credit, cost and customer.

Credit
A swap is a credit instrument that can be an asset or liability to the borrower, which means the correspondent bank requires security. The correspondent bank accomplishes this by requiring a senior position in the loan credit. In a borrower default, the correspondent bank has the first lien on the loan collateral.

In practice, the community bank makes the correspondent bank whole for the borrower’s swap liability. This means the community bank has an unrecognized contingent liability for each indirect swap.

Additionally, due to the credit nature of swaps, the correspondent bank must agree to the amount of proceeds, or the loan-to-value at which the bank lends. This has real-world implications for banks as they compete for loans.

Cost
While there are no out-of-pocket costs associated with putting the borrower into a swap with a correspondent bank, there are costs embedded in the swap rate that drives up the cost for the borrower and could potentially make the bank uncompetitive. These costs are often opaque — and can be significant.

Customer
A colleague of mine refers to indirect swaps as “swaps on a blind date.” It’s a funny but apt way of putting it. The borrower enters into a derivative with a correspondent bank that they have no relationship. And the borrower is accepting unsecured exposure as well: if the correspondent bank defaults and owes the borrower on the swap, they have no recourse except as an unsecured creditor.

A common theme of the three C’s is control. With indirect swaps, the community bank cedes control of the credit, they cede control of the cost of the swap and they cede control of the relationship with their customer. That’s why the majority of banks choose to offer swaps directly to their customers. Doing so allows them to manage the credit, including loan proceeds, and doesn’t subordinate the bank’s credit to a third party in the case of a workout. It allows the bank to own the pricing decision and control the cost of the swap to the borrower, making the bank’s loan pricing more competitive. It allows the bank to keep all aspects of the customer relationship within the institution.

Offering swaps to borrowers also opens the door for banks to use swaps as a balance sheet risk management tool. In this context, derivatives are an additional tool for the bank to manage interest rate risk holistically.

But what about the complexity of derivatives? How does an executive with little or no experience in derivatives educate the board and equip his/her team? How will swaps be managed? The majority of banks choose to partner with an independent third party to do the heavy lifting of educating, equipping, and managing a customer swaps program. A good partner will serve as an advisor and advocate, ensuring that the bank is fully compliant and utilizing best practices.

Indirect swaps may be simple — but a traditional solution of offering swaps directly to borrowers is a better way to meet customer demand for long-term fixed-rate loans.

Avoiding Pitfalls of Covid-19 Modifications for Swapped Loans

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Many banks are modifying commercial loans as they and their commercial borrowers grapple with the economic fallout of the Covid-19 pandemic.

Payment relief could include incorporating interest-only periods, principal and interest payment deferrals, and/or loan and swap maturity/amortization extensions. While modifications can provide borrowers with much-needed financial flexibility, they also risk creating unintended accounting, legal and economic consequences.

Don’t forget the swaps
Lenders need to determine whether there is a swap associated with loans when contemplating a modification. Prior to modification, lenders should coordinate efforts with their Treasury or swap desk to address these swapped loans, and ensure that loan and swap documentation are consistent regarding the terms of the modification.

Develop realistic repayment plans
Lenders need to consider how deferred obligations will be repaid when creating a temporary payment deferral plan. The lender may need to offer an interest-only period so a borrower can repay the deferred interest before principal amortization resumes, or deferred interest payments could be added to the principal balance of the loan. Lenders also should consider whether the proposed modification will be sufficient, given the severity of the borrower’s challenges. The costs associated with amending a swapped loan may convince a lender to offer a more substantive longer-term deferral, rather than repeatedly kicking the can down the road with a series of short-term fixes.

Determine whether swap amendment is necessary
The modified loan terms may necessitate an amendment of the associated swap. It may be possible to leave the swap in place without amendment if you are only adding an interest-only period, as long as the borrower is comfortable with their loan being slightly underhedged. But if you are contemplating a full payment deferral, it typically will be desirable to replace the existing swap transaction with a new forward-starting transaction commencing when the borrower is expected to resume making principal and interest payments.

Understand bank or borrower hedge accounting impact of loan modifications
Lenders often hedge the value of their fixed-rate loans or other assets through formalized hedging programs. A popular strategy has been to designate these swaps as fair value hedges using the shortcut method.

This method requires that the economic terms of the asset, such as amortization of principal and timing of interest payments, precisely match those of the hedge. A mismatch due to a loan payment deferral would cause the lender to lose the hedge’s shortcut status. The lender’s hedging program potentially could maintain hedge accounting treatment using the more cumbersome long-haul method if that mismatch scenario was contemplated in the hedge inception documentation.

Borrowers who have taken variable rate loans may have entered into swaps to gain synthetic rate protection. Restructuring  a hedge to defer payments alongside the loan’s deferred payments could jeopardize an accounting-sensitive borrower’s hedge accounting treatment. It is possible for the borrower to reapply hedge accounting under the amended terms, although the restart has additional considerations compared to a new un-amended hedge. If hedge accounting is not restarted, the derivative’s valuation changes thereafter would create earnings volatility per accounting rules. While borrowers should be responsible for their own accounting, lenders’ awareness of these potential issues will only help client relationships in these uncertain times.

Take stock of counterparty derivative exposure
As interest rates plunge to record lows, many lenders have seen their counterparty exposure climb well above initially-approved limits. Hedge modifications may further exacerbate this situation by increasing or extending counterparty credit exposure. We recommend that lenders work with their credit teams to reassess their counterparty exposure and update limits.

Accounting guidance also requires the evaluation of credit valuation adjustments to customer swap portfolios. Lenders should ensure that their assumptions about the creditworthiness of their counterparties reflect current market conditions. These adjustments could also have a material impact on swap valuations.

Hope for the best, plan for the worst
Hopefully, loan modifications will give borrowers the opportunity to regain their financial footing. However, some may face continued financial challenges after the crisis. Lenders should use the modification process to prepare for potential defaults. Loan deferments or modifications should provide for the retention of the lender’s rights to declare a default under the loan documents and any swap agreements. The lender, through consultation with its credit team, may want to take this opportunity to bolster its position through the inclusion of additional guarantors or other credit enhancements.

The economic fallout from the global pandemic continues to have a profound impact upon borrowers and lenders alike. Adopting a thoughtful approach to loan modifications, especially when the financing structure includes a swap or other hedge, may make the process a little less disruptive for all.  

When Rates are Zero, Derivatives Make Every Basis Point Count

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It’s been one quarter after another of surprises from the Federal Reserve Board.

After shocking many forecasters in 2019 by making three quarter-point cuts to its benchmark interest rate target, the data-dependent Fed was widely thought to be on hold entering 2020. But the quick onset of the coronavirus pandemic hitting the United States in March 2020 quickly rendered banks’ forecasts for stable rates useless. The Fed has acted aggressively to provide liquidity, sending its benchmark back to the zero-bound range, where rates last languished from 2008 to 2015.

During those seven years of zero percent interest rates, banks learned two important lessons:

  1. The impact of a single basis point change in the yield of an asset or the rate paid on a funding instrument is more material when starting from a lower base. In times like these, it pays to be vigilant when considering available choices in loans and investments on the asset side of the balance sheet, and in deposits and borrowings on liability side.
  2. Even when we think we know what is going to happen next, we really don’t know. There was an annual chorus in the early and mid-2010s: “This is the year for higher rates.” Everyone believed that the next move would certainly be higher than the last one. In reality, short-rates remained frozen near zero for years, while multiple rounds of quantitative easing from the Fed pushed long-rates lower and the yield curve flatter before “lift off” finally began in 2015.

The most effective tools to capture every basis point and trade uncertainty for certainty are interest rate derivatives. Liquidity and funding questions have taken center stage, given the uncertainty around loan originations, payment deferrals and deposit flows. In the current environment, banks with access to traditional swaps, caps and floors can separate decisions about rate protection from decisions about  funding/liquidity and realize meaningful savings in the process.

To illustrate: A bank looking to access the wholesale funding market might typically start with fixed-rate advances from their Federal Home Loan Bank. These instruments are essentially a bundled product consisting of liquidity and interest rate protection benefits; the cost of each component is rolled into the quoted advance rate. By choosing to access short-term funding instead, a bank can then execute an interest rate swap or cap to hedge the re-pricing risk that occurs each time the funding rolls over. Separating funding from rate protection enables the bank to save the liquidity premium built into the fixed-rate advance.

Some potential benefits of utilizing derivatives in the funding process include:

  • Using a swap can save an estimated 25 to 75 basis points compared to the like-term fixed-rate advance.
  • In early April 2020, certain swap strategies tied to 3-month LIBOR enabled banks to access negative net funding costs for the first reset period of the hedge.
  • Swaps have a symmetric prepayment characteristic built-in; standard fixed-rate advances include a one-way penalty if rates are lower.
  • In addition to LIBOR, swaps can be executed using the effective Fed Funds rate in tandem with an overnight borrowing position.
  • Interest rate caps can be used to enjoy current low borrowing rates for as long as they last, while offering the comfort of an upper limit in the cap strike.

Many community banks that want to compete for fixed-rate loans with terms of 10 years or more but view derivatives as too complex have opted to engage in indirect/third-party swap programs. These programs place their borrowers into a derivative, while remaining “derivative-free” themselves. In addition to leaving significant revenue on the table, those taking this “toe-in-the-water” approach miss out on the opportunity to utilize derivatives to reduce funding costs. 

While accounting concerns are the No. 1 reason cited by community banks for avoiding traditional interest rate derivatives, recent changes from the Financial Accounting Standards Board have completely overhauled this narrative. For banks that have steered clear of swaps — thinking they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help a board and management team separate facts from fears and make the best decision for their institution.

With the recent return to rock-bottom interest rates, maintaining a laser focus on funding costs is more critical than ever. A financial institution with hedging capabilities installed in the risk management toolkit is better equipped to protect its net interest margin and make every basis point count.

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

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derivatives-8-20-19.pngWe don’t buy products; we “hire” products to get a job done. For banks, interest rate swaps are often just the thing they need to accomplish their most important work.

As Harvard Business School Professor Theodore Leavitt famously said, “People don’t want to buy a quarter-inch drill. They want a quarter-inch hole!” For banks needing to balance the blend of fixed- and floating-rate loans and deposits on their books, no product gets the job done more effectively than an interest rate swap.

Yet, because swaps carry the label of derivative, many community banks are hesitant to engage them — similar to a first-time homeowner on a DIY project avoiding power tools due to fear of injury or lack of knowledge. To maintain peace of mind while accessing the power of interest rate derivatives, community banks should keep these five safety tips in mind:

1. Finding the Derivative
The most-compelling benefit of an interest rate swap is that everyone gets what they want: the borrower enjoys a 10-year fixed rate, the bank maintains a floating yield. If a program offers this benefit in a “derivative-free” package, there is likely an interest rate swap hiding beneath the surface.

Transparency is essential in creating a safe work environment. Maybe my bank is not a party to a derivative, but what about my Main Street borrower? Safety begins with understanding the mechanics and the parties to any rate swap that might be present.

2. Understanding Derivative Pricing
Because the parties that assist community banks with swaps are typically compensated by building extra basis points into the final swap rate, it is important to have a basic understanding of derivative pricing to remain injury-free. When it comes to swap rates, not all basis points are created equal.

Just like the price/yield relationship with a fixed-income security, the “price value” of each basis point in an interest rate swap is a function of both notional amount and maturity term. So, while an extra five basis points would amount to $2,250 on a $1 million swap for a 5 year/25-year commercial mortgage, the value of fees would grow to $40,000 if the five extra basis points were embedded into a $10 million loan with a 10 year/25-year structure. Community banks should understand the amount of compensation built into each transaction in order to remain out of harm’s way.

3. Documenting with ISDA
The International Swaps and Derivatives Association has been standardizing over-the-counter derivatives market practices for the past 40 years, since the infancy of swaps. One of its first projects was designing the document framework known today as the ISDA Master Agreement, or “The ISDA” for short. Sometimes maligned for its length and complexity, the ISDA is often overlooked as a valuable safety shield for community banks who value simplicity.

Although originally built “by Wall Street for Wall Street,” the ISDA is carefully designed to protect both parties in a derivative relationship, defines key terms and sets forth remedies for a non-defaulting party should the other party fail to perform. Since it is recognized across the globe as the industry-standard, engaging in swaps without the protection of the ISDA can be hazardous.

4. Determining Collateral for Counterparty Risk
Counterparty risk, or the risk that an interest rate swap provider will fail to honor its obligations in the contract, can be mitigated by holding cash or securities as collateral. Before 2008, large banks and dealers required community banks to post collateral to secure their risk but were unwilling to reciprocate. The resulting damage caused by the failure of Lehman Brothers Holdings led to a self-imposed shift in market practices, whereby collateral terms in most swap relationships today are bilateral. Community banks considering using derivatives should seize this opportunity to hold collateral as a precautionary measure for the unexpected.

5. Utilizing Hedge Accounting
Embracing the recently updated hedge accounting standard is the final key to reducing the risk and volatility associated with these tools. With recent changes, the Financial Accounting Standards Board has succeeded in delivering what it promises on the cover of its now-mandatory update to ASC 815: “Targeted Improvements to Accounting for Hedging Activities.” One key improvement that helps protect community banks is the added ability to hedge portfolios of fixed-rate assets. That, when paired with more flexibility in application, has transformed hedge accounting from foe to friend for banks.

By taking heed of these five safety tips, community banks and their boards of directors can confidently consider adding interest rate derivatives to their risk management tool kits.

Community Banks and Derivatives: Debunking the Four Biggest Myths

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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.

5m-1b-assets-chart.png

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.

1-2b-assets-chart.png

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.

2-5-b-assets-chart.png

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.

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.