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.

Core Processing? Find the Aces Up Your Sleeve

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Outsourced core processing usually represents regional and community banks’ most significant — and most maligned — contractual relationship. Core technology is a heavy financial line item, an essential component of bank operations and, too often, a contractual minefield.

But contrary to popular belief, it is possible for banks to negotiate critical contractual issues with core processing providers. No matter their size, banks can negotiate both the business and legal terms of these agreements. Technology consultants and outside legal counsel can play impactful, complementary roles to help level the playing field. Be certain that your bank is well advised and allocating adequate resources to these matters.

Critical Contractual Issues
From a legal angle, we at BFKN routinely look at and comment on dozens of separate points in a typical agreement — some of which are of critical importance as the arrangement matures. We have favorably revised termination penalties, service levels and remedies, the definition and ownership of data, caps on annual fee increases, limitations of liability, information security and business continuity provisions, ongoing diligence and audit rights, deconversion fees and the co-termination of all services and products, among many other items.

Exclusivity provisions which prevent banks from securing competing products without incurring penalties are also a focus for many organizations seeking to futureproof their core processing; a vendor reserving exclusivity, whether outright or through volume minimums, can hinder the bank’s ability to innovate.

Engaging External Resources
Banks are generally at a disadvantage in vendor contract negotiations, given that vendors negotiate their forms frequently against many parties and banks do not. Fortunately, there is a robust industry of technology consultants, of varying degrees of competence and quality, that work specifically in the core processing and technology vendor space. Most banks should engage both technology consultants, which can tackle the practical and business angles of the vendor relationship, and outside legal counsel, to focus on legal and regulatory concerns.

When considering whether to bring in outside advisors, executives at institutions considering a change in their vendor or approaching a renewal or significant change in their core processing services should ask the following questions:

  • Has the bank thoroughly evaluated its existing relationship and potential alternatives?
  • Would it be helpful to have an outside consultant with a perspective on the current market review the key business terms and pricing considerations?
  • Is the bank confident that the existing agreement sufficiently details the parties’ legal rights and responsibilities? Could it benefit from an informed legal review?
  • If considering an extension of an existing relationship, can any proposed changes be addressed sufficiently in an amendment to the existing contract, or is it time for a full restatement (and a full review) of the documentation?
  • Are there strategic considerations, such as a potential combination with another entity or the exploration of a fintech venture, that may raise complex issues down the line?

Leveraging Internal Resources
Dedicating the right internal resources also helps banks ensure that they maximize their leverage when negotiating a core processing agreement. As a general matter, directors and senior management should have an ongoing familiarity with the bank’s vendor relationship. For many, this can seem a Herculean task. Core processing contracts often span hundreds of pages and terms are gradually added, dropped and altered through overriding amendments. Nevertheless, by understanding, outlining, and tracking key contractual terms and ongoing performance, directors and senior management can proactively assess the processor and apprise its limitations.

This engagement can result in better outcomes. Are there any performance issues or problems with the bank’s current vendor? If a provider is falling short, there may be alternatives. Diverse technology offerings are introduced to the market continually. Of course, establishing a new relationship can be a painstaking process, and there are risks to breaking with the “devil you know.” Yet we are having more conversations with banks that are exploring less-traditional core technology vendors and products.

Short of a wholesale switch of vendors and products, it is possible for banks to negotiate for contractual protections against a vendor’s limitations. And even if senior management takes the lead in negotiating against the vendor, directors can play a valuable role in the negotiation process. We’ve seen positive and concrete results when the board or a key director is engaged at a high level.

If it’s time to start negotiating with a core processing provider, don’t leave your chips on the table. Fully utilizing both internal and external resources can ensure that the bank’s core processing relationship supports the bank for years to come.

Banks Inherited a Wholesale Balance Sheet During the Pandemic. Here’s What to Do.

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Bank managements and directors must recognize how cash has changed significantly over the past seven quarters, from the fourth quarter of 2019 to the third quarter of 2021. The median cash-to-earning assets for all publicly traded banks has grown to 10% in recent quarters, up from 4% pre-pandemic. This is a direct impact of the Covid-19 pandemic on deposit flows from government stimulus and the reluctance to deploy cash in a time of historically low interest rates.

The result is a healthy “wholesale” balance sheet that is separate and distinct from banks’ normal operations. This must be factored into growth plans for 2022 and 2023. We think it may take several quarters to properly deploy the excess liquidity. Investors already demand faster loan growth and their tolerance towards low purchases of securities may wane. The pressure to take action on cash is real, and it should be seen as an opportunity and certainly not a curse. We see excess cash as a high-class problem that can be met with a successful response at all banks.

We expect financial institutions will become far more open about their two balance sheet positions in the near future. First, let’s talk about the “normal” operation with stated goals and objectives on growth (e.g. loans, earnings per share and returns on tangible equity). Next, segment the “wholesale” balance sheet, which contains the cash position and any extra liquidity in short-term securities. Using our industry data above (10% cash in earning assets, up from 4% pre-pandemic), a $3 billion community bank has $300 million in cash instead of the usual $120 million it carried two years earlier — this establishes a $180 million wholesale position. Company management should directly communicate how this separate liquidity will be used to enhance earnings and returns in future quarters. Likewise, boards should stay engaged on how this cash gets utilized within their risk tolerance.

Late in the fourth quarter of 2021, certain company acquisitions disclosed the use of excess cash as a key rationale of the deal. An example is Ameris Bancorp, whose executive team stated in its December 2021 purchase of Balboa Capital that the transaction was funded by excess cash. Back in May 2021, Regions Financial (which is neutral-rated by Janney) acquired EnerBank with a home improvement finance strategy that would deploy its liquidity into new loans. Regions has since completed additional M&A deals with the same explanation. Many more small M&A transactions seem likely in 2022 using cash deployment as an underlying theme.

It has been my experience for three decades as an equity analyst that banks miss chances to explain their strategy in a succinct yet powerful manner. Remaining shy under the pretense of conservatism does not generally reward a higher stock valuation. Instead, banks who are direct and loud about their strategy (and then execute) tend to be rewarded with a stronger stock price. Hence, it is a far better idea to express a game plan for cash and a bank’s distinct “wholesale” balance sheet.

The current cash positions (which produced little to no earnings return in prior quarters) are now a superb opportunity to make a difference with investors. We encourage banks to be direct on how they will utilize excess cash and liquidity separate from their existing operations. The Janney Research team estimates banks can generate nearly a 10% boost to EPS by 2023 from managing excess cash alone. This is separate from any benefit from higher interest rates and Federal Reserve policy shifts that may occur.

Outlining a cash strategy in 2022 and 2023 is a critical way to differentiate the bank’s story with investors. Bank executives and directors must take advantage of this opportunity with a direct game plan and communicate it accordingly.

Why Every Basis Point Matters Now

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derivatives-2-17-17.pngAfter eight years of waiting for interest rates to make a meaningful move higher, the fed funds rate is making a slow creep towards 2 percent. With a more volatile yield curve expected in the upcoming years and continued competition for loans, net interest margins (NIM) may continue to compress for many financial institutions. The key to achieve NIM expansion will involve strong loan pricing discipline and the full toolkit of financial products to harvest every available basis point.

Where to look on the balance sheet? Here are some suggestions.

Loan Portfolio
The loan portfolio is a great place to look for opportunities to improve the profitability. Being able to win loans and thus grow earning assets is critical to long-term success. A common problem, however, is the mismatch between market demand for long-term, fixed rate loans and the institution’s reluctance to offer the same.

Oftentimes, a financial institution’s interest rate risk position is not aligned to make long-term, fixed rate loans. A few alternatives are available to provide a win-win for the bank and the borrower:

  • Match funding long-term loans with wholesale funding sources
  • Offer long-term loans and hedge them with interest rate swaps
  • Offer a floating rate loan and an interest rate swap to the borrower and offset the interest rate swap with a swap dealer to recognize fee income upfront

With the ability to offer long-term fixed rate loans, the financial institution will open the door to greater loan volumes, improved NIM, and profitability.

How much does a financial institution leave on the table when prepayment penalties are waived? A common comment from lenders is that borrowers are rejecting prepayment language in the loan.

How much is this foregone prepayment language worth? As you can see from the table below, for a 5-year loan using a 20-year amortization, the value of not including prepayment language is 90 basis points per year.

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At a minimum, financial institutions should look to write into the loan at least a 1- to 2-year lock out on prepayment, which drops the value of that option from 90 basis points to 54 basis points for a 1-year lock out or 34 basis points for a 2-year lock out. That may be more workable while staying competitive.

Investment Portfolio
The investment portfolio typically makes up 20 percent to 25 percent of earning assets for many institutions. Given its importance to the financial institution’s earnings, bond trade execution efficiency may be a way to pick up a basis point or two in NIM.

A financial institution investing in new issue bonds should look at the prospectus and determine the underwriting fees and sales concessions for the issuance. There are many examples in which the underwriting fees and sales concessions are 50 to 100 basis points higher between two bonds from the same issuer with the same characteristics, with both issued at par. To put that in yield terms, on a 5-year bond, the yield difference can be anywhere between 10 and 20 basis points per year.

If you are purchasing agency debentures in the secondary market, you can access all the information you need from the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE) to determine the mark up of the bonds you purchased. Using Bloomberg’s trade history function (TDH), in many cases, it is easy to determine where you bought the bond and how much the broker marked up the bond. Similar to the new issue example above, a mark-up of 25 to 50 basis points more than you could have transacted would equate to 5 to 10 basis points in yield on a 5-year bond.

For a typical investment portfolio, executing the more efficient transactions would increase NIM by 1.5 to 5 basis points. For many institutions, simply executing bond transactions more efficiently equates to a 1 percent to 3 percent improvement in return on assets and return on equity.

Wholesale Funding
A financial institution can use short-term Federal Home Loan Bank (FHLB) advances combined with an interest rate swap to lock in the funding for the desired term. By entering into a swap coupled with borrowing short-term from the FHLB, an institution can save a significant amount of interest expense. Here is an example below:

borrowing-chart.PNG

Derivatives
As you can see from a few of the previous examples, derivatives can be useful tools. Getting established to use derivatives takes some time, but once in place, management will have a tool that can quickly be used to take advantage of inefficient market pricing or to change the interest rate risk profile of the institution.

Number of Community Banks Using Derivatives, by Year

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Conclusion
In a low interest-rate environment and with increased volatility in rates across the yield curve, net interest margins are projected to continue to be under pressure. The above suggestions could be crucial to ensuring long-term success. Offering longer-term loans and instilling more efficient loan pricing is the start to improved financial performance.