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BirdsEye View

hedging bank interest rate risk in a supercommunity bank: an opportunity or a mistake?

In 2004, one could not find a self-confessed liability-sensitive bank. Almost all banks reported anticipated margin expansion with rate increases, given their balance sheet asset sensitivity. As we all know, this did not come to pass, and many more banks have experienced margin compression and further pressure with rising rate sand an inverted yield curve.

As rates threaten to start declining, I suspect the number of self-professed liability-sensitive banks will increase greatly. For those few asset-sensitive banks that are concerned about the impact of declining rates on your margin, this article is for you. It is co-authored by Steve Raffaele, the CFO of Sterling Bank in Houston, whose contribution to the content is invaluable. The article is a heavy one, I know, but it does tackle a central issue for banks' profitability in 2007. We will follow it by a Hedging Interest Risk Part Deux, which will address the risks associated with this activity and suggest some mitigation strategies.

CFOs and risk managers, I'd love your comments on the article below and its sibling, to appear within the month.

Grab a Coke, Iced tea, or a beer, and enjoy!

Hedging Bank Interest Rate Risk in a SuperCommunity Bank: An Opportunity or a Mistake?
  1. Is now the right time to hedge net interest margin?
    1. Current Fed cycle is aged

      The interest rate environment in the past five years has been without precedent. Since June of 2004, the Federal Reserve has increased short term interest rates 17 times and 425 basis points from a historical low in the Fed Funds rate. These changes have wreaked havoc on many banks' margins both on the way down in 2000 - 2004 and on the way up during the past two years. Banks, investors and analysts alike are asking, "What's next?" There are always many conflicting signals that impact the economic conditions and inflation expectations that drive Federal Reserve Board policy, and Fed Watching isn't banks' favorite sport. The question is, as the yield curve makes a seismic move, do banks of all sizes have options to protect their net interest margins going forward? In the past, non mega banks did not consider hedging as an alternative. They lacked the expertise to be effective at hedging and were loath to be at the mercy of the investment banks that live and breathe these markets every day. The purpose of this article is to review a few of the alternatives that are available to the majority of banks in the US who wish to manage their net interest margins beyond the basic funding and loan pricing strategies.

      This article isn't about advocating hedging; rather, it centers on reducing the feeling of helplessness that too many bank CEOs and CFOs have experienced in these uncharted waters and recognizes a few of the tools that are available in the marketplace to help them manage through future turmoil in the interest rate environment.

      This is particularly relevant as many investors are now suggesting that the current cycle of Fed tightening is poised to turn sometime in the next year, possibly as soon as the first quarter of 2007. History is on the side of those who say "the end is near" and that lower short term rates are on the horizon. If history repeats itself, the lagged effect of previous rate increases will likely mean that the Fed goes too far. In the last 4 tightening cycles, the next cycle easing started 5 months later on average.

    2. Asset sensitive banks need to prepare

      When a new cycle of Fed easing does start again, asset sensitive banks are faced with potential erosion in their net interest margin. Many of these banks are still recovering from the interest rate environment of December 2000 to June 2003 when the Fed Funds Target Rate moved down 550 basis points in response to Fed concerns about a weakening economy. Coming out of this period, the industry saw companies take very public write-downs and even get sold as decisions made in response to margin pressures came home to roost. For almost all asset sensitive banks, this last cycle of declining short term rates and margin compression meant significant pressure on earnings, especially with deposit rates effectively floored out. Banks were faced with hard choices about compensation costs, product pricing and capital expense budgets. Most SuperCommunity banks managed through the last two rate cycles and have now benefited from higher short term rates in spite of the flat yield curve.

      While the net interest margin may not be back to where it was in late 2000, asset sensitive banks are now typically operating within a net interest margin range that will sustain their business and yield sufficient profits. Having endured the lowest Fed Funds rates ever and then enjoyed the subsequent benefit of an upward drive in short term rates, no asset sensitive bank wants to go back to a low short term rate environment, flat yield curve or not, unprepared.

  2. How does hedging compare to other options?

    Asset sensitive SuperCommunity banks have several options for protection against another period of declining short term interest rates where revenue decelerates due to net interest margin compression. Now is the time to review them and make decisions about the costs/benefit tradeoffs they represent, potentially avoiding the pressure to mortgage the banks' future for the sake of current earnings.

    1. On-balance Sheet Options - Restructure Assets and Liabilities

      The first option is to shift the duration and repricing characteristics of on-balance sheet assets and/or liabilities. Extending the duration of assets, such as loans or investments by lengthening maturities or by tilting the mix toward more fixed rate and reducing the effective duration of borrowings and interest bearing deposits by shortening maturities and creating additional repricing opportunities as short term rates move downward is a viable option. The result of either or both of these combinations, would be to increase net interest spread as short term rates moved lower and the yield curve steepened -- with liabilities repricing lower and asset yields remaining relatively stable.

      In the case of loans and deposits, product and pricing strategy can be shifted to direct customer flows to targeted durations. Wholesale financial alternatives include the use of leverage with short term borrowings, the addition of longer maturity municipal bonds to the HTM portfolio, the purchase of fixed rate mortgage related securities, agencies or loan participations, as well as the use of various combinations of short term or variable rate borrowing alternatives.

      Pros: Able to addresses risk exposure using familiar products with less policy risk

      The primary benefit of on-balance sheet responses to shifting of interest rate risk is general familiarity with the tools that are used. Changes in allocations to loans, investments, deposits and borrowings are likely covered by existing policy or various board or management committee processes. Likewise, implementation of these strategies is typically within the current confines of Sarbanes process flows, authorization limits, accounting policy and financial controls. In the case of new asset classes or products, while explanation and analysis would still be required, both management and the board would typically consider these types of activities as extensions of what the bank is already doing on a daily basis as opposed to something completely unusual or new.

      Cons: May require a long term commitment, require changes in customer behaviors, bank products, pricing strategy and may increase leverage, optionality and balance sheet complexity.

      The main disadvantage of on-balance sheet interest rate risk management strategies are that they generally involve longer term commitments, are imprecise due to embedded options that are driven by borrower actions and, where loans and deposits are involved, may shift employee or customer behavior. The average maturity of loans and investments may extend beyond the next likely interest rate cycle; and, depending on the shape of the curve, may ultimately be held at a loss. In addition, prepayment speeds are a function of a combination of factors, not the least of which is refinancing alternatives, that may substantially alter the effectiveness of this strategy. We all know that customers like to fix rates in a rising rate environment and then shift them to variable as rates decline. They might not cooperate with our balance sheet restructuring strategy, no matter how convincing loan officers and retail bankers are.

      Lastly, the use of pricing to influence customers product flows has an impact not only on the balance sheet, but also on the bank's culture and reputation. Depending on where these customers come from and the training of the bank's sales force, the bank's message itself can be altered. In spite of the fact that the products and terms of on-balance sheet tools are, ostensibly, easily understood, the optionality that is created, both financially and behaviorally, may be hard to measure or manage and, worse yet, may introduce new risks beyond those targeted by the strategy alone.

    2. Hybrid Alternatives - Execute Structured Funding Transactions

      A second strategy for altering interest rate risk is to embed derivatives in on-balance sheet funding arrangements such as structured repurchase agreements or FHLB advances. These financings are typically structured through either a securities dealer or the FHLB. By means of shifting potential borrowing costs, the bank is effectively able to purchase interest rate risk "insurance" to moderate the impact of lower short term rates on net interest margin.

      Using the example of structured repo with an embedded floor (only one embedded option), the bank would pledge collateral for variable rate funding tied to an index. The spread to the index would then be determined by the historical volatility of the index, the maturity of the borrowing and the strike rate for the floor on this index. Initially, all-in borrowing costs would be higher than non-structured (optionless) wholesale borrowings, but as short term rates continued decline and eventually the index dropped below a predetermined rate (the strike price on the floor), funding costs would then decline at an increasing rate. As a result, during a Fed easing cycle, the bank would potentially offset margin compression with wholesale funding costs well below levels where the bank would have otherwise been borrowing.

      Pros: Addresses risk exposure & funding needs in a direct manner without policy risk

      The primary advantage of structured borrowings is that financing arrangements can be customized using embedded derivatives such that the bank makes efficient use of pledgable securities to meet both its funding needs and interest rate risk profile objectives – without the need to account for these derivatives on a separate, stand alone basis. Because the borrowings are secured and the embedded derivative is considered "clearly and closely related" to the host contract, the derivative does not have to be bifurcated from its host (the repurchase agreement) and marked-to-market with changes in its value potentially run through earnings. Derivatives that are commonly embedded in these structured collateralized borrowings include: caps, floors, puts, calls and swaptions – the combination of which depends on the bank's desired funding cost and risk profile. In addition, to the extent that the bank is selling optionality within the contract(s), absolute funding cost levels in structured borrowings can be designed to be lower than straight wholesale borrowings.

      Cons: Higher relative cost, collateral considerations, reduced flexibility

      One disadvantage of structured repurchase agreements is that a detailed analysis of the instrument is required in order to determine whether the embedded derivative should be bifurcated and accounted for separately from the host (i.e., measured and displayed separately on the balance sheet). Unfortunately, there are financial products currently available that claim to provide the benefits of derivative features without the accounting burden when, in fact, they do not meet the standards and do require separate accounting.

      Another disadvantage of structured repurchase agreements is that they require the use of investment portfolio collateral and that the dealer involved looks to make money on each component in the transaction. As a result, structured borrowings often contain a slightly higher straight cost of funds (were no options sold by the bank) and that the embedded derivative is relatively expensive when compared to stand alone off-balance sheet derivatives. In addition, if a structured repo transaction represents a marginal increase in borrowings for the bank and is not required at any time for funding core lending activities, the bank is effectively leveraging up in addition to embedding interest rate insurance in its borrowings. Lastly, like an insurance policy, the premium may be spent and no loss ever realized.

    3. Do Nothing - Accept the Risk

      The third option is to do nothing and accept the risk and optionality embedded in the balance sheet.

      Pros: No transactional cost or added complexity

      The advantage of doing nothing is that the bank has made a decision based on a rate outlook that involves no transaction costs or incremental complexity. If rates stay within a certain range wherein the balance sheet continues to generate the kind of margin and earnings that will sustain the bank's business model, no change to strategy is a legitimate option.

      Cons: Does not address risk exposure and policy exceptions, not to mention margin compression and feeling like a sitting duck

      The disadvantage of doing nothing is that it becomes a de facto bet on rates and does not address the scenarios that are not on the radar screen for management, but are likely of concern from the perspective of policy limits and enterprise risk management – such as the potential that interest rates decrease by an order of magnitude when the management (or board) discussion is focused on flat to increased rates.

    4. Off-balance Sheet Options - Execute Derivative Transactions

      The fourth option is to execute stand alone derivative contracts. As such, there are a number of alternatives for off-balance sheet hedging of the interest rate risk associated with a declining short term rate environment, these include: receive fixed swaps, purchased floors, interest rate collars, selling bond puts and buying bond calls.

      Using the example of a floor, the bank would select the index level (e.g., WSJ Prime) below which the bank's net interest margin would start to be increasingly impacted in a negative fashion. An interest rate floor is a contract that pays the bank if interest rates fall below a pre-determined "strike" rate, in exchange for an upfront premium. In this case, the floor would be a stand alone contract (again, very much like an insurance policy) specifically designated as a hedge against the risk that Prime-based floating rate loan interest cash flows would decline significantly during a period of decreasing short term rates. The cost of the floor (the upfront premium) would then be determined by the historical volatility of the index, the maturity of the contract, and the strike rate on the index below which the counterparty would pay according to the floor contract; and this cost would then essentially be amortized over the life of the floor (if the requirements of hedge accounting under FAS 133 are met). As short term rates continued decline and eventually the index dropped below the predetermined rate (the strike price on the floor), the counterparty would pay the difference between the floor strike rate and the current interest rate according to the contract. As a result, during a Fed easing cycle, the bank would potentially offset margin compression with interest income offsets it receives from the floor.

      Using another example, in the case where the yield curve is not inverted, the bank might benefit more from entering into a receive-fixed swap. An interest rate swap is a contract between two parties committing one party to pay an agreed to fixed rate and the other party to pay a variable rate based on an index such as Prime or Libor. A swap would provide an immediate benefit to the bank's margin as well as immediate margin protection against lower short term rates. However, should short term rates rise, the swap would moderate the bank's margin upside due to its effectively higher concentration in fixed rate interest income. Similar to the floor example, the swap could be designated as a cash flow hedge against an underlying pool of Prime-based loans.

      Pros: Addresses risk exposure in an efficient, direct and timely manner with no impact on employees and customers

      The advantage of stand-alone derivatives is that the bank can surgically tailor a hedge that is specific to the bank's interest rate risk profile, timeframe, rate outlook and budget. Because these hedge contract(s) stand alone and are fairly standardized, the bank can run a competitive pricing process that is transparent and that has no impact on customers or employees. Using the insurance analogy, the cost of insurance and means for obtaining it are unbundled and operationally efficient.

      Cons: Increased operational and accounting complexity and adds costs that may not be recouped, plus accounting and policy risk (can you read "restatement?")

      The primary disadvantages of off balance sheet hedging are the risks associated with the application of complex accounting standards and the associated operational burden that results from more extensive analysis, modeling, execution, documentation and monitoring of the transaction - all in the context of an environment with higher standards for materiality, restatement of financial results, board oversight and financial controls. Once again, like an insurance policy, the premium may be spent while no loss is ever realized.

      To summarize these four alternatives:

      Strategy Comparison On-Balance Sheet Hybrid Alternative Do Nothing Off-Balance Sheet
      Accounting Risk Low Low None Moderate to High
      Operational Risk Low Low None Moderate to High
      Cost Low to High Moderate to High None Low
      Effectiveness Low to Moderate High None High

      In all four cases, interest rate risk should be assessed and monitored in an intensive fashion before and after the bank selects a strategy. However, given the current rate environment and shape of the curve, off balance sheet hedging with floors, collars, or swaps is a particularly viable strategy right now for asset sensitive banks due to the following factors:

      • Prime based derivatives are available in the market to hedge Prime based loan interest cash flows that may decline in the coming months.

      • Availability of cash flow hedge accounting treatment under FAS 133 wherein changes in the fair market value of the collar/floor do not run through the income statement but rather, like gains and losses in the AFS investment portfolio, through Other Comprehensive Income in the Equity section of the balance sheet.

      • Lower absolute cost of floor premiums as a result of significantly lower volatility since late 2004, which can be can often be offset by premium income from the sale of a cap (which creates a collar). Premiums paid for floors and/or collars can be amortized over the life of the contract(s) based on the floorlet/collarlet amortization schedule prepared at the time the hedge is entered into.

    In the second installment of this two-part article we will discuss hedging risks and benefits for asset sensitive banks.