Hedging Interest Rate Risk

Tom Farin, Chairman of the Board, Farin & Associates, Inc.

Q. What is the most effective way to hedge interest rate risk?

A.
Last week, for the zillionth time, I was asked whether community institutions should use SWAPs to hedge their interest rate risk. “After all, the big banks use them, shouldn’t we?” Let’s review for a second what a SWAP is and why big banks use them.  

Like community institutions, big banks need to do a reasonable job of matching the duration of their funding to the duration of their assets. Say you need to hedge a book of five-year duration assets. You could go out and attempt to raise five-year duration funding. If that funding was five-year CDs, you’d have two problems.  

First, customers don’t want to go long at the bottom of the rate cycle. So you’d need to bribe them with rates, which may be significantly above wholesale funding rates. Second, your early withdrawal penalties are probably insufficient to hold onto that funding in a rising rate environment of any significance. So we’re paying above wholesale rates for deposits that may not provide the hedge when we need it the most.

Big banks realize this, so they look for where deposit funding is cheap relative to the wholesale curve. Say that’s at the one-year point of the curve. Then they execute an interest rate swap to move the duration of that one-year funding out to five years. The swap pays the institution the one-year rate and charges the institution the five-year rate, locking in that rate for five years. The institution pays a fee for the swap based on the notional principal amount of the SWAP. It also pays (or receives) the difference between the one- and five-year rate. The penalty problem with the five-year CD goes away as early withdrawals on one-year CDs are less frequent and less painful than early withdrawal penalties on five-year CDs.

With an interest rate SWAP, you are buying an insurance policy. You pay a premium (the fee). The protection bought is the fact that as the one-year rate rises in a rising rate environment, the increased income from the one-year side of the swap covers the increase in interest expense as the one-year CD rolls over at a higher rate. Between the short-term funding and the SWAP, you’ve locked in a five-year rate. The downside for a community bank is that swaps can be expensive (insurance premium), and there are a fair amount of accounting and regulatory issues associated with their use. This raises the issue of whether a SWAP is the most cost-effective insurance policy (hedge).

This is a very relevant issue to community institutions as you have a number of other ways to hedge the interest rate risk. For example, you could take out a FHLB Advance with a duration of five years. The advance will effectively hedge the risk in the five-year asset at a small spread over five-year Treasury rates. Of course, that means the advance is more expensive than the one-year CD. In this case, the insurance premium is the difference between the one-year rate and the five-year rate. The protection is that your cost of funds is locked in for the duration of the asset it is used to fund.  

Aside from a high funding cost, there may be some additional issues associated with the FHLB Advance. First, regulators are not big fans of wholesale funding. So employing advances on a large scale to fund long-duration assets may bring you some unwanted regulatory attention and will push you closer to policy limits on the use of wholesale funding, reducing the borrowing capacity available to you in a liquidity stress event. Second, you may not need the funding as you currently have excess liquidity. Finally, borrowing from the FHLB when you have excess liquidity will grow the bank, reducing capital ratios.

Role of Non-Maturity Deposits in Hedging Interest Rate Risk

Wouldn’t it be nice to find a hedge that pays you the premium rather than you having to pay the premium? “That’s silly, Farin. Insurance policies don’t pay you a premium while providing protection.” There is one exception to that general rule.

Non-maturity deposits are another potential funding source for long-term assets. “Wait a second, Farin, the contract says immediately repricable and immediately withdrawable.  That is short-term variable rate funding. I’d still have to swap it to fund a long-term asset.”  Maybe so, maybe not!

You have had someone do a core deposit study for your shop, right? If the core deposit study is well executed, you will have three outputs on various categories of non-maturity deposits: pricing betas, surge balances and decay rates. Pricing betas tell you how much of the change in market rates you passed along to the customers in the past. Here is a set of pricing beta averages we pulled together about 18 months ago based on looking back on studies we had performed on community institutions where we felt we had good data.  These betas are averages from those 20 studies. This is by no means an industry average study. Please don’t input these averages into your A/L model. Rather, they are here to illustrate some key points.

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Since 1985, Farin & Associates has been a leader in providing financial analysis and consulting services. We deliver balance sheet management and earnings improvement solutions to banks and thrifts, nationwide. FARIN’s services include, capital planning services, in-house and out-sourced Asset Liability Management solutions, core deposit analysis, retail deposit & loan pricing programs, consulting, and CPE-approved education webinars/workshops.

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