Managing Interest Rate Risk In Loans

Interest Rate Risk Management at Banks

The Federal Reserve held off in raising rates at its November meeting, preferring to assess the results of the presidential election and allow time to make further progress on their twin goals of full employment and price stability.  Since that November meeting, the results of the presidential elections have convinced markets of future expected inflationary pressures resulting from fiscal stimulus in the form of tax cuts and increased government spending.  Furthermore, the Fed Chair’s dashboard of job data has continued to improve, and an indication of remaining slack in the economy points that of the nine indicators tracked by the dashboard, six are back to pre-recession levels, and three indicators are returning to those levels.  The most recent nonfarm payrolls met expectations, and the official unemployment rate fell to 4.6% (equaling the rate last seen in 2007).  The market is now pricing a near 100% probability of an interest rate increase in December and then an additional two to four hikes in 2017 (although the path of interest rates will be data dependent as often pronounced by the Federal Reserve).  Given this background, community banks are reviewing their strategies on loan pricing and structuring for 2017.  Last week we posted an article about how community banks should assess the benefits versus risks/costs of using hedges to manage risk.  In this post, we spell out hedging programs available to community banks and some possible pros and cons of each strategy.

Balance Sheet Versus Instrument Specific Hedging

 

One consideration for community banks that want to implement a hedge program is whether to use hedges on a balance sheet level or individual instrument level (like discreet loans, deposits or advances).  With a balance sheet hedge, a set of assets or liabilities are hedged.  With a loan level hedge, each loan is hedged individually.  Either strategy can use swaps, caps, floors or cancellable features for the hedges.  The biggest difference between the two strategies is that balance sheet hedges can be more efficient on execution and this efficiency typically starts at $10mm in notional volume on individual trades.  Loan level hedges can be as small as $500k in notional size, but execution pricing is less efficient.  There are advantages and disadvantages to each strategy as outlined in the table below that compares a hedge at the loan level compared to a hedge on a bank's balance sheet:

Bank swap or hedge at the loan level compared to the balance sheet

With our years of experience working with community banks, we find that loan level hedging is easier to analyze, understand, implement and account for.  We see banks (including regional and super-regional banks) prefer loan level hedging over balance sheet hedging.

Types of Loan Level Hedging

There are three general types of loan level hedging programs available to community banks.  In an embedded swap program the swap is executed on the back-end between the bank and a broker-dealer.  In a back-to-back swap program, two swaps are used, one with the broker-dealer and one with the borrower.  In an off-balance sheet program, another entity holds a derivative so that the bank does not carry the hedge and need not account for a derivative.  In the table below, we compare the advantages, disadvantages and best uses of an embedded balance sheet swap, a back-to-back swap and an off balance sheet (ARC-style) transaction. 

Comparison matrix of different hedge and swap methods

In our experience, the off-balance sheet hedge program is best suited for community banks, and that is why we designed such a program – called Assumable Rate Conversion (ARC) program.  We use ARC at CenterState Bank and offer the program to community banks across the country.  ARC puts the lender at an advantage over banks that do not have a hedging program, and ARC may also be superior to other hedging programs because of the ease of use for the borrower (documentation and billing is simpler and more understandable).  

Conclusion

In a future blog, we will consider some practical and recent applications by community banks of the ARC hedge program.  We will highlight some case studies and demonstrate how community banks can better compete against larger banks for the best and most profitable borrowers.  We will also explain how community banks currently position their loans through the ARC program against competitors that do not offer hedges and those competitors that only offer the complex derivative programs that require many pages of documentation.  While we believe that interest rate hedges are a useful tool in today’s interest rate environment, we are also quick to point out that hedges are not the right fit in every circumstance, for all borrowers or even all banks.  Each executive bank team must arrive at its own conclusion.  With complete information about hedging alternatives community bank managers can make the appropriate decision for their specific institution.