Let’s break each of these categories down into greater detail.
Loans and deposits are the heart of banking. While diversifying revenue by adding sources of fee income is critical to the long-term health of a bank, ultimately a financial institution needs to collect deposits and lend them out in order to fulfill its mission.
However, fulfilling this mission can create a mismatch between depositor and borrower demands. Depositors are typically willing to accept interest rates that adjust with short-term rates. Borrowers, on the other hand, often want loans that are tied to longer-term rates. So, managing interest rate risk solely through the mix of loan and deposit products can result in too much interest rate risk, or make the bank uncompetitive if it chooses not to provide longer-term fixed-rate financing.
The second challenge is the amount of time and capital it takes to change a bank’s interest rate risk position using loans and deposits. For example, a financial institution with all 5-year fixed-rate loans, and all deposits tied to the federal funds rate, can’t force their existing borrowers into new short-term loans as rates rise, or their depositors into time deposits like CDs.
Loans and deposits are core to running a bank. Managing the interest rate risk they create can be done with the products themselves, but often management needs other tools to augment this. What are those tools?
The investment portfolio can be an excellent way to manage interest rate risk. If the loan portfolio is mostly longer-term fixed-rate loans, then it would be prudent to consider holding shorter-term assets in the investment portfolio – and vice versa. The investment portfolio also has the added benefit of requiring less capital than loans, since most bonds that a bank will buy require only a small percentage of the capital that a typical loan requires.
There are a couple of considerations to keep in mind when using the bond portfolio to manage interest rate risk. The investment portfolio should be seen first and foremost as a source of liquidity. This may result in management making certain decisions about the portfolio that actually increase the bank’s interest rate risk, but ultimately are the right decision for the bank, from a liquidity perspective.
The investment portfolio is also a source of income for the bank. But when thinking about deploying capital to generate earning assets, the return on the investment portfolio typically isn’t as attractive as making loans. That said, the investment portfolio is an often-overlooked component of a bank’s balance sheet and too often is seen only as a source of liquidity for making loans, and for ensuring a bank’s safety and soundness during an economic downturn.
Bank management teams that seek to optimize their entire balance sheet recognize that they can get more from their investment portfolio than liquidity, and look to increase yield and manage interest rate risk while still maintaining liquidity. These teams often look to independent, non-broker/dealer advisors for assistance with their investment portfolio. For example, increasing the yield on a $100 million portfolio by 50 basis points would generate an additional $500,000 in annual investment income while maintaining liquidity and managing interest rate risk.
Another straightforward way to manage interest rate risk is through the use of wholesale funding sources, which can include Fed funds, loans from the institution’s Federal Home Loan Bank, brokered deposits, foreign deposits and even borrowing in the public debt markets. For instance, it is common for financial institutions to “match-fund” long-term fixed-rate loans by going to their Federal Home Loan Bank and borrowing an amount and term roughly equal to that of a commercial loan. By doing so, the bank locks in the spread between the interest rate on the loan and the cost of its funding.
While this is a simple and effective way to manage interest rate risk, there are a couple of considerations. If the bank already has enough liquidity to fund the loan, taking on additional funding is not necessary and will “gross-up” the balance sheet, but not materially improve its profitability. This is often the case in post-boom, early-to-mid recessionary periods when loan demand is weaker, and deposits are easy to gather.
It’s important to note that funding loan growth with wholesale funding sources can be a cause of concern for regulators and bank examiners. While wholesale funding can be a cost-effective way to fund a bank’s loan growth, banks that place too much emphasis on wholesale funding may come under extra scrutiny by regulators.
Tools to manage interest rate risk exist on every bank’s balance sheet, but let’s discuss a third tool – namely, derivatives. Derivatives haven’t always had the best reputation. It’s true that they can be used improperly for speculation or without proper credit risk mitigation. At times in the past, they have been sold with unneeded complexity, in a way that only lines the pockets of the seller and does not benefit the buyer.
But when used prudently as a risk management tool, not for speculation and with proper credit risk mitigation, they are very useful for managing interest rate risk. And unlike using loans and deposits, they have an immediate impact, and are very precise with very little use of capital.
Let’s start by defining the most common and plain vanilla of interest rate derivatives: the swap. An interest rate swap is an agreement between two parties to exchange interest payments on an agreed-upon notional principal amount for a given period of time. One party agrees to pay a fixed-rate of interest, which is called the swap rate. The other party agrees to pay a floating-rate of interest tied to a published index, like LIBOR. The swap rate is the present value average of what the floating-rate is expected to be over the life of the swap. There is no out of pocket cost to using swaps. Fees are typically embedded in the fixed-rate of the swap itself.
Interest rate swaps are useful for parties looking to convert a series of interest payments from fixed to floating and vice versa. In the context of interest rate risk management, they help banks align the interest rate risk of their assets and liabilities.
There are two ways banks use derivatives to manage interest rate risk. One is by using macro balance sheet strategies that are deployed at the portfolio level. The second is done at the individual loan level, either by hedging individual fixed-rate loans or by offering commercial customers swaps directly, in what is often referred to as a back-to-back swap.
I’ll walk you through each at a high level, beginning with macro balance sheet strategies.
Financial institutions typically employ balance sheet hedging strategies when one of two things is true:
- Their interest rate risk position is approaching limits, and/or;
- Management is concerned that a change in interest rates would adversely impact the bank’s net interest income (NII) or its economic value of equity (EVE).
For example, a liability-sensitive bank – that is, a bank whose NII shrinks when interest rates go up – will want to hedge against rising short-term rates. In that scenario, management may want to use a pay-fixed swap to convert an adjustable-rate liability to fixed. The bank would match up the cost of the liability to the floating leg of the swap. Those two would cancel each other out, and the bank would be left paying the fixed-rate of the swap, which effectively converts the floating-rate liability to fixed.
An asset-sensitive bank – that is, a bank whose NII shrinks when interest rates go down – will want to hedge against falling short-term rates. It would want to use a receive-fixed swap to convert a pool of floating-rate assets to fixed. They would match the floating leg of the swap to the floating-rate on the pool of loans, such that what they owe on the floating leg of the swap is offset by what they receive from the loans. That leaves the bank receiving the fixed-rate of the swap.
These are two examples that financial institutions commonly employ, and while they may sound complicated to someone who does not have a lot of experience with derivatives, they are very common transactions that are quite safe. And there are many more hedging strategies a bank can use at the macro level to manage its interest rate risk.
An important aspect of any balance sheet hedging strategy is the accounting treatment for the derivative. Derivatives must be marked-to-market each period, and if a derivative is not designated as a hedge of a specific risk at inception and then measured for its effectiveness throughout its life, those marked-to-market changes in value will go through the income statement, disrupting the bank’s earnings.
Macro balance sheet hedging strategies are efficient. A financial institution can change its interest rate risk profile immediately and with very little capital allocation. But sometimes they are more than what is needed. Management teams may instead want to take an incremental approach to managing interest rate risk. Loan level hedging allows for this, and brings the added benefit of providing lenders with an additional tool to compete for and win commercial relationships.
Let’s talk about hedging strategies using derivatives at the individual loan level. There are two types of loan level hedging strategies, beginning with hedging individual fixed-rate loans. It’s important to keep in mind that this strategy requires the derivatives to be specially designated as a hedge of the loan and is an area where prudent management teams hire advisors to assist them.
Let me explain with a simple example: a borrower comes to your bank wanting a $5 million loan with a fixed-rate of 10 years. According to the bank’s loan policy, it can’t make a 10-year fixed-rate loan over $1 million. What should management do? If you say no, the borrower will probably take their business elsewhere. So how can you meet the customer’s requirement?
Using a plain vanilla interest rate swap that matches the terms of the loan – including the fixed-rate, principal amount, term and amortization – the bank can effectively convert the fixed-rate loan to a floating-rate loan. Here’s how this would work:
- The bank makes the fixed-rate loan and receives a fixed interest rate from the borrower.
- On the back end, the bank then enters into a pay-fixed interest rate swap, where it pays a fixed-rate equal to the rate it is receiving on the loan.
- These cash flows effectively cancel each other out, and leave the bank receiving the floating-rate leg of the swap.
The other loan level hedging strategy is commonly referred to as a back-to-back swap.
Back-to-back swaps work as follows: the bank enters into two separate transactions with the customer, a floating-rate loan and a companion fixed-rate swap with its customer. These transactions create a synthetic fixed-rate structure. For example, the customer borrows at floating-rates, but because of the swap, effectively pays a fixed-rate on the loan. The bank then executes an offsetting swap with a swap dealer, thereby leaving it with only the economic impacts of the floating-rate loan.
The swap rate includes a swap fee, which the bank earns to cover the costs to originate and service the swap with the customer and for the additional extension of credit.
The difference between the wholesale rate, which is the price the bank pays for its swap, and the retail rate, which is the price the borrower pays for its swap, is equal to the fee that the bank earns. The dealer pays the bank this sum within two business days of executing the swap. The swap fee depends on the size and structure of the deal and the customer’s credit.
You may be asking, why would a bank want to complicate things with the borrower? There are a few reasons for this:
- The bank can meet a customer's financing preference without taking on unneeded interest rate risk, while at the same time earning fee income.
- The bank can provide a product to its qualified customers that offers more flexibility and a better prepayment profile than a traditional fixed-rate loan with market-based prepayment.
- The bank can level the playing field with larger financial institutions that also offer swaps, and with non-bank lenders that offer long-term fixed-rate debt.
- A swap allows the bank to separate the credit decision – “do I want to lend for 5 or more years to this customer?” – from the interest rate risk decision – “am I comfortable taking on 5 or more years of fixed-rate risk?”
Let’s quickly review some of the main points.
- The management of interest rate risk is one of the most important responsibilities of your bank’s senior executive team, and oversight of that function is one of the most important duties of the board of directors.
- The tools that most banks use to manage their interest rate risk include loans and deposits, wholesale methods like the bond portfolio and non-deposit funding, and derivatives.
- Interest rate risk can be managed through the mix of loans and deposits, although this can result in either too much risk on the balance sheet, or place the bank at a competitive disadvantage if it is reluctant to offer long-term fixed-rate financing.
- The investment portfolio can be an excellent way to manage interest rate risk. However, it should be viewed primarily as a source of liquidity, and also as a profit center if managed correctly.
- Wholesale funding sources can be used to manage interest rate risk, but are subject to regulatory oversight.
- When used prudently to manage interest rate risk, derivatives can have an immediate impact on a bank’s risk profile, and they require very little capital.
- Derivatives can be used in either a macro balance sheet strategy, or at the individual loan level.
Interest rate risk is embedded in every financial institution’s balance sheet, and managing that embedded risk has long been a core function of the bank. The bank has existing tools like loan and deposit products, the investment portfolio and wholesale funding to manage interest rate risk. But because of their effectiveness, flexibility and increasingly common use, board members should encourage their management teams to consider adding derivatives to their tool kit.
Thank you for joining me for this Online Training Series video about managing interest rate risk.
This video was produced by Bank Director as part of their Online Training Series for bank boards of directors.
