Merriam-Webster’s dictionary defines derivative as a “contract or security that derives its value from that of an underlying asset or from the value of a rate or index of asset value.” Community bankers all too often add their own (four letter) adjectives to such contracts, as derivatives have an image problem.
It is not without some justification that bankers have concerns. Most of the securities that melted down in 2008 and 2009 were toxic instruments that were mortgage- or asset-backed derivatives, which we now know were almost certain to fail at the slightest hiccup in the housing market.
What community bankers may be missing, however, is the opportunity to use well-structured and easy-to-understand interest rate products to not increase risk, but to actually control and reduce it. Banking regulators have recognized this, and are actually on record as saying that the use of interest rate swaps can be an effective tool for reducing rate risk.
Tried and True
Let’s first draw a distinction between the poorly structured assets that wrought havoc with hundreds of community bank investment portfolios, and the prudent use of interest rate products that are useful in risk management. The former were a type of investment, backed by some kinds of assets or the credit of the private-label issuer and in most cases sported investment-grade credit ratings. Community bankers subsequently learned that the ratings were fleeting, to say the least.
Interest rate products, conversely, have grown in popularity over the last several years as the market for such products has gotten down to community banks’ scale. There are now more than 1,000 banks of under $1 billion in size that currently have derivative contracts in place. In fact, the guidance that the OCC uses to define best practices for the use of financial derivatives is dated 1998.
With rates near historic lows, two common themes are emerging:
1. Banks want to know how to meet borrower demand for long-term, fixed-rate financing without incurring the associated interest rate risk.
2. Senior bankers are increasingly concerned about the impact of the investment portfolio mark-to-market on capital ratios in a rising rate environment.
Interest rate products provide an excellent solution to borrower demand for long-term, fixed-rate loans. Using interest rate swaps in conjunction with fixed-rate loan originations create attractively priced floating rate assets and can also be an additional source of fee income. Implementing a commercial loan hedging program mitigates interest rate risk and gives lenders additional flexibility to customize financing options to meet borrower’s needs.
Implementation of Dodd-Frank regulations has added complexity to some of the traditional commercial loan hedging products — making room for products that are in many ways more appropriate for community bank borrowers. Given the intricacies of hedging, most community banks will opt to partner with a capital markets firm to support their commercial loan hedging activities. It is critical to select a partner that provides a turnkey solution and supports products appropriate for community bank borrowers.
Many bankers are also concerned about the impact of rising rates on their capital ratios. Others are concerned about how to create more balance sheet flexibility in a rising-rate environment. The good news is that there are a number of strategies designed to minimize price volatility in the AFS securities portfolio, extend the duration of liabilities, protect tangible common equity and provide added flexibility to manage through a rising-rate environment. These macro-level strategies typically involve a discussion with management regarding concerns and an analysis of the institution’s overall balance sheet structure. Once all relevant factors are considered, then an effective strategy can be designed and executed.
Time to Act: Now
Community bankers are also using rate swaps to convert their floating rate trust-preferred securities into fixed. And for those who believe that rates are not at risk of rising immediately, forward-start swaps, which delay the effect until a designated date in the future, can be the answer.
Most analysts feel that interest rates may be range-bound for some time. Nevertheless, bankers can get a jump on the next phase of the rate cycle by familiarizing themselves with the benefits of balance sheet hedging. A wealth of educational material, including live modeling, is available that can demystify the process. The use of interest rate products by community banks is certain to become not just more popular, but more necessary.
Copyright (c) June 2013 by BankNews Media