Hedging Strategies to Complement Funding Needs

Rising interest rates have reoriented attention on depository funding needs and continue to threaten access to cost-efficient sources of funding. As of March 31, 2023, commercial banks with $1-50 billion in assets have seen accelerated deposit outflows relative to a year ago. Credit unions, while more stable, have also seen a slowdown. Figure 1 (above) shows a systemic rise in non-maturity deposits (NMDs) for commercial banks to the point where they have converged with credit unions. However, both credit unions and banks have seen a substantial shift in funding composition from NMDs to term and wholesale funding sources, with most of the wholesale funding being less than one-year maturity. This shift can cause margin pressure and an increase in interest rate risk exposure for institutions without a funding strategy in place. By using hedging techniques, depository institutions can lower their all-in cost of funds while still using short-term wholesale funding sources and targeting an interest rate risk (IRR) profile similar to a longer-term borrowing.

Hedging using interest rate swaps is a common practice for financial institutions seeking to alter the interest rate risk, or duration, of a position or portfolio. Sometimes called synthetic alteration, depository institutions can combine a short-term funding source, such as a one-month borrowing, with an interest rate swap to effectively increase the duration of the funding source. When combined with proper asset pricing, a hedged funding cost allows an institution to collect profits through elements at their disposal like credit and liquidity, rather than having margins compressed by something that is out of their control such as interest rate movements. Synthetic alteration is also a more cost-efficient way to access longer duration funding versus tapping into the usual sources of term funding available – the Federal Home Loan Bank (FHLB) or the brokered deposit market.

The longer the term of a wholesale funding source, typically the higher the rate relative to a risk-free interest rate. This relationship can be measured by calculating the term liquidity premiums (TLP), which is calculated as the difference between the term borrowing rate and a risk-free swap rate. TLPs almost always increase as the borrowing term increases, hence, the cost can be substantial to access term liquidity for a given period of time. Hedging with interest rate swaps allows you to essentially “earn” this premium, which can equate to material savings. An example of this is shown in Figure 2 below.

The mechanics of synthetic alteration involve a pay-fixed, receive-float interest rate swap cash-flow hedging a short-term funding source with a strong correlation to short-term market rates. The floating rate received on the swap offsets the floating rate paid on the liability, and your new funding cost becomes the pay fixed rate of the swap plus any residual spread between the floating rates, as demonstrated in Figure 3 below. A “strong correlation” in this case refers to FASB ASC 815’s definition, which states to qualify for hedge accounting the interest rate on the hedged item must have a coefficient of determination (“R squared”) of 0.80 or greater versus market rates, and the interest rate on the hedged item must have a regression slope coefficient between 0.80-1.20 versus market rates. The third criterion required by the accounting guidelines states that the hedge balance may never exceed the hedged item balance.

Alec Hollis is Managing Director for ALM Strategy Group at ALM First Financial Advisors in Dallas, Texas.