Depository Resilience: Strategies in a Shifting Interest Rate Environment
Hedging allows CUs to mitigate risks outside their control and focus on core competencies to drive growth.
Rising deposit rates have been pressuring net interest margins (NIMs) in recent quarters. Competition for deposits has led to increases in higher-cost deposit products, such as certificates of deposit and money market accounts, as well as an increasing need to explore wholesale funding options. NIMs for the credit union industry are not markedly lower, as Exhibit 1 shows, but many institutions are facing pressures on managing funding costs.
Gone are the days of zero short-term interest rates. However, rising funding costs can represent a hedgeable risk. Institutions can implement hedging programs that allow for more flexibility in meeting customer needs through mitigating the interest risk that can arise from doing so. When combined with proper asset pricing, hedging allows institutions to target a margin and keep it as interest rates change.
Hedging Strategies in the Current Rate Environment
While there are a number of strategies that can assist financial institutions, there are two we are currently focusing on. We will first begin discussing hedging strategies for an institution that is liability sensitive. An institution is considered liability-sensitive when its liabilities reprice faster than its assets, meaning it is funding assets with comparatively shorter duration liabilities. Attracting longer term deposits is difficult for most institutions and term wholesale funding comes with its own costs; funding short and hedging with interest rate swaps is a potentially more economical route to go. This can be achieved through a strategy known as synthetic alteration. Synthetic alteration involves overlaying a pay fixed/receive float interest rate swap on a short-term funding source, known as a payer swap (receiving fixed would be known as a receiver swap). An example is shown in Exhibit 2.
Even though the source of funds is short-term, when combined with a payer swap the result is equivalent to a termed funding source from an IRR standpoint. Take, for example, an institution that has a $100 million borrowing position that matures monthly and is rolled month-over-month. The institution pays essentially an overnight rate on the borrowing position and the rate resets each roll date. To better match fund the balance sheet, the institution can extend the duration of its funding. Exhibit 3 shows the cost comparison of swap rates versus an equivalent maturity FHLB borrowing.
The example above shows the all-in funding costs can be lower, especially as the maturity increases. For institutions that don’t need to term out their liquidity source this can be a great option, especially since the cost of termed funding can be very high, as indicated by the term liquidity premium (TLP).
The next strategy is intended for institutions that are asset-sensitive, indicating assets reprice faster than liabilities. This is most common in institutions that have short-term or floating rate assets paired with a stable core funding base. A common example of this is a commercial lender that funds floating rate loans with non-interest commercial deposit products. In a rising rate environment, the core deposit franchise value of these institutions rises and profits increase, but as rates fall deposit rates cannot be reset any lower and in turn the core deposit franchise value decreases as profit margins compress. A common hedging strategy to protect franchise value is to use receive fixed/pay float (receiver) interest rate swaps to convert floating-rate assets to fixed rate. An example of this is shown in Exhibit 4.
Effective balance sheet management involves many tactics to stabilize and enhance profits. Hedging is imperative because it allows an institution to mitigate risks that are outside its control and focus on its core competencies to drive growth and profitability. Hedging interest rate risk can drive better performance as it allows for focus on aspects of profitability that are in their control, such as proper asset and liability pricing.
Tyler Madden is Director for ALM Strategy Group at ALM First Financial Advisors in Dallas, Texas.
Alec Hollis, CFA is Managing Director for ALM Strategy Group.