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Finding cost-efficient sources of funding has become a growing challenge for financial institutions.
Banks and credit unions have both seen accelerated deposit outflows as well as a substantial shift in funding composition from non-maturity deposits (NMDs) to term and wholesale funding sources, with most of the wholesale funding being less than one-year maturity.
Lowering All-In Funding Costs
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.
Synthetic Alteration
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.
Material Savings
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 Exhibit 1 below.
Exhibit 1: FHLB Term Liquidity Premiums
Understanding the Mechanics
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 Exhibit 2 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.
Exhibit 2
Another Advantage
Synthetic alteration of short-term funding also has another advantage versus wholesale term funding sources. Interest rate swaps are not a funding source because they are off-balance sheet. If short-term borrowings already exist on the balance sheet, then the balance sheet does not need to be leveraged to increase funding duration and thus capital ratios do not decrease. This is especially advantageous if no additional liquidity is needed, but the institution is still looking to extend the duration of their liabilities to better fit the asset risk profile. Furthermore, since the short-term funding source needs to be continuously “rolled” to maintain the hedging relationship, it can be replaced with any short-term funding source that meets the accounting relationship requirements. In effect, this means each month an institution can select the lowest cost one-month funding source, whether it be FHLB or other, while still maintaining the hedge relationship.
Materially Reduce Term Funding Costs
Given the continued liquidity pressures in today’s historically high interest rate environment and increasing use of wholesale funding sources, depository institutions that have access to derivatives can use synthetic alteration to materially reduce their term funding costs and better duration-match funds with the assets being funded.
Want to learn more about Hedging Strategies? Contact us at info@almfirst.com to discuss more best practices in risk management.
