Alec Hollis, CFA, Director, ALM Strategy Group
Why Is Now the Time to Consider Hedging Strategies?
Financial institutions are clearly seeing higher rates and a flatter curve in 2018. With the market expecting one more rate hike in December, it is important to look at your depository’s current financial conditions and hedging strategies with today’s rate environment in mind.
How Long Will Higher Net Interest Margins Persist?
The overall banking system, including both credit unions and banks, has performed remarkably well during the most recent monetary tightening cycle. Since 2015, the U.S. Federal Reserve has hiked the Fed Funds Rate a total of eight times, increasing it from 0.25% to 2.25%. During the same timeframe, credit union net interest margins (NIMs) have been generally higher, increasing from 3.23% in Quarter 2, 2015 to 3.51% in Quarter 2, 2018. Bank performance has been positive as well increasing 34 bps over the same time period.
A hefty chunk of the increase could be attributable to strong loan demand. The overall credit union industry’s loan-to-share ratio now sits just under 83%, relative to 75% in mid-2015. A higher allocation to loans is correlated with higher NIMs, since loans tend to yield more than either cash or NCUA-permissible investments. Commercial banks have experienced a similar trend in loan-to-deposit ratio, ending Q2 2018 at 73%, with smaller, community banks $1-3 billion in assets now at nearly 87%.
However, the largest driver of volatility in a financial institution’s NIM is volatility in its cost of funds (COF) which has been relatively non-existent as of late. The graph below illustrates that interest income as a percentage of average assets has increased almost 40 basis points, while cost of funds as a percentage of average assets increased only 12 basis points. Banks have seen similar trends, although there have been wider ranges in COF within certain regions. A larger movement in funding costs relative to total assets (36 basis points) has been offset by a 69 basis point jump in interest income as a percentage of average assets.
Why Have Deposits Been So Sticky?
The abnormality of this COF stickiness has been observed and commented on by many market participants. The timing and magnitude of rising deposit rates represent a key risk to financial institutions today, as it could offset the recent rise in industry NIMs; deposit betas have been very low compared with previous tightening cycles.
What is a Deposit Beta?
A deposit beta is a measure of the volatility of a bank’s or credit union’s deposit rate. The higher the beta, the higher the responsiveness of the deposit rate to changes in market rates. The Office of the Comptroller of the Currency (OCC) has noted the risk rising rates may pose on deposit mixes and costs, as it was introduced as a key risk issue this year. Banks have not increased deposit rates as much as in previous tightening cycles, and accordingly, the OCC suggests the recent industry-wide NIM expansion may not persist.
Why Should My Depository Consider Hedging?
More financial institutions are considering putting hedging programs in place as increased volatility in interest rates can negatively impact business. This is particularly true in the face of rising loan demand without a matching core liability. Hedging programs aim to protect the institution from fluctuations in interest rates, typically by locking in revenues and costs.
It is helpful to categorize the balance sheet into two separate functions: the core retail function and the wholesale function. The core retail function involves lending and acquiring core deposits. The wholesale side, on the other hand, involves ALM (asset/liability management) and investment portfolio management. Combined, these areas are responsible for managing the liquidity and interest-rate risk position of the overall balance sheet.
How Does Hedging Aid Liquidity and Protect Against IRR?
Liquidity has been a hot topic recently with financial institution executives. Mainly, the “strong loan demand amidst slowing deposit growth story”. If this story persists, the industry COF may be poised to increase simply due to increased demand of wholesale funding. However, this opens the door to additional interest-rate risk, as the institution would be effectively funding core assets with non-core funding.
For depositories with strong capital ratios, this could prove to be an effective solution, especially if coupled with hedging. Excessive balance sheet duration could be hedged by paying a fixed rate on an interest rate swap. While hedging the fair value of these loans might put some pressure on short-term margins, locking in a margin can produce long-term benefits, particularly given a lack of a natural hedge on the liability side. While a lower economic value of a loan might not be marked-to-market, it is realized through income over time through holding a low or negative carry asset on the balance sheet.
Another option involves deleveraging; particularly, engaging in loan sales/participations. Loan sales can be a great avenue for generating liquidity and should be evaluated within liquidity management. Selling low carry, low yielding loans could prove quite compelling, especially if it is coupled with the removal of high-cost funding. The result: a smaller, more efficient balance sheet. The participation route ensures the customer relationship is retained, while shedding risk and generating liquidity.
How Can Depositories Make Room for Future, More Stable Growth?
Loan sales might involve taking an upfront loss, especially given the trend in interest rates over the last year. While taking an upfront loss can be a hurdle to overcome in some boardrooms, it can be beneficial in the long-run.
Effective balance sheet management often involves a blend of tactics to keep NIMs stable and credit risk at bay. Financial institutions should generally favor maximizing the economic value of the institution over bolstering short-term earnings and margins. In some cases, this might lead to expenses and/or upfront losses to make room for future, more stable growth.