Effective balance sheet hedging in the current climate

Even before the coronavirus pandemic escalated in early March, market participants expected that there would soon be a decline in interest rates. Many assumed that the late stage of the business cycle would be the impetus for the decline, leading to a possible recession in 2021. To prepare for this market event, many began implementing hedging strategies, lengthening the duration of floating-rate assets.

Few projected, however, the magnitude of the situation that was about to unfold. The impacts of COVID-19 prompted the Federal Reserve to announce two emergency rate cuts on March 3 and March 15, totaling 150 basis points. The speed and magnitude of the move surprised even those who considered themselves prepared for a reduction in rates. As a result, banks were suddenly tackling new levels of net interest margin pressures and evaluating their asset-liability management strategies.

Current market conditions present financial institutions, equipped with the proper tools and strategic playbook, with opportunities that can provide some welcomed relief during this period of historically low yields.

In this article we will explore balance sheet hedging strategies that help preserve margin in a low interest rate environment, where every basis point matters. We designed these strategies to optimize the costs associated with the liability side of the balance sheet, while decreasing risk to future rising interest rate scenarios.

Leveraging interest rate derivatives

Interest rate swaps, and similar plain-vanilla derivative products, are an effective and transparent mechanism to separate the interest rate risk from the liquidity and funding risk while an institution also diversifies and optimizes their funding mix.

When properly structured from both an economic and hedge accounting perspective, interest rate swaps are one of the most effective solutions to reduce wholesale funding costs. The risk management trade-off inherent in this approach is straightforward to understand, model and quantify through the traditional asset-liability committee (ALCO) process.

Longer term funding vehicles, such as Federal Home Loan Bank term advances or brokered certificates of deposit, contain a yield premium to compensate the cash provider for the liquidity risk, credit risk and other uncertainties that arise during the life of the borrowing. These market-based unknowns are most visible in the short term and, by extension, the relative compensation demanded by investors for long-term investments is larger as a spread to the risk-free rate.

By funding the institution with short-term borrowings and using an efficient and transparent derivative instrument to lengthen the duration of their liability, institutions that are comfortable with the liquidity tradeoff can achieve meaningful cost savings relative to term financing alternatives.

Positioning portfolios away from LIBOR

Given the likely sunset of LIBOR by the end of 2021, a large number of financial institutions have begun the process of transitioning their risk management approaches away from the tainted index, often electing to use structures tied to the federal funds rate.

At my company, Chatham Financial, for example, there has already been a meaningful shift away from LIBOR, with roughly 50% of all transactions referencing non-LIBOR indexes in the last 12 months. Historically, LIBOR had accounted for nearly all hedging activity.

The market’s transition away from LIBOR represents one of the largest shifts in risk management processes that has occurred over the past several decades. How banks adjust to this new paradigm can have a lasting impact on important economic outcomes.

To come out stronger on the other side of this crisis, financial institutions must seek out new opportunities created by the current low interest rate environment and embrace strategies to mitigate the negative impacts of unexpected market movements.

The critical first step in this process is to build the operational framework that includes the prudent use of interest rate derivatives as a risk management tool to give your institution the best chance at navigating turbulent markets.

Greg Martell, CFA, is director of balance sheet risk management at Chatham Financial.