Last year, as the Federal Reserve was preparing for its long-anticipated first monetary tightening in nearly a decade, the conversation began to focus on the generation of bankers whose concept of “normal” consisted of short-term interest rates near zero percent and holding steady.
So, now that the suspense is over and we have “lift-off” in the Fed Funds target, attention has shifted towards what will happen next. Gradual adjustments in the stance of monetary policy are consistent with a continued moderate pace of economic expansion, continued strength in the labor markets and a rise in inflation towards the 2% objective. Indeed, Fed officials have penciled in four more quarter-point rate hikes in 2016 according to their “dot plot,” although by remaining “data dependent” they have reserved the right to change their minds.
If rising short-term interest rates do indeed become the “new normal,” then the Fed’s promise to move gradually equips community banks and credit unions with a window of opportunity to prepare for changes in their operating environment. Here are three ideas that can help them get the process started:
Review loan and deposit re-pricing. More than likely, regulators have already begun to ask about deposit re-pricing and decay assumptions being used for interest rate risk modeling purposes. The problem is that there is no historical precedent for how rates and deposit pricing will behave after the massive monetary accommodation that took place during and after the 2008 financial crisis. That aside, it was over a decade ago (2004-2006) that the markets last experienced a Fed tightening cycle when the Fed Funds target rate moved up steadily, from 1% to 5.25%. The balance sheets at most institutions look much different today, so historical comparisons are rendered that much trickier.
Rather than laboring over one assumption that will likely not match reality, consider running the interest rate risk model with two or three different “beta” assumptions in order to see results in a more conservative stressed scenario. On the loan side of the equation, a combination of competitive pressures and the appetite for yield have led banks to bulk up their fixed-rate loan portfolios. As rates rise, optional prepayments will likely slow, exposing extension risk for banks. The choice to limit new fixed-rate lending carries with it the risk that borrowers will take not only their loan requests, but also deposits and other services, to a competitor.
Review bond portfolio/wholesale funding. In the six weeks leading up to the December 2015 Fed Open Market Committee (FOMC) meeting, the two-year/10-year Treasury yield curve flattened by roughly the equivalent of the Fed’s tightening move: twenty-five basis points. Historically, the Fed’s credibility as an inflation fighter, along with expectations of a cooling economy, has contributed to a flattening of the yield curve during a Fed tightening cycle.
Accordingly, community banks and credit unions should model interest rate risk in a flattening curve environment in addition to the standard parallel rate shifts. In the securities portfolio, barbell strategies tend to out-perform bulleted and laddered portfolios in bear flattening scenarios, in which short-term interest rates are rising more quickly than long-term interest rates, and are generally higher yielding for equivalent duration. An outright shortening of duration can be challenging due to lack of supply in floating-rate issues and the reality of further compressing the net interest margin. On the funding side, adding brokered certificate of deposit and term Federal Home Loan Bank advances can help with liability-sensitivity, but may also unnecessarily balloon the balance sheet for an institution that remains flush with deposits.
Consider interest rate derivatives. While some still refer to derivatives as the “D-word,” many community banks have taken steps to add interest rate swaps and caps to their interest rate risk management tool kit. Before considering a specific hedging strategy to mitigate exposure to rising rates, a community bank should establish a foundation which includes the following:
- Education for the board and management team;
- A hedging policy that establishes objectives and authority;
- Accounting parameters (mark-to-market vs. hedge accounting);
- Counterparty approval and International Swaps and Derivatives Association (ISDA) documents;
- Regulatory compliance (Dodd-Frank Title VII).
Once these building blocks are in place, interest rate derivatives can be utilized as capital-efficient tools to quickly alter the interest rate risk profile of a community bank.
There has been no shortage of turmoil and market volatility during the opening weeks of 2016; falling equity and commodity prices have led some to already question the Fed’s willingness to continue on the path to higher short-term interest rates. For financial institutions that need to get their interest rate risk house in order, this may be the perfect opportunity to “fix the roof while the sun is still shining.”
Mr. Newman is managing director, Financial Institutions, at Kennett Square, Penn.-based Chatham Financial, which provides comprehensive interest rate hedging expertise. He can be reached at firstname.lastname@example.org.