The term “hedge” originates from the Old English “hecg”, referring to a fence — whether living or artificial — that provides protection. This notion of safeguarding has evolved over the centuries, with the verb “to hedge” taking on meanings like “to dodge” or “to evade” as early as the 1590s, and later expanding to signify the practice of insuring oneself against loss. For community financial institutions (CFIs), the decision to hedge isn’t just a matter of strategy; it’s a pivotal choice that can safeguard their balance sheets in an era of fluctuating interest rates. While not every institution chooses to embrace this protective barrier, those that do can navigate the complexities of financial risks with greater confidence.Interest rate risk was a major concern for respondents in Bank Director’s 2024 Risk Survey. It’s no wonder. Persistently high interest rates have squeezed bank margins and earnings, given the increasingly expensive funding landscape and the number of fixed-rate assets many CFIs carry. Yet 80% of total survey respondents — 91% of those at CFIs with between $250MM and $500MM in assets, and 89% of those at CFIs with between $500MM and $1B in assets — say that they don’t hedge, even though hedging instruments can help manage interest rate risk. Why CFIs Don’t HedgeCFIs have a variety of reasons for not hedging. Financial institutions may be concerned that hedge accounting is complex, collateral and capital requirements tie up liquidity, and/or believe that interest rates are about to decline, so there’s less of a need to hedge against the possibility that interest rates will climb. Here are a few of the major reasons why CFIs wouldn’t venture into a traditional loan hedge using a rate back-to-back swap:
- Managing derivatives. Derivatives may carry a historically negative impression for a lot of financial institutions. Traditional back-to-back swaps require the lender to carry derivatives on their balance sheet, making for complicated accounting.
- Collateral requirements. Many financial institutions are fielding liquidity concerns and have been for a bit now. Entering into a loan hedge that requires them to post unknown amounts of collateral over an uncertain period of time merely to oblige to the agreement can seem unappealing and risky.
- Upcoming rate changes. As interest rates begin to fall now that the Fed has loosened monetary policy, financial institutions might anticipate hedged loan swaps to become less beneficial.
The Risks of Not HedgingThe most obvious risk of not hedging, of course, is the risk that a CFI’s primary strategy will lose value as economic conditions change. Without a hedge, the CFI will have no corresponding gain to offset the loss.Regulatory risk is another possibility. Bank examiners may have looked askance at traditional back-to-back swaps in the past, but there are different methods of loan hedging that indicate a positive sign that financial institutions are managing interest-rate risk. In fact, survey respondents whose businesses had a regulatory exam since March 2023 said that the examiner paid particular attention to their interest-rate sensitivity. The Case for Hedging — Especially Interest Rate SwapsThe long period during which interest rates stayed at all-time lows ended a couple of years ago. Future interest rate directions and timing are impossible to know, so hedging against rate changes is a smart strategy.CFI business models naturally carry interest rate risk. Financial institutions use short-term deposits to fund fixed-rate commercial loans with 5- to 10-year durations. Deposits can reprice faster than loans, and mobile and internet banking mean that CFI clients find it simpler to move deposits to institutions that offer better rates. Digital banking technology, money market funds and other bank account alternatives, and customer sophistication have all created a world in which balance sheet risk changes much faster than it did 20 years ago. CFIs need to be quick to address that risk, and it’s faster and typically less expensive to employ an interest rate swap than to change a CFI’s loan or deposit pricing or restructure a balance sheet to address drivers of interest rate risk. While a 2017 change in accounting rules for hedges makes it less complex to account for hedges that cover cash flow from an asset pool, it’s simpler still to arrange a loan-level interest rate swap through a correspondent bank such as PCBB, which offers hedging without complicated accounting or extensive documentation. In the case of interest rate swaps, like those offered by PCBB’s Borrower’s Loan Protection®, there are some distinct advantages:
- Reduced interest rate risk and credit risk
- No ISDA documentation
- No CFI collateral or capital is required
- Gain hedging benefits without putting derivatives on your balance sheet
Regulators often approve of strategies to mitigate interest rate risk. Despite the reputation traditional hedging carries, certain other methods of loan hedging, like interest rate swaps, are much more favorable and advantageous in a world of uncertain future rates. Contact us today about our hedging solutions to start reaping some of the benefits.
