Community Bank Hedging Options
Over the last 15 years, an ever greater percentage of community banks have embraced some form of interest rate hedging. Approximately 1,000 banks in the country use some form of hedging products to manage risk, generate fee income, or provide product offerings demanded by their customers. Most of the top 100 banks (by asset size) have robust derivative solutions. However, about one in five community banks offer some form of loan-by-loan hedging products. One question posed by many community bankers is what are bank hedging options, and should a bank utilize loan-level or balance sheet hedges. Each has advantages and disadvantages, and the right solution may differ for each community bank.
Loan-level Vs. Balance Sheet Hedging
For loan-level products, the hedging solution is associated with individual loans. For balance sheet solutions, the hedge is associated with a set of assets or liabilities being hedged. The instruments available for use are similar – banks have successfully used swaps, caps, floors, collars, and cancellable swaps for both loans and balance sheets. The difference between the two options includes size, efficiency, accounting, and sales strategy. Community banks have historically used loan-level hedging because of the simplicity in accounting, fee generation opportunities, and the resulting lender pricing and structuring discipline.
Advantages and Disadvantages In Bank Hedging Options
The most significant advantage of balance sheet hedging is the efficiency in execution. Generally, balance sheet hedges are more efficient when the notional hedge size is $10mm or greater. Community banks can usually save anywhere from five to 15bps on execution costs – compared to loan-level hedging, where loans at least $250k in size are hedged. Another advantage of balance sheet hedging is that it immediately impacts the bank’s balance sheet – it can extend or reduce duration with just one trade. The flip side is that if the balance sheet composition changes over time, or the interest rate or loan environment changes over time – as they typically do – the balance sheet hedge initially implemented may no longer be the right hedging solution for the bank.
The biggest advantages of loan-level hedging are that it does not require an all-or-none decision, and community banks can choose to apply this product as needed on a loan-by-loan basis. Further, the accounting is simple, and programs are available where the derivative is not on the community bank’s balance sheet – SouthState Bank uses such a program called ARC. Loan-level hedging also allows community banks to generate fee income (which is not available through balance sheet hedges). Most importantly, loan-level hedging instills pricing and structuring discipline on lenders that removes free options to borrowers and shifts economic downsides and negative convexity away from the bank’s balance sheet. Conversely, a balance sheet hedge almost always shifts negative convexity to the bank.
The table below compares and contrasts community bank hedging options. Community banks are not precluded from using both options, but the majority of community banks have chosen loan-level hedging exclusively. Most larger regional and national banks use both options. In our blog next week, we will consider what features and providers community banks should consider when choosing a loan-level hedging product.
|Description||Each loan is hedged individually||A set of assets or liabilities are hedged|
|Instruments available||Swap, cap, floor, cancellable features, and combinations||Swap, cap, floor, cancellable features, and combinations|
|Execution and size||Available on loans as small as $250k with costs borne by the borrower||Efficiency is created with a hedge size greater than $10mm|
|Advantages||• Does not require an all-or-none decision
• Simple accounting
• May be added in small amounts as balance sheet, interest rates, and marketing opportunities change
• Cost of prepayment shifted to the borrower
• Marketing support for lenders and more disciplined pricing for bank
• Ability to generate fees
|• Borrower or depositor is not involved in the hedging process
• Large and immediate hedge impact
• Cheaper execution
• Most effective for existing balance sheet GAP mismatch
|Disadvantages||• Not immediately effective for existing balance sheet GAP issues
• Requires lenders to market and understand the product
|• Possibly complex accounting
• Extensive ALM analysis required to achieve an effective strategy
• Transfer repayment and convexity risk from borrowers and depositors to bank
• More execution risk (one hedge trade vs. many, and management must make one large decision on timing, instrument type, and notional amount)