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BirdsEye View

hedging risks and benefits for asset sensitive supercommunity banks

As promised, below is the second installment of the hedging article, co-authored with Steve Raffaele, CFO of Sterling Bank in Houston. I find it especially relevant given the growing uncertainty in the financial markets.

You might want to fortify yourself with some delicious purple duck sauce before you settle down to read this "heavy" article. Liat's friends eat it without the duck, and I highly recommend it on top of a pile of whipped cream. Then again, anything goes with a pile of whipped cream, including nothing (or, better yet, some high quality chocolate sauce).

Also, thanks to the many of you who emailed me about Liat's article on London's restaurants. You can find her next column, a scathing commentary on the current Paris restaurant scene, in BirdDroppings. As always, she is right on the money, as so many non-Parisian French foodies have confirmed with me in recent months.

Have an awesome weekend, and enjoy the vestiges of summer,

Hedging Risks and Benefits For Asset Sensitive Supercommunity Banks

In our last piece, we discussed several alternatives that are available to asset sensitive SuperCommunity banks interested in protecting themselves against another period of declining short term interest rates where revenue decelerates due to net interest margin compression:

  • On-balance Sheet Options – Restructuring Assets and Liabilities
  • Hybrid Alternatives – Executing Structured Funding Transactions
  • Off-balance Sheet Options – Executing Derivative Transactions
  • Do Nothing – Accept the Risk

We contrasted the trade offs relative to each of these options and concluded that now is the time to review them and make a decision about the costs and benefits of each. One or more of these financial strategies may be good alternatives, but because off-balance sheet hedging of interest rate risk, with floors, collars or swaps, offers some particular advantages in the current rate environment, both the risks and benefits of hedging should be carefully considered before implementing such a strategy.

  1. What are the risks of off-balance sheet hedging?

    Although strategies involving derivatives generally are referred to as "off balance sheet", by definition, derivatives are technically assets/liabilities that are shown on the balance sheet at their then current fair value. As such, there are four primary issues that super-community banks will face when putting on an "off-balance sheet" hedge: perceptions, selection, accounting, and policy/administration.

    1. Perception of the hedge

      One of the biggest hurdles that a bank faces is the perception of the hedge with executive management and the board of directors. In the post-Enron era, when the words "derivatives," "off-balance sheet" and "complexity" are discussed in the same paragraph, concerns about interest rate risk become secondary to concerns about other forms of liability. Creating a proper balance in this discussion involves communicating clarity and focus through a well defined risk management strategy (that is borne only out of shareholder interests), proper interest rate risk modeling (including validation of IRR/ALM models), adequate accounting and operational research, competent staffing, early involvement of audit (both internal and external), communication with ALCO and the audit committee, and, if appropriate, the use of external specialists (e.g,, firms like Chatham Financial that provide full service hedging and accounting expertise).

    2. Selecting the hedge

      The next major issue that a bank faces when contemplating a hedging strategy is that of selecting the hedge. Assuming the bank has a seasoned and validated interest rate risk model, the threat to earnings and valuation should be quantified and assessed using scenario analysis. Scenarios that include rate shocks, curve twists, ramps and other interest rate conditions quickly demonstrate that in many of these scenarios, interest rate risk will become a secondary threat to the bank given the potential economic and market conditions that would accompany these rate environments. In any event, interest rate risk should be isolated and distilled into a few likely proxy scenarios that become the focus of the hedging strategy. These same scenarios can then be run with and without various combinations of hedges (type, size, maturity, and strike) until a solution appears that represents the right alternative for the bank. The optimal solution will be a unique mix of cost, risk reduction and administrative burden that is based on the bank's own balance sheet, pricing strategy, rate outlook and growth expectations.

    3. Accounting for the hedge

      Most SuperCommunity bank management teams have an aversion to mark-to-market gains and losses running through the income statement, and, as a result, seek hedge accounting treatment under FAS 133. While this may or may not be an overemphasized concern, hedge accounting treatment is available given an appropriate commitment by management to policies and procedures, hedge designation documentation and hedge effectiveness testing. From the perspective of FASB, an election of hedge accounting treatment is appropriate when the purpose of the hedge(s) is to offset financial risk and not to generate speculative revenues. There are several types of risks defined and a few different hedge designations available under the hedge accounting provisions of FAS 133, but the hedge accounting alternative most suited to managing net interest margin pressure due to lower income from variable rate loans is a "cash flow hedge." In summary, in order to qualify for hedge accounting as a cash flow hedge, there are a number of conditions that must be met but they generally fall into four categories:

      • Definitions: Meet the hedged item criteria defined in FAS 133

      • Documentation: Define and document the hedging relationship with a "hedge designation memo" that identifies:

        • The risk management objective and strategy for undertaking the hedging relationship,

        • The hedging instrument,

        • The hedged transaction,

        • The nature of the risk being hedged (e.g., Prime-based loan cash flows),

        • How the instrument's effectiveness in hedging exposure to variability in cash flows will be assessed, and how ineffectiveness, if any, will be measured.

      • Determination: Determine basis for an expectation that the hedge will be "highly effective" (in practice, generally interpreted as 80% to 125%) and test at least quarterly to assess how well the hedge is accomplishing its goal.

      • Disclosure: Provide adequate financial statement disclosures.

    4. Policy & Administration

      In the last five years, there have been numerous public displays of the pitfalls that surround hedging and FAS 133. The number of accounting restatements involving hedging seems to have skyrocketed in the last several years and also to incorporate a number of management policy issues, some of which have been quite innocent while others have involved scandal and malfeasance. In general, these issues fall into five categories:

      1. Misuse of Shortcut Method: What was meant to be an exception to rules around effectiveness testing by FASB became the rule; namely, the use of a provision in FAS 133 that if certain conditions were met, hedge effectiveness (I.e., "no ineffectiveness") could be assumed and no testing would be required. Many companies found this exception a simple and attractive alternative to devoting resources to determining "no ineffectiveness" on an ongoing basis; but later determined that short cut conditions where not actually met at the outset. The issue then became that they could not go back and select another means for demonstrating that the hedges were highly effective (even if they actually were) and, thus, had to restate financial results to reflect changes in the market values of these hedges through time. In many of these cases, investors saw through these restatements as accounting form over economic substance. Notably however, the short cut method doesn't apply to situations where the bank is focused on hedging the risk associated with pools of Prime or Libor-based loans.

      2. Failure to close out hedges: A basic tenant of hedge accounting is the assumption that gains/losses on the hedge are moving in the opposite direction and by the same magnitude as that of the asset/liability. In some cases, the asset or liability no longer existed on the balance sheet, but the hedge was still applied to a position that no longer existed.

      3. Re-designation of hedges: In a similar effort to obtain hedge accounting, hedges that were re-designated from one asset (or liability) to another were assumed to be highly effective -- even though the hedges did not have a fair value of zero at the outset of the new hedging relationship, which is required by FAS 133 in order to assume "no ineffectiveness".

      4. Misinterpretation or disregard of accounting rules: There is no doubt that the subject matter when coupled with the accounting literature makes for a complex implementation of strategy. Not only is FAS 133 a complicated pronouncement, but it has also been affected by FAS 138, 140, 149, and 150, as well as various EITF interpretations and DIG guidance. The public has seen companies that misinterpreted accounting standards and others that disregarded the rules entirely in favor of their own interpretation or a desired outcome. In some cases, where methods for accounting for a hedge where changed, a "correction of an error" (that would require an accounting restatement) was called a "change in accounting estimate" in order to avoid a restatement. In the end, a firm with a strong "tone at the top" is more likely to avoid the pitfalls of a misapplication of GAAP.

      5. Incomplete or untimely documentation: One of the most fundamental and important aspects of hedge accounting is documentation. FAS 133 calls for formal documentation which typically takes the form of a "Hedge Designation Memo" that must be completed shortly after (or at time) the hedge contracts are executed - not, as has been the case with some, months or years later. Other documentation should also include an Interest Rate Derivative Policy, any necessary modifications to ALCO and Investment Policy, a discussion of the impact that the transaction will have on the bank's financial statements and a designation for income tax purposes.

  2. What are the benefits of off-balance sheet hedging?

    The primary advantage of stand-alone derivatives is that the bank can surgically tailor a hedge that is specific to the bank's interest rate risk profile, timeframe, rate outlook and budget. Because these hedge contract(s) stand alone and are fairly standardized, the bank can run a competitive pricing process that is transparent and that has no impact on customers or employees. Using the insurance analogy, the cost of insurance and means for obtaining it are unbundled and operationally efficient.

Asset sensitive banks using interest rate floors, collars, or swaps as an interest rate risk management strategy in the current environment will reduce the potential volatility of earnings under what seems to be a likely scenario: lower short term interest rates within the next couple of years. As result, the banks that carefully manage interest rate risk through hedging can expect to remain more competitive and have greater operational flexibility due to their higher relative earnings if short term rates go down. In addition these banks will have a means for operating within reasonable interest rate risk policy compliance limits - all at a cost that is reasonable should rates do nothing ... or even go the other direction entirely.