Community bank reduces interest expense through a pay-fixed swap
A $3.5B Mid-Atlantic community bank contacted Chatham for a second opinion after a broker-dealer suggested the bank hedge against falling short-term rates. After multiple conversations and customized analyses with Chatham, the bank realized rising interest rates posed a greater risk to their balance sheet.
Hedging strategy to reduce interest expense and maintain accounting flexibility
Chatham’s Balance Sheet Risk Management team provided pro forma results for Net Interest Income (NII) and economic value of equity (EVE), modeling swaps and caps of various terms and sizes. The bank decided that a $100M five-year pay-fixed swap was the best strategy to hedge rising rates.
For accounting purposes, the bank initially planned to designate the swap as a cash flow hedge of short-term liabilities like rolling FHLB advances or brokered CDs. They could save greater than a quarter point of interest expense using the swap compared to a five-year FHLB fixed-rate advance.
Throughout conversations with Chatham’s in-house hedge accounting team, the bank determined that pointing the swap to fixed-rate assets in a portfolio layer method fair value hedge was a better accounting path. There are several reasons for this:
- The bank had more certainty about the assets remaining outstanding versus the ongoing need for funding. Confidence in the underlying hedged item is critical to achieving a good accounting outcome.
- The bank preferred the flexibility to layer additional hedges on the same fixed-rate asset portfolio.
- The bank welcomed the favorable recognition of early termination valuations. While the bank does not plan to unwind the swap before maturity, they valued this feature compared to a cash flow hedge.
The bank recognized that derivative accounting, while more accessible than ever, is still very nuanced and one of the most complex portions of the accounting standard.
The bank achieved its desired outcome — a hedge against rising short-term rates — with a pay-fixed swap. Instead of using the muscle-memory approach of a cash flow hedge against short-term liabilities, the bank used the portfolio layer method designation to shorten the duration of a pool of fixed-rate assets. The result was the same economic outcome, reducing interest expense by greater than a quarter point, but with more accounting flexibility.
What you need to know in less than two minutes
Jason Lange explains how financial institutions can reduce their overall interest expense through the use of interest rate swaps or option products. Watch this brief video to learn more.
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Balance Sheet Risk Management
Financial Institutions | Kennett Square, PATodd Cuppia is a Managing Director and leads Chatham Financial's Balance Sheet Risk Management practice. Todd works with financial institution clients on developing and executing strategies to manage complex economic risks.
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Financial Institutions | Denver, COBen Lewis is a Managing Director and Global Head of Sales for our Financial Institutions team. He leads business development efforts in the Western U.S. and works with depositories helping them manage interest rate risk.
Financial Institutions | Kennett Square, PAEri Panoti leads the Financial Institutions Hedge Accounting practice and advises clients on hedge accounting policy and application for both balance sheet risk management strategies as well as customer hedging needs.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.23-0090