Pub. 10 2020-2021 Issue 5

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S — H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S January • February 2021 17 are disappointingly low. Even though liquidity profiles appear strong and are trending stronger, economic un- certainty creates unpredictability in depositor behavior. As such, some institutions feel more comfortable with investments that maintain maximum flexibility in the future — sale-ability and pledge-ability — with lower yield as a trade-off. Other institutions have looked to extend their investment portfolios further out on the curve to increase yield while mitigat- ing tail risk by match funding with 5+ year structures at historically low rates. For instance, banks have worked with some firms to utilize their inexpensive, longer-dated funding mechanisms at attractive rates. Many corners of the banking indus- try are concerned that low rates, slower loan origination, and excess liquidity trends are here to stay for the foreseeable future and have begun searching for loan surrogates. Allowing these banks to extend their liability portfolio’s duration at a scalable level opens the door to more asset purchase strategies. We have seen two specific asset strategies gain momen - tum: exploring community and regional bank subordinated debt as an investment option and analyzing how to invest in municipals without ruining their interest rate plan. As an alternative to extending the liability portfolio, some institutions have swapped fixed rate municipals to floating, thus obtaining an attractive yield with reduced duration risk and protect- ing Tangible Common Equity. Exploring risk/reward profiles of earning assets is nothing new to balance sheet manag- ers, but the environment has certainly evolved since the start of 2020. Managing excess liquidity while planning for interest rate risk manage- ment has also become slightly more complicated on the liability side. How does a bank choose from the various funding options and hedging strategies available? The decision-making process must consider balance sheet composi- tion (i.e., the availability of liabilities to hedge), impact to earnings and capital (in addition to liquidity) from the strat- egy and practical applications, such as hedge accounting. It’s generally recommended for accounting simplicity and hedging flex - ibility to first evaluate liability hedges when attempting a shift in interest rate risk profile. Many institutions took advantage of both spot-starting and forward-starting cash flow hedges over the past year. Forward-starting swaps on forecasted borrowings allow the bank to purchase longer duration assets today and know they will maintain the future’s attractive spread. For exam- ple, offerings like IntraFi Network’s (formerly Promontory Interfinancial Network) IntraFi Network Deposits give banks the ability to launch these funding contracts six months to one year in the future, while locking in their rate now to hedge against any increase in funding costs before the launch date. This allows the bank maximum flexi - bility in planning its liquidity now and well into the future. But what about banks flush with liquidity with no future funding needs anticipated? Part of the answer arose from a surprising place: dealing with yet another source of stress — the LIBOR transition. The FASB released ASC 848 Reference Rate Reform in March 2020 to address potential concerns about the impact of the up- coming LIBOR transition on hedge ac- counting. Although LIBOR fallback is expected at year-end 2021, guidance is applied immediately to help users explore potential alternative contracts and rates. It allows banks to be proac- tive in dealing with LIBOR cessation and identify a new hedged exposure. The bank can then modify the hedge to match the new (non-LIBOR) exposure, adjusting the fixed-rate or adding a f loating rate spread to keep the transaction NPV-neutral. Finally, the bank can amend their hedging memo to ref lect the new exposure, and the hedge relationship continues without de-designation. A positive balance sheet strategy development comes from this guid- ance — by allowing banks to consider a change to a non-LIBOR hedged item, essentially providing added flexibil - ity to banks that have implemented strategies using wholesale funding paired with swaps, a strategy that many banks smartly continue to explore. The guidance allows those banks to consid- er replacing the existing funding with other sources for cheaper and more customizable wholesale borrowings or even deposit products without impact- ing hedge accounting. These products allow a bank to replicate the previous funding instruments’ details, but at a considerably discounted cost. Banks can leverage the new accounting guidance to change the hedged exposure from wholesale funding to deposits without a re-designation event, allowing the bank to pay down wholesale borrowings. For banks that now have many more depos- its than when they first implemented the strategy, reducing their current need for wholesale funding, this is a welcome change in funding source that maintains the interest rate protection they continue to need. This rule can be applied in a variety of different ways. Banks can make changes to the interest rate index, the spread to that index, the reset period, pay frequency, business day conven- tions, payment and reset dates, the strike price of an existing option, the repricing calculation, and may even add an interest rate cap or floor that is out- of-the-money on a spot basis. On the other hand, some aspects of the hedge are unrelated to the reference rate reform: an institution cannot effect a change to the notional amount, matu- rity date, change from an interest rate to a stated fixed rate, or add a variable unrelated to LIBOR. Ultimately, none of these options singlehandedly solve the problem of too much liquidity with too few safe places to deploy them while earning an attractive yield and protecting against the eventuality of rising rates. Like life in 2020, the key is to deploy various creative tactics to weather the storm and emerge a stronger institution. n Many corners of the banking industry are concerned that low rates, slower loan origination, and excess liquidity trends are here to stay for the foreseeable future and have begun searching for loan surrogates.