Why It’s Not Too Late for Interest Rate Swaps By Bob Newman, Chatham Financial “Has the train left the station? Are we trying to bolt the door after the horse has left the stable?” These are the types of questions community bank Directors are asking in the aftermath of the largest single-year interest rate increase since 1980. Playing catch-up in its fight to control inflation, the Federal Reserve’s rate hikes in 2022 were both unexpected and larger than in any previous decades. One year later, some industry observers have begun to argue that an overly aggressive Fed may soon need to reverse course to prevent a recession. If the worst is truly behind us, this line of argument goes, “Why should a bank executive invest time in 2023 to install interest rate hedging capabilities?” Because, we argue, there will always be uncertainty regarding the direction and speed of change in interest rates. Swaps give institutions enormous power because they have the ability to exchange that uncertainty (floating rate) for certainty (fixed rate). Here are three strategies we think banks with direct access to interest rate derivatives will deploy in 2023. These ideas are timeless but are particularly relevant based on where we are today in the economic cycle: 1. Individual Loans A borrower hedging program enables a bank to retain a floatingrate asset while the borrower secures fixed-rate financing via a swap. With on-balance sheet loan rates jumping from the mid-3% range to as high as 6% to 7%, booking the fixed-rate loan seems like the best thing to do. But weak or negotiable prepayment language often means that a fixedrate loan really behaves like a oneway floater. For example, a loan booked at 6.5% today will never move higher — but if the market corrects lower, you can expect a call from the borrower looking for a downward rate adjustment. Some banks without access to hedging tools have placed their borrowers into loan-level interest rate swaps by involving an outside party in the loan agreement. These indirect swaps are designed as a convenience product for small banks to get their toe in the water and accommodate larger borrowers with a long-term fixed rate. By keeping the community bank swap-free, indirect programs also prevent the bank from considering the following two balance sheet strategies that protect and enhance net interest margin. 2. Securities Portfolio Perhaps the greatest pain point related to interest rates that banks experience in 2022 was marking the securities portfolio to market prices and booking the resulting unrealized losses in the accumulated other comprehensive income, or AOCI, account. Banks without swaps installed were forced to choose between two bad options during the excess liquidity surge of 2020: hold onto cash that earned virtually nothing or purchase low-yielding long-term Today, more than 40 years since their creation, one thing is certain: it’s not too late for any bank to start using interest rate derivatives. 12 THE ARIZONA BANKER
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