Why Don’t Banks Hedge More?

Although there has been increased interest in hedging to manage interest rate risk, the nation’s banks tend to avoid swaps. 

The persistently high interest rate environment has squeezed bank margins and earnings, given the amount of fixed-rate assets banks carry and the increasingly expensive funding environment. Derivates and swaps are one tool financial institutions can use to manage their interest rate risk stemming from those dynamics. But experts say bankers remain skeptical of these instruments, given their historically negative impression, concerns that the accounting is complex and a belief that interest rates may begin to decline. 

Interest rate risk was a major concern in Bank Director’s 2024 Risk Survey, even though 80% of respondents in January 2024 said their bank did not engage in any hedging to offset the impact of higher interest rates in 2023. Hedging is particularly low at small banks. A closer look at the data shows that 91% of respondents at banks with $250 million and $500 million in assets and 89% of respondents at banks with between $500 million and $1 billion said their bank doesn’t hedge.

One small bank that has a different view is Southern Bank of Tennessee. “Hedging is not a bet,” says Justin Cary, chief credit officer at the $424 million institution. “You’ve already placed the bet with your balance sheet structure, and you’ve got to figure out what can mitigate that risk in the event you’re wrong.”

Cary saw interest rate risk rising throughout 2022 and 2023 at the Mount Juliet, Tennessee-based bank, including in its economic value of equity, or EVE, model, and he became worried about the long-term impact on earnings. Southern Bank’s historical performance indicated it takes two years for earnings to fully recover after interest rate changes. What’s more, Cary realized the bank’s business model needed to be risk-adjusted to correct its natural sensitivity to interest rates.

Southern Bank executed several moves to reduce its interest rate risk in late 2023, including adding swaps on 3% of assets. Cary says a director on the board thanked him recently for executing these swaps; the swaps plus other steps means that Southern Bank should bring its EVE within bank-determined limits by the end of 2024. 

It’s faster for a bank to add a swap than shift its loan or deposit pricing, and they’re cheaper than balance sheet restructurings that would allow banks to address major drivers of interest rate risk on their balance sheet. 

“Derivatives do their best work when the environment changes more quickly than you can adjust your pricing or lending strategy or your portfolio in general,” says Todd Cuppia, a managing director at Chatham Financial who leads the balance sheet risk management practice.

Both Cuppia and Scott Hildenbrand, who heads the investment bank Piper Sandler Cos.’ financial strategies group, say their firms were busier in 2023 than in 2022 helping banks execute interest rate swaps. One long-term driver behind hedging strategies may be bank examiners. Hildenbrand says they have “shifted their tune from ‘Why on earth are you hedging?’ to ‘Why don’t you have a hedging policy in place?’” 

Indeed, of respondents to Bank Director’s 2024 Risk Survey who said their institution had undergone a regulatory exam since March 2023, half reported heightened examiner attention to their interest rate sensitivity. The Federal Reserve said in its May Supervision and Regulation Report that its supervisors had “initiated continuous monitoring for a small number of firms with risk profiles vulnerable to funding pressures [to assess] the adequacy of firms’ liquidity and interest rate risk management.” Examiner findings increased overall at Fed-supervised banks in the second half of 2023, including weaknesses in managing liquidity and interest rate risk. 

Another important, if not new, development was a 2017 change in how companies accounted for hedges in their books. The Financial Accounting Standards Board approved the “last of layer” method that made it easier to account for hedges that cover the cash flow from a pool of assets. Bankers that may have a negative impression of hedges from the 2007-09 financial crisis or remember hedges as complex financial instruments may want to revisit the current accounting approach to hedging if they’re interested in adding this interest rate risk protection. 

Still, there are plenty of reasons why banks may opt not to hedge. One argument against implementing swaps to hedge against higher rates now is that the Federal Reserve’s Federal Open Market Committee may lower interest rates before the end of 2024, making certain swaps less useful to a bank trying to lower its interest rate risk. The yield curve, or difference between long-term rates and short-term rates, is currently inverted, but that could change, making hedging less attractive as a strategy. 

Cary says that community banks’ focus on the Fed’s moves ignores the interest rate risk that their business models naturally carry. As he sees it, a typical community bank like his often makes fixed-rate commercial real estate loans with durations of five to 10 years. Those assets inherently carry interest rate and repricing risk if the bank uses short-term deposits to fund those loans, and demand deposits have the ability to reprice faster than loans — something many banks have painfully learned in 2023. 

Customers in the age of mobile and internet banking also have an easier time rate shopping and moving money, another long-term trend. Hildenbrand says balance sheet risk changes much faster now than it did two decades ago, when he began his career, aided by digital banking technology, deposit alternatives like money market funds and customer sophistication. In response, banks should become “more nimble.”

“You have no idea where rates are going to go,” says Hildenbrand. “You cannot predict, but you can prepare.”