Your Wisconsin Balance Sheet Solutions Team:
Fred Kelly • Jonathan Ferebee • David Holsted
877-506-7075
ICBA Securities is a member of FINRA/SIPC
Exclusively Endorsed by
Securities execution services are offered by ICBA Securities Corporation a registered broker-dealer and Member FINRA/SIPC. Other services and products
mentioned are n
y be offered by separate but affiliated companies. Please visit our website for additional important disclosures
and information.
Interest Rate
Risk Solutions
The quick back up in rates that occurred in the 2nd quarter
caught many banks off guard and provided a painful reminder
of what higher rates can do to investment portfolio values
and book capital levels. This rate move also prompted the
FDIC to re-emphasize the importance of interest rate risk
oversight and management in Financial Institution Letter (FIL-
46-2013) released October 8, 2013.
Over the last 5 years, sluggish loan growth, an influx of
deposits and generational lows in interest rates have created
conflicts among the three primary purposes of the invest-
ment portfolio: liquidity, interest rate risk management and
earnings. Now, perhaps more than at any time in the recent
past, it is important for banks to protect the investment
portfolio against a repeat of the 2nd quarter rate moves. As is
pointed out in the FDIC’s letter, failure to protect investment
portfolio values can lead to losses as well as liquidity and
capital constraints.
Historically banks have protected the investment portfo-
lio against rising rates by shortening durations - either buying
shorter or selling longer duration bonds. While this technique
works, it may not be the most efficient way of managing
existing risk nor is it the only option. Many banks are utilizing
alternative strategies to protect investment portfolio and
book capital values.
The first alternative, a direct hedge of the investment
portfolio, is one in which the bank uses an interest rate swap
and designates specific investment securities in a hedge ac-
counting relationship. The second, an indirect hedge, is one
in which the bank uses an interest rate swap and designates
assets (other than bonds) or liabilities in a hedge accounting
relationship. The economic outcomes of both strategies are
similar; however, the accounting outcomes may be signifi-
cantly different.
The traditional process for developing balance sheet risk
management strategies starts with the bank’s current balance
sheet and IRR profile. The models used to compute the IRR
profile (EAR and EVE) employ numerous assumptions about
pricing, new business volumes and other important variables.
This makes these models useful tools for projecting earnings
in various rate scenarios, but also makes their output suscep-
tible to the assumptions used.
When using EVE, many of the “values” cannot be im-
mediately realized or monetized. For example, the traditional
fixed rate FHLB advance has a prepayment penalty in a falling
rate environment but has no prepayment benefit in a rising
rate environment. The typical EVE model assumes that these
advances lose value as rates fall and gain value as rates rise.
The shortcoming of this approach is that the rising rate values
cannot be immediately realized or monetized.
We make the above points to illustrate why focusing on
the investment portfolio and its sensitivity to changing market
interest rates is so important in today’s environment. While
this is a non-traditional approach to IRR management, the
investment portfolio is a sensible place to find IRR exposures
that are not impacted by modeling assumptions, is a signifi-
cant source of risk for many banks and is inherently manage-
able. Therefore, we believe it makes sense to find ways to
“protect” its value.
A direct hedge of the investment portfolio may be pre-
ferred by banks that actively manage the investment portfolio.
With the direct hedge, if rates rise and you sell the bond, you
would simultaneously terminate the swap. The value of the
bond and the value of the swap would both be recognized in
current earnings.
With an indirect hedge, assuming the bank hedged
a deposit account; the bank would simultaneously sell the
bond and terminate the swap. The value of the bond would
be recognized in current earnings while the value of the swap
would be recognized in earnings over the remaining life of
the hedge accounting relationship (assuming the associated
risk exposure still existed).
For many banks, the investment portfolio may provide
the only opportunity to achieve hedge accounting treatment.
For those other banks that have plenty of assets or liabilities
that do lend themselves to favorable hedge accounting treat-
ment, an indirect hedge may be the preferred approach.
If you are concerned about rates moving higher and
would like our help developing and executing a well crafted
risk management strategy for your bank, please contact your
Vining Sparks/ICBA Securities account representative.
Rick Redmond, Director-Balance Sheet Strategies
Protecting Investment Portfolio
and Book Capital Values
Your Wisconsin Balance Sheet Solutions Team:
Fred Kelly • Jonathan Ferebee • David Holsted
877-506-7075
ICBA Securities is a member of FINRA/SIPC
Exclusively Endorsed by
Securities execution services are offered by ICBA Securities Corporation a registered broker-dealer and Member FINRA/SIPC. Other services and products
mentioned are not insured by SIPC and may be offered by separate but affiliated companies. Please visit our website for additional important disclosures
and information.
rest Rate
Risk Solutions
The quick back up in rates that occurred in the 2nd quarter
caught many banks off guard and provided a pai ful reminder
of what higher rates can do to i vestment portfolio values
and book capital l vels. This rate move also prompted th
FDIC t re-emphasiz the importance of inte est rat risk
oversight and m nagem nt in Financial I stitution Letter (FIL-
46-2013) released Octob r 8, 2013.
Ove the last 5 years, sluggish loan growth, an influx of
deposits and generational lows in interest rates have created
conflic mong the hree primary purposes of t e invest-
ment portfolio: liquidity, interest rate risk management and
ear ings. N w, perhaps more than at any time in th recent
p st, it i important for banks to protect the inves ment
or folio against a repeat of the 2nd quart r rat moves. As is
inted out i the FDIC’s letter, failure to protect investment
rtfolio values can lead to losses as well as liquidity and
capital constraints.
Historically banks have protected the investment portfo-
lio against rising rates by shortening urations - either buying
shorter or selling longer duratio bonds. While this t chnique
w rks, it may not be the mos efficie t way of managing
existing risk nor is it the only option. Many banks are utilizing
alternative strategies to protect investment portfolio and
book capital v lues.
The first lternative, a direct hedge of the investment
portfolio, is one in which the bank uses an int rest rate swap
and designates specifi investment curities in a hedge ac-
counting relationship. The second, an indir ct hedg , is one
in which the ba k uses an interest r te swap and designat s
assets (other than bonds) or liabilities in a hedge accou ting
relationship. T e ec omic outcom s of both str tegies are
similar; however, the accounting outcomes may be signifi-
cantly differ nt.
The traditional process for developing balance sheet risk
management strategies starts with the bank’s curr nt balance
sheet and IRR profile. The models used to comp t the IRR
profile (EAR and EVE) employ numerous assu tions about
icing, new business volumes and other important v riables.
This makes these models seful tools for projecting e rnings
in various rate cenarios, but also makes their output suscep-
tible t the assumptions used.
When using EVE, many of the “values” cannot be im-
mediately realized or monetized. For example, the traditional
fix rate FHLB a vance has a prepayment p nalty in a falling
rat environment but has no prepayment benefit in a rising
i
. The typical EVE mod l assumes th t these
advances lose value as rates fall and gain val e as rates ris .
The shortc ming of this approach is that the rising rate values
cannot be i mediately realized or monetiz d.
We make the bove points to illustrate why focusing on
the inv stment portfolio and it sensitivity to c anging market
interest rates is so import t in today’s envir nment. While
this is a non-traditional approach to IRR management, t e
investment portfolio is sensible place to fi d IRR xposures
that are not impacted by modeling ssumptions, is a signifi-
cant source of risk for many banks and is inherently manage-
able. Therefore, we believe it ma es sen e to find ways to
“protect” its value.
A direct hedge of the investment portfolio may be pre-
ferred by banks that activ ly manage he investment portfolio.
With the direct hedge, if rates rise and you sell he bond, y u
would simultaneously te minate the swap. The value of the
b nd and the value of he sw p would both be recognized in
current earnings.
With a indirect hedge, assuming the bank hedged
a deposit account; the bank would simultaneously sell the
bond and termi ate the swap. The value of the bond would
e recognized i current earnings while the value of the swap
would be recog ized i earnings over the remaining lif of
the hedge a counting rel tio ship (assuming the associated
risk exposure still existed).
For many banks, the investment portfolio may provide
the only opportu ity to achi ve h dge acc unting treatm nt.
For those other banks th t a pl nty of assets or liabilities
that d l nd themselves to f orable hedge acc unting tr at-
ment, an i
irect h dge may be the pr ferred approach.
If you are oncern d about rates moving higher and
would like our help dev loping and executi
a well crafted
risk management strategy for your bank, please contact your
Vining Sparks/ICBA Securities account repr sentative.
Rick Redmond, Director-Balance Sheet Strategies
Protecting Investment Portfolio
and Book Capital Values
