Rising rates fuel banks’ return to FHLB advances and hedging strategies

More banks are turning again to wholesale funding and hedging to limit volatility in their liabilities.

By John Hintze

Customers drawing down deposits have prompted banks to increase their use of the wholesale funding markets, while a bifurcation has emerged between banks using structured products to mitigate the negative impact of rising rates on their bond portfolios and the very largest banks seeking to extend higher rates on their loan assets.

Virtually all banks saw deposits increase to historically high levels during the pandemic as customers sought the safety of federally insured accounts, often buoyed by federal emergency checks. Deposit levels are now returning to more normal levels, prompting especially smaller banks to compensate by returning to wholesale funding.

Banks’ Federal Home Loan Bank advances jumped to nearly $326 billion in second quarter of 2022, up from $204 billion in the previous quarter and a low of $189 billion in fourth quarter 2021, reports the FDIC. FHLB advances reached a high of $613 billion in first quarter 2020, the quarter in which pandemic lockdowns began, and dropped rapidly to $378 billion over the next quarter.

The volume of FHLB advances should continue to increase this year, along with other forms of bank wholesale funding, such as brokered deposits and short-term bonds, notes Todd Cuppia, managing director and head of Kennett Square, Pennsylvania-headquartered Chatham Financial’s balance sheet risk-management practice for financial institutions.

Banks’ use of brokered deposits similarly dropped at the start of the pandemic and fell to a low in fourth quarter 2021, of $594 Billion, after which it has started to climb, although less rapidly than FHLB advances, according to data from the FDIC and Kroll Bond Rating Agency. In second quarter 2022, brokered deposits reached $645 billion, up from $595 billion the quarter before, an 8.4 percent increase compared to FHLB advances’ 60 percent increase.

The very largest national banks still have abundant deposits. For example, J.P. Morgan reported a 9 percent increase in deposits in the second quarter. However, says Cuppia, smaller regional competitors with less demand for deposits are turning again to wholesale funding and hedging those instruments to limit volatility in their liabilities.

“We probably went two years when we didn’t see any funding hedges, and now in some cases it’s multiple times a day,” Cuppia says.

The FHLB of Indianapolis and other FLHBs are offering creative products designed to meet bank clients’ current needs, says Jerry Clark, director of client engagement at Moody’s Analytics. Clark points out that includes a variety of structured advances, such as put and call options, as well as more sophisticated products such as collars, which employ options to set floors and caps on rate moves to reduce rate volatility.

In a basic structure, banks anticipating interest rates peaking within a certain time frame and then falling again may take an FHLB advance today at a relatively low rate for specified period, after which it foresees customers shifting back again to deposits.

“Banks don’t want to bet the farm, but that’s what asset/liability management is all about—positioning the bank so it doesn’t get hit hard if rates do unexpectedly kick out and turn against it,” Clark said.

The FHLBs’ structured advances offer convenience and a known counterparty. But banks may pay a premium.

“We find that it is typically less expensive to purchase the same derivative without embedding it into the borrowing product itself,” Tevis says.

Cuppia said approximately 30 percent of the banks Chatham works with are hedging rising rates, to limit volatility on the liability side and also in their bond investment portfolios. With rates close to zero during the pandemic, those banks often invested in longer-term fixed-rate bonds with higher yields, he adds, and now they are hedging against the incremental price risk of rates increasing and corresponding bond prices falling by paying fixed on interest-rate swaps that will gain in value as rates rise.

That should reduce the impact on other comprehensive income, a financial-statement measure reflecting debt instruments’ valuation changes that investors scrutinize. The banks pursuing those transactions typically have assets of $250 billion or less, Cuppia says.

Ethan Heisler, a longtime bank analyst and now a senior adviser at KRBA, noted in a September report that the sharp hike in interest rates in the second quarter led to a “plunge in negative accumulated OCI … that was tied to a surge in FHLB advances.”

FHLB advances nevertheless remain near a 20-year low, Heisler says, and the surge in the quarter compared to brokered deposits may simply indicate that it is easier and less time consuming to use advances when there’s a rush to shore up liquidity. In addition, loan growth in the commercial real estate and multifamily housing markets remains strong, and banks focused in those areas may be supplementing their deposit funding to support that growth, he adds

The other 70 percent of Chatham’s clients tend to be larger banks that anticipate rates dropping next year in the wake of central banks’ aggressive interest rate hikes. Cuppia noted that the market currently anticipates Fed Funds peaking in February around 4.5 percent, and then starting to decline, prompting those banks to hedge increasingly against the downside risk of falling rates squeezing their margins on loan assets.

“They want to continue to tell shareholders that they’re earning this higher level of income, and they‘re looking to lock in some of the levels available in the market today,” Cuppia says.

In some cases, says Matthew Tevis, managing partner at Chatham and head of its financial institutions team, the banks are hedging on a forward starting basis, seeking to “ride” the rate increases and but have protection to activate closer to when rates peak. Whether that happens at 4.5 percent or higher—JPMorgan Chase Chairman and CEO Jamie Dimon warned recently about the latter—remains to be seen.

Should rates peak after a rapid rise and then begin to fall, one way to hedge subsequent downside risk is with a collar hedging strategy, which many bank clients are increasingly pursuing. In such a strategy, the bank purchases an option to put a floor on falling rates that makes sense for the institution’s balance sheet and sells a cap on rising rates.

“The bank can create a band that’s wide enough where it still gets a lot of the upside if the Fed continues to raise rates the way it’s signaling, and hedge that downside risk,” Tevis says, adding that such strategies can be executed on a no-cost basis if structured properly.

John Hintze is a frequent contributor to the ABA Banking Journal.