By John Hintze
As the Federal Reserve was cutting interest-rates last fall, the anticipation was for further cuts in the new year. Record tariffs and whether they result in a recession, inflation or an ugly combination of the two have stymied more cuts and even introduced the possibility of rate increases, leaving banks in a pickle about how to protect their balance-sheets.
Increasing balance-sheet cash is the most basic hedge, and most banks are already prepared on that front. Ethan Heisler, editor and chief of the Bank Treasury Newsletter and former banking analyst at Citigroup, notes that banks’ cash holdings have remained near historical highs as a percentage of total assets ever since the 2008 financial crisis. According to Fed data, cash as a percentage of total assets spiked dramatically from less 5% in 2008 to nearly 20% by 2015, and it now hovers around 15%.
The rapid rise of FedNow and other instant payment systems have contributed to banks holding more cash, Heisler said. But bank treasurers’ more conservative approach to managing liquidity really started after the liquidity crunch following SVB’s failure, and it has been further fueled by the new administration’s policies.
“Banks are waiting to see what’s going to happen in the next months, retaining deposits and not investing,” Heisler says. “When bonds I bought three years ago mature, I might leave the proceeds at the Fed longer or put them into even shorter-maturity securities.”
Smaller banks turn to swaps
In the wake of the failing of Silicon Vally Bank and increased regulatory scrutiny, even smaller banks with only a few billion dollars in assets are using swaps and other derivatives to more proactively hedge risk, says Todd Cuppia, head of Chatham Financial’s balance-sheet-management practice. Since smaller banks tend to focus lending on retail customers’ mortgages and other fixed-rate products and fund themselves with short-term deposits, they typically will use pay fixed swaps to protect against the impact of rising rates on both sides of the balance sheet. By paying fixed rate and receiving floating rate, they can shorten the duration of long-term, fixed assets such as 30-year mortgages, or lengthen the duration of funding on the liability side.
“There are incentives to use one or the other, and usually they’ll use both, depending on their circumstances,” Cuppia says.
The concentration of a bank’s portfolio is a key factor. Wisconsin’s Johnson Bank has layered on approximately $325 million in receive fixed swaps to protect against falling rates. Its simulation model considers the state of the yield curve, the direction of rates and other factors, and it has indicated that rates falling by 2% or more would significantly contract margins stemming from the bank’s book of commercial floating-rate loans.
“We’re less concerned about rates going up, because margins on that same book of commercial variable [rate loans] goes up,” says Mark Behrens, CFO of Johnson Financial Group, the holding company of the $6.8 billion-asset bank and Johnson Wealth, which provides wealth management services.
The receive fixed swaps also hedge the risk of the secured overnight financing rate falling in times of stress, when investors seek the safety of the overnight repos that generate the benchmark, while the bank’s funding costs rise.
“That’s a concern and it’s the main reason for laying in receive fixed swaps,” Behrens says.
In 2021, when rates were at historical lows, the bank originated approximately $100 million in pay fixed swaps on the liability side to lock in the low-cost funding, Behrens says. And as those swaps mature, it is declining to renew them.
A much larger regional bank with assets totaling just under $100 billion has instead layered on pay fixed swaps on the asset side as a hedge against its available-for-sale book of fixed-income securities falling in value in the event rates increase, the issue that harmed SVB and other regional banks.
“On the liability side, pay fixed swaps have been used to create a synthetic, fixed-term funding rate while rolling actual borrowings over a shorter period,” says the bank’s CFO.
Smaller institutions, however, may find it challenging to find cost effective swaps.
“If you think about the amount of capital that a large bank dealer will have to put on its balance sheet for the return it will get, the economics to serve smaller institutions become very difficult,” Heisler says.
Swaps of $10 million fetch better pricing
Behrens said his 32-branch bank has found dealers offering reasonable pricing on swaps of $10 million or more, with his bank’s transactions typically in the $25 million range.
“If you ask for a $1 million swap, if they even do it the execution and pricing will probably be poor,” he says.
Both Cuppia and Heisler pointed to the CME Group’s Eris Swap Futures as alternative hedging tools for smaller banks, since they can be traded directly or through a future commission merchant at about half the price of over-the-counter (OTC) swaps. Cuppia explains that they provide similar hedging benefits, although there’s less flexibility to match the hedge to the underlying risk. He added that a few years ago the CME enabled portfolio margining of the Eris product with other CME products, reducing its costs and increasing liquidity, but it remains relatively unknown in the banking community.
In fact, the banks contacted by the ABA Banking Journal had heard of the Eris product but had not used it, although Behrens said it looked interesting enough to ask his company’s treasurer to take a closer look.
Larger banks’ tendency to have more floating-rate exposure through their commercial and industrial loans, Cuppia says, incentivizes them to engage in more sophisticated derivatives transactions, often involving options, to target hedges more accurately. In a forward starting floor, for example, the bank pays the option premium to a Wall Street counterparty to protect against interest rates falling below a specified level at a certain point in the future.
“Until that time, the bank doesn’t need to recognize any of the premium expenses associated with purchasing the option,” Cuppia says.
Darren Hermann, EVP and treasurer at UMB Bank, says his bank is not a significant user of derivatives relative to the size of its balance sheet, but it has employed them to protect its earnings in rising and falling rate environments. In late 2023, for example, it began adding falling rate protection by laddering in one-year forward-start and spot-start interest-rate floors and floor spreads over the next 12 months, reaching its current notional position of $3 billion.
He added that the bank evaluates and selects hedges, including floors, floor spreads, caps and collars, based on a number of factors in the context of current market conditions. It also protects against declining rates by altering the terms of its loans and bonds, or by lowering excess cash on its balance sheet by investing in bonds to lock in yields.
UMB is a major custodian and generates fee income form assets under management that are often tied to the performance of the stock market, which has been very volatile in 2025.
“We have looked at hedging that risk but to date have chosen not to do so,” Hermann says.
Contributing editor John Hintze is a financial journalist who writes frequently for the ABA Banking Journal.
