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FMS Boston ALCO/Interest Rate Risk Update: Regulatory Conversations and Practical Strategies February 25, 2014 Ryan Henley, CFA Head of Financial Institutions.

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Presentation on theme: "FMS Boston ALCO/Interest Rate Risk Update: Regulatory Conversations and Practical Strategies February 25, 2014 Ryan Henley, CFA Head of Financial Institutions."— Presentation transcript:

1 FMS Boston ALCO/Interest Rate Risk Update: Regulatory Conversations and Practical Strategies February 25, 2014 Ryan Henley, CFA Head of Financial Institutions Strategies rhenley@sterneagee.com (205) 949-3509

2 Regulatory Conversations 2

3 Recent conversation with one of the three regulatory agencies yielded the following input: Regulatory Focus Asset Liability and Liquidity Management a Focus for 2014 Stress repricing betas and decay assumptions – Representatives from business lines to speak to account relationships – CD disintermediation – penalty evaluation – Detailed account analysis/decay study Account openings/closings and average balances over time Surge accounts 10 yrs of history Update every 1-2 years unless significant rate changes – Peer data useful only if peer group representative of markets and operating structure Policy Components Challenging rate shock policy limits – Why? Perhaps speak to acceptable/necessary net interest margin (NIM) Non-parallel shift limits not necessary – Review for necessary NIM 3

4 Case Study: Money Market Stress Testing The following is a study into the impact of an underestimation in liability correlation assumptions. Like many financial institutions such as the one below, disintermediation has occurred away from time deposits into money market and checking accounts. Changes: The chart below illustrates the changes of this sample institution over time 4

5 Case Study: Net Interest Income Stress Test As seen by the graph below, the bank is expected to earn a 3.37% net interest margin or around $9.8MM in net interest income over the next year if rates stay the same. For every additional 10% contributed to the correlation for money market accounts (which represent just under 50% of the total funding base), the margin is forecast to decline by 17 bps. 5

6 Case Study: Economic Value Stress Testing If we take the analysis a step further and make assumptions relating changes in deposit terms to income impact, we can extrapolate the effects on economic value. 6 Projected correlation increases along with declining terms estimate the income impact due to partial outflow, replaced by wholesale funding and/or disintermediation Value changes in +400 scenario declines to -20% (12 month scenario) from -14% (base case scenario)

7 ASSET MIX REBALANCING STRATEGY 7

8 Background The combination of a few key factors have created a favorable backdrop for a strategy to immediately accrete earnings and enhance margin. Strategy Hedge a small portion of your floating rate loans through a receive-fixed interest rate swap This strategy is designed as a risk mitigant against the possibility that short term rates do not increase for an extended period of time Operating Environment Backdrop Competitive environment for loan growth – In the money floors more difficult now to implement – Unfloored Libor/Prime floating accruals pressuring margin The curve is near a historically steep level, which enables: – Immediate NIM accretion by “fixing” the interest rate on a subset of floating rate loans – Aggressive origination enabled (floors unnecessary) as can effectively “fix” at treasury level – Attractive “roll down” on the curve provides flexibility/protection as time elapses 8

9 Short-End Interest Rate Considerations FOMC Statement Excerpt: 12/18/13 “The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.” Loan Origination – Fixed Floating Mix Issues Real Case Study – Institution’s loan growth has shifted fixed/floating composition significantly – Resulted in shifted A/L profile to moderate asset sensitivity 9

10 Strategy Overview In order to qualify for proper hedge accounting, it is best to aggregate a pool of: – Libor loans (benchmark interest rate, mindful of reset date, day count, floors, etc) – Prime based loans (non-benchmark interest rate, mindful of spreads, day count, floors, etc.) Floored Loans: in many cases, depending on the rate, the strategy could still provide an opportunity to accrete earnings and enhance margin 10 Variable StructureMaturityFixed RateSpread 1 Mo Libor4 Yr Hedge1.19%104 bps 1 Mo Libor5 Yr Hedge1.58%143 bps

11 Accrual/Roll Down Considerations Curve Steepness – 3 yr to 5 yr points on the curve 11 5 yr vs. 4 yr Swap Rate (2000 to current) The green highlights represent the steepest portions of the curve Above, we illustrate the historical steepness of the curve between the 5 yr and 4 yr point of the curve tracing back to 2000. Contrast with timing of previous Fed Funds tightening environment

12 Accrual/Roll Down Considerations Illustration of previous 5 yr swap rates in relation to QE (operation twist) action Cumulative Income Relative to Horizon Market Value (100mm notional, 5 yr term assumed) 12

13 TCE PROTECTION STRATEGY 13

14 Strategic Considerations In an economic backdrop that begs the question of not if rates will increase further, but when the rate increase will occur (and to what extent), financial institutions continue to seek methods to protect from further unrealized losses within the securities portfolio Given that the unrealized loss on investment securities classified as available-for-sale is marked-to-market within Other Comprehensive Income, increased unrealized losses have an adverse impact on the bank’s Tangible Common Equity (and hence Tangible Book Value/Share) position To best protect against these risks, the following strategies are often evaluated: – Portfolio restructure strategies to shorten duration – Usage of Held-to-Maturity designation to ‘shield’ from Unrealized Losses – Hedging via pay-fixed Interest rate swaps or caps Within the remainder of this presentation, we will explore the usage and application of pay- fixed interest rate swaps to hedge the bank’s exposure to rising rates 14

15 12/31 AFS Investment Portfolio Impact on TCE In the +200 bps scenario, TCE declines $22mm from existing position which results in a 121 bp decline in the TCE ratio to 8.81% and $0.64/share decline in TBV. 15 * Assumes 35% statutory tax rate

16 Proposed Solution: Pay-Fixed Interest Rate Swaps 16 Fixed Swap Rate 3m Libor DebtSwap FHLB Swap Counterparty A pay-fixed interest rate swap is an effective hedge to guard against rising interest rates (protect TCE). This instrument is a synthetic fixed rate borrowing, where the changes in market value of the swap move in the opposite direction of fixed rate securities and are recorded in Other Comprehensive Income (OCI) -- not earnings. – Opportunity for utilization depends on structure and presence of existing wholesale funding book (e.g., FHLB advances, brokered CDs, etc.) – Compared to other solutions for rates up protection (Held-to-Maturity designation and longer term fixed rate funding), this provides realizable gain in rates up and limits future balance sheet encumbrance To utilize this protection, many institutions have implemented the use of deferred-start interest rate swaps. A deferred-start interest rate swap offers the following benefits vs. a spot-starting swap: – No near term margin compression with deferred start – utilize the accommodative Fed during the swap deferral period (floating rate period) – Future fixed borrowing rate is based off of today's historically low forward curve – Flexibility to increase funding as needed, rather than immediately growing the balance sheet (cash flows hedged must be deemed “probable” they do not have to exist during deferral period, only once accruals begin on the swap) Sample Bank

17 Application: Maturing Wholesale Funding As discussed on the previous slide, the utilization of a deferred-start interest rate swap allows for flexibility in its application to the bank’s balance sheet given that cash flows hedged must be deemed “probable”. They do not have to exist during deferral period but once accruals begin on the swap. Thus, planning to replace the bank’s maturing FHLB advances with LIBOR-based funding as they come due would allow for an effective cash flow hedge relationship and effectively create a floating-to-fixed funding instrument when paired with deferred-start swaps. 17 In addition to the mark-to- market through OCI characteristic created by the cash flow hedge relationship, the utilization of this funding vehicle has proven to be cheaper vs. standard fixed rate FHLB advances

18 Proposed Swap Buckets 18 In order to stagger deferral periods and maturities, we divided the strategy into 2 individual swap structures (“buckets”): In other words, 6 year term begins at end of 2.5 year deferral period and the 7 year term begins at the end of 3 year deferral period. *indicative rates as of 1/31/14 BucketNotionalStructureFinal MaturityFixed Rate 1 $30,000,000In 2.5 for 68.5 yr3.45% 2 $30,000,000In 3 for 710 yr3.77% $60,000,0003.61%

19 Deferred Swap Strategy: TCE Risk Offset 19 Impact on TCE of $60mm deferred swaps (as described on previous slide) illustrated below: The deferred swap strategy provides the ability to offset 20% of the AFS investment portfolio’s impact to TCE, resulting in the preservation of a TCE ratio of 9.05% in the +200 bps scenario

20 Deferred Swap Strategy: TCE and TBV Preservation 20 Summary of impact to TCE and TBV as a result of $60mm deferred swaps illustrated below: The deferred swap strategy provides the ability to preserve 24 bps of TCE and $0.12/share of TBV in the +200 bps scenario

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