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Financial Managers Society - Deriving Value with Bob Newman

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A PUBLICATION OF THE FINANCIAL MANAGERS SOCIETY SEPTEMBER/OCTOBER 2019 | FMSinc.org WELL-FOUNDED FEARS The main objections community institutions often have to derivatives are relatively straightforward: derivatives are risky and necessitate complex accounting. "There is such a negative connotation to the word 'derivative,'" says Scott Hildenbrand, principal and chief balance sheet strategist at Sandler O'Neill + Partners. "I think a lot of people are hung up on the accounting, which they think of as messy – that's not necessarily the case but it's certainly the perception. The second hang-up is that people think of derivatives as rate bets. I think the big misconception isn't people misunderstanding derivatives themselves so much as the use and purpose of a derivative." Much of the wariness surrounding derivatives comes from their admittedly tumultuous history. Derivatives are a fairly recent invention that nonetheless have accumulated an impressive rap sheet. "This product was invented by the market as an innovation to really help folks deal with the unprecedented volatility and the extremely high interest rates of the early eighties," says Bob Newman, managing director at Chatham Financial. "In the thirty- odd years since their origination, there have been a lot of examples of people who have either misused or speculated with derivatives, who gave the product a bad name and created a lot of fear. With that being said, there have been some really positive changes that make now a very good time for community banks to take a fresh look at derivatives." One of the most infamous cases of misuse of derivatives was Proctor & Gamble's mid- 90s derivatives scandal – an episode that still looms large in many bankers' minds. "Proctor & Gamble's investors were upset because according to the rules at the time, derivatives really didn't appear on the financial statements – they were only mentioned in the footnotes," Newman explains. "So after the scandal, FASB created a new standard that said organizations had to bring the derivatives out of the footnotes. However, that created a lot of volatility on the income statement, so FASB created hedge accounting to act as a shock absorber. It was designed with good intentions, but there were a lot of rules to be followed, and if you didn't dot every I and cross every T you could lose the privilege of doing hedge accounting. All of this is to say some scars and instinctual fear remain because in its original incarnation hedge accounting was difficult to apply and quite unforgiving." With such a messy history, it's no wonder many institutions are leery of entering the world of derivatives. After all, derivative securities had a devastating role in the financial crisis of 2008. And the fact of the matter is that there certainly is risk involved in using derivatives. Hildenbrand says that potential risk falls into three basic areas: risk the counterparty will default, risk of ineffective accounting and risk of regulator pushback. However, recent developments have minimized many of those concerns. "With the use of derivatives on the rise and the recent rule changes, regulators are on board with the potential increase in the use of derivatives as well," he notes. DERIVATIVES DONE RIGHT An argument can be made that derivatives are misunderstood and many of the major objections to them outdated. FASB's 2017 changes to the accounting standard were intended to streamline the process and make it more accessible. "I would call the new and revised hedge accounting standard a game-changer for community banks because it has become much more practical," Newman says. F E AT U R E BY THE NUMBERS DERIVING VALUE IS IT TIME FOR COMMUNITY INSTITUTIONS TO RECONSIDER DERIVATIVES? According to the OCC's Quarterly Report on Bank Trading and Derivatives Activities for the first quarter of 2019, roughly 27% of commercial banks and savings associations in the U.S. are using derivatives. According to S&P Global Market Intelligence's Bank Call Report Data as of the end of 2018, that number is much lower for smaller community institutions – only about 7% of community banks with assets between $500 million and $1 billion use interest rate derivatives. Meanwhile, the OCC notes that a small group of large banks dominates derivatives activity. With derivatives seemingly tailor-made to offer banks a way to manage their interest rate risk, why aren't more community institutions interested in exercising this particular option? In the thirty-odd years since their origination, there have been a lot of examples of people who either misused or speculated with derivatives, who gave the product a bad name and created a lot of fear. I think there have been some really positive changes that make now a very good time for community banks to take a fresh look at derivatives. Bob Newman, Managing Director – Chatham Financial 27% of commercial banks and savings association use derivatives 7% of community banks with assets between $500 million and $1 billion use derivatives 88% of the total banking industry's derivative notional amounts is made up by four large banks Sources: OCC's Quarterly Report on Bank Trading and Derivatives Activity Q1 2019 and S&P Global Market Intelligence's Bank Call Report Data Q4 2018

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