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Hedging Deposits to Reduce Liability Sensitivity

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chathamfinancial.com 1 Chatham has long espoused POLAR (the Path Of Least Accounting Resistance) when it comes to balance sheet risk management. There is a bias towards simplicity and operating in the cash flow hedge accounting model whenever possible, in order to minimize or even eliminate hedge ineffectiveness and P&L volatility. For a liability sensitive FI, reducing asset duration or extending liability duration, or both, can have the desired impact on the FI's interest rate risk position. Once a financial institution decides it will use derivatives to make these adjustments, the question of what to hedge takes center stage. This whitepaper focuses on increasing liability duration (and thus reducing liability sensitivity) by hedging deposit accounts. Of course we apply our POLAR methodology to determine the simplest and most effective economic and accounting solution. WHY HEDGE DEPOSITS? Deposit accounts are central to banking and are at the heart of customer relationships. These accounts can be pooled, tiered, or indexed in ways that are beneficial to both the depositor and the FI. This allows the FI to serve its core customers with market rates, while at the same time hold down the FI's cost of funds. The inherent flexibility of these accounts can therefore lend themselves nicely to deposit hedging. Following are a few reasons why deposit accounts might be the right thing for your FI to hedge. Deposits require no new leverage. FIs need not take down new FHLB advances in order to find something to hedge. New funding means new cash to deploy, and many FIs don't need or want such funds right now. Deposit accounts, tiers, and pools can be quite large. The size of the required hedge often dictates the choice of the underlying hedged item. Larger accounts give the FI more flexibility to ultimately hedge the portion of the available funds that is enough to "move the needle" with respect to the FI's interest rate risk position. Deposit terms are controlled by the FI. Depending on the account type and desired outcome, the FI can choose amongst its existing deposit products, amend the terms of existing products, or create new products in order to achieve the desired characteristics to hedge. Deposit hedges can be very flexible. Any amount of the pool that you reasonably expect to be on deposit throughout the life of the hedge can be designated against, for any period of time (subject to your trading line limits). A deposit hedge creates a synthetic borrowing profile at any point on the curve that you choose. WHAT ARE THE COMMONLY ENCOUNTERED DEPOSIT HEDGES? Explicitly indexed deposits hedge. If the FI has deposit products that are explicitly indexed to LIBOR, Fed Funds, Prime, or some other index, these are good candidates for an indexed deposit hedge. The index, whether it is a full or modified rate, can often be hedged with precision, and incur little to no ineffectiveness. These accounts are most often encountered where the FI has a contractual arrangement with an obligation to a specific customer or pool of customers. For example, municipal customers, or a broker, as in the case of brokered variable-rate deposits. Occasionally, a specific deposit product or tier is explicitly indexed and therefore is a good candidate for a hedge. Consideration must be given to the term of the contract relative to the term of the swap, and dealt with properly in the hedge documentation. Typically, a cash flow hedge against full LIBOR or Fed Funds deposit accounts is hedging changes to the benchmark interest rate, whereas a cash flow hedge against Prime or a percentage of LIBOR is hedging overall changes in cash flows including any spread to the index. Term deposit (CD) hedge. If the FI issues short- term, fixed-rate certificates of deposit directly or through a broker, it can hedge the LIBOR component of the fixed rate CD, as long as it reissues the same product with the same economics (but with a prevailing market rate) through the maturity date of the swap. Figure 1 shows the national average of CD rates over the past 10 years for 90-day CDs versus 3-month LIBOR.

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