The Bank of Canada left its key interest rate unchanged at 5% for the third consecutive time since July 2023 and as Canada’s inflation rate seems to have reached a plateau, economists consider that a lower rate cycle is about to begin.
In this article we review four different hedging approaches. Banks, cooperatives and community-based financial institutions need to do a reasonable job of matching the duration of their funding to the duration of their assets. For instance, an Ontario credit union might be required to hedge a book of 5 year duration assets. On a case-by-case basis, one of the four options can be applied:
- Raise GIC funding with 5-year duration: In a rising rate environment, customers don’t want to go long, plus early withdrawal penalties will likely be insufficient to hold onto that funding.
- An alternative is to raising 5-year deposit funding is to raise cheap funds using the
wholesale curve, for example, at the 1 year point of the curve. Then execute an interest
rate swap to move the duration of that 1 year funding out to 5 years. The institution
also pays a fee for the swap based on the notional principal amount of the swap, plus
also pay (or receive) the difference between the 1 and 5 year rate. Under this scenario,
the early withdrawal penalty problem with the 5 year GIC goes away as early
withdrawals on 1 year CDs are less frequent.
- With an interest rate swap, institutions can buy an insurance policy, paying a premium (the fee). The protection bought is the fact that as the 1 year rate rises in a rising rate environment, the increased income from the 1 year side of the swap covers the increase in interest expense as the 1 year GIC rolls over at a higher rate. Between the short-term funding and the swap, the institution can lock in a 5 year rate. The downside under this scenario is that swaps can be expensive (i.e., insurance premium) and there are a fair amount of accounting and regulatory issues associated with their use.
- A third scenario for Ontario CUs is that they can take out a 5-year advance from Central 1. The advance can effectively hedge the risk in the 5 year asset at a small spread over 5 year Treasury rate. Of course that means the advance is more expensive than the 1 year GIC. In this case the insurance premium is the difference between the 1 year rate and the 5 year rate. In a nutshell, institutions’ cost of funds is locked in for the duration of the asset it is used to fund. Aside from a high funding cost, there may be some additional issues associated with the Central 1 Advance, for example, regulatory scrutiny, pushing the institution closer to policy limits on the use of wholesale funding, and reducing the borrowing capacity available in a liquidity stress event.
- Whilst under each scenario above, the financial institution is required to pay the premium to match funding duration. However, Non-Maturity Deposits (NMDs) offer a potential matched funding source. NMDs can be organized into three categories, volatile, rate sensitive and core. If the core deposit study is well executed, and key parameters can be defined, such as, pricing betas, surge balances, and decay rates, institutions can field funding side with offsetting duration. The bottom line is that properly using core deposits to fund long-term assets is a much more cost effective hedge than interest rate swaps.
For more information on this topic, or to learn how the Team BBA can assist your organization, contact our team.