Afraid of Derivatives? Not These 3 Little Banks

Greene County Bank is an unlikely pioneer in currency futures trading.

But the $23 million-asset bank in Strafford, Mo. - population 1,166 - is one of a handful of tiny banks that have latched onto futures trading as an tool for important balance sheet management. It is using Eurodollar futures to hedge the interest rate risk of its certificates of deposit.

Only three banks with under $100 million in assets are making extensive use of futures, data from the Office of the Comptroller of the Currency show.

Greene County Bank posted net income of $40,000 for 1995, and most of its liabilities are six-month certificates of deposit. But Greene County's financial report to regulators stands out from those filed by its peers because its hedges those liabilities with an eye-popping $160 million of derivatives contracts.

These numbers might sound disturbing to anyone who remembers the Orange County bankruptcy or the losses suffered by major corporations like Procter & Gamble and Gibson Greetings Inc. when their derivatives based hedging strategies backfired amid rising rates two years ago.

"Let's face it," said Bernard Rullman, the president of Greene County Bank, "people hear you're using derivatives, they get scared."

But experts say Greene County is using the derivatives safely, albeit creatively. Unable to afford swap contracts used by larger banks to hedge against interest rate changes, Greene County gets the benefits of swaps by buying inexpensive, publicly traded Eurodollar futures contracts.

Because the Eurodollar futures market is highly liquid and the contracts are affordable, it is an ideal venue for small banks seeking to hedge their portfolios for a short time. "If the bank's purpose is replicating the short-term swap market, using Eurodollars is a sound practice," said Barry Seaman, vice-president at General Re Financial Products.

"The contracts have worked really well for us," Mr. Rullman said, adding as an afterthought, "You've got to know what you can afford to lose with these things."

One other small bank - Enterprise National Bank of Palm Beach, Fla. - is following the same strategy. A third bank, English (Ind.) State Bank is doing much the same, but with more traditional swaps and over-the-counter options, not Eurodollar contracts. English State Bank has $81 million in assets and $150 million in notional value of derivatives.

One Enterprise Bank executive said his bank's strategy might work for any small bank, but acknowledged that many might be wary.

"Why aren't other banks doing what we're doing?" he asked. Because "it's a horse of a different color."

Greene County Bank began buying three-month Eurodollar contracts four years ago, to minimize the rate exposure of its growing portfolio. The bank buys futures partly because its balance sheet has changed in recent years. Last year, for example, deposits increased 20% and loans 26%

Mr. Rullman says Greene County Bank divides its contracts $80 million short and $80 million long. Thus its credit exposure to the contracts nets out to zero.

The notional value of the derivatives is much higher than the bank's liabilities because the bank buys new contracts every quarter for several years in advance at $1 million in notional value each.

By buying short-term futures contracts and selling them when it issues a new CD, tiny Greene County Bank can "replicate the swap market," Mr. Rullman says.

Banks can do this by selling Eurodollar contracts every time they issue a new CD. Selling enough Eurodollar contracts to cover the duration of the CD provides a rate of interest. This protects the bank against quarterly fluctuations in interest rates that may affect how much money the bank can make from the CD.

So by selling Eurodollar futures the bank is swapping a potentially floating rate of interest for a guaranteed fixed rate.

Currently, most banks that do interest rate swaps are big ones, which pay big-league derivatives traders to arrange contracts with counterparties.

According to OCC records, 507 banks reported using derivatives in the second quarter. But only 2% of banks with under $100 million in assets use derivatives at all, according to the American Bankers Association.

The small banks may be reluctant because the word "derivatives" still conjures up images of the ruin of Barings PLC, Orange County's bankruptcy, and unscrupulous dealers pushing complicated transactions on unsophisticated customers.

Still, bank analysts and risk management consultants say the instruments can be a powerful hedging tool. OCC data show derivatives are becoming more popular, which may indicate that banks are learning how to use them intelligently.

But though hedging with derivatives may be beneficial, it isn't readily accessible for small banks. Their portfolios are too small for most derivatives dealers to bother with, bank executives say.

And interest rate swap transactions - the most popular kind of derivatives contract among banks, according to OCC data - are too expensive for most small banks. Dealer fees of 50 to 80 basis points are embedded in the cost of nearly every swap contract, said Stephen Gillig, chief financial officer at Fort Wayne National Bank in Indiana.

But a $1 million three-month Eurodollar futures contract traded at the Chicago Mercantile Exchange costs only about $50, said Mr. Gillig. Such prices and the contracts' flexibility enable Fort Wayne National Bank, with $1.5 billion in assets, to accumulate $1.1 billion in notional value in derivatives futures contracts, mostly in Eurodollar futures.

Because Eurodollar contracts are so easy to trade, banks can enter or leave the market easily, said Mr. Gillig. Getting rid of a made-to-order swap contract may be difficult if the counterparty is not interested.

Still, the Eurodollar futures would pose some risk in the event of a major spike in interest rates. That's an accounting hassle for small banks, which tend to lack the staff to watch the market closely.

It's also difficult to hedge very far in advance, General Re's Mr. Seaman said, because the Eurodollar futures market is not very liquid after five years. But because Greene County is mainly worried about insuring against changes in six-month CDs, this time constraint is not a major consideration.

If there's any downside to Eurodollar futures, says Mr. Rullman, it's that his bank's officers must meet a little more often. But even that's not so bad as it used to be.

"It used to be we met every month to go over what we were doing," he said. "But with interest rates so steady of late, we don't have to do that so much anymore. Maybe every quarter now."

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