Regional banks use hedging tactics to combat rate cuts

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Last year, when most banking experts were predicting that interest rates would keep going up, several regional banks began placing bets that the economy would soften and that rates would actually go down.

Now those banks, which include KeyCorp in Cleveland, Fifth Third Bancorp in Cincinnati and Regions Financial in Birmingham, Ala., are poised to see those bets pay off if the Federal Reserve, as expected, cuts rates later this year.

The three companies, along with several others, began purchasing derivatives last year to hedge against falling rates, and the decision hurt profits in the short term as rates continued to rise.

The $144.5 billion-asset KeyCorp, which released second-quarter results on Tuesday, has been one of the most aggressive banks in the use of hedging, said Peter Winter, an analyst at Wedbush Securities.

It has executed a total of $15 billion in hedging transactions since the third quarter of 2018, including about $3 billion of swaps and floors in the second quarter. Due to the hedging, net interest income will be reduced by less than 1% if the Fed cuts rates 100 basis points, Chief Financial Officer Don Kimble said during a conference call Tuesday.

The hedging “did cost us some margin over the last few quarters, but we think that it was prudent for us to be able to manage to that level especially given the current outlook that we see for interest rates,” Kimble said.

The Federal Reserve is expected to cut rates between one and three times this year, according to market observers and analysts. Lower rates typically reduce a bank’s net interest margin, as floating-rate loans switch to the lower rate and newly originated loans are placed on the books at lower rates.

Winter said that hedging strategies will help Key protect its net interest margin and net interest income if rates fall.

“Putting on hedges as an insurance protection to lower rates comes at a cost and potential lost revenue from upside to higher rates,” Winter said. “Other banks didn’t want to give up that potential upside. Now Key is seeing the benefit, while other banks are paying the price.”

Key’s net income fell 13% to $405 million from a year earlier. Earnings per share of 40 cents were 4 cents below the mean estimate of analysts compiled by FactSet Research Systems.

Excluding one-time items, including $52 in pretax expenses from job cuts this year and a $78 million gain from the sale of a business unit a year earlier, Key’s net income increased slightly on a yearly basis, Winter said.

The $168.8 billion-asset Fifth Third approved $11 billion of hedges during the fourth quarter.

“You can’t protect 100% of the balance sheet, but we protected the downside of the balance sheet much better than a lot of our peers have,” Chairman, President and CEO Greg Carmichael said in an interview.

Carmichael pointed to expansion in the bank’s net interest margin in the second quarter, particularly compared with some other regional banks.

Year over year, Fifth Third’s net interest margin widened 16 basis points to 3.37%. Carmichael said that if the Fed cuts rates later this year, he expects Fifth Third will see less pressure on its margins than some of its peers.

Additionally, Fifth Third restructured its securities portfolio during the quarter by reducing its exposure to mortgage-backed securities. That move will protect the bank’s net interest income if rates fall and is the equivalent of adding $10 billion of interest rate swaps, said Marty Mosby, an analyst at Vining Sparks.

The $127.5 billion-asset Regions has implemented a total of $19.5 billion of interest rate swaps and floors, “to provide stability to the company's net interest income and net interest margin in a lower interest rate environment,” the company said in its second-quarter earnings release. Regions launched its hedging program in the first quarter of 2018.

Regions’ use of “hedges will stabilize our interest rate sensitivity profile in 2020 and beyond,” David Turner, chief financial officer, said during a Friday conference call.

Other banks that have used hedges in the past two years include the $162.7 billion-asset Citizens Financial Group in Providence, R.I.; the $51.6 billion-asset People’s United Financial in Bridgeport, Conn.; and the $121.6 billion-asset M&T Bank in Buffalo, N.Y.

“We use … hedging to take that volatility out of our earnings,” Darren King, chief financial officer at M&T, said during a Thursday conference call. “That’s what gives us the wherewithal when things get a little volatile … to not have to be overly draconian on expenses.”

Hedging may be great insurance, but some bankers are opposed to the idea. Johnny Allison, chairman of the $15.3 billion-asset Home BancShares in Conway, Ark., said on Thursday that the holding company for Centennial Bank doesn’t use hedges. The reason: Banks can get burned if they bet one way, and rates move in the opposite direction.

“I watched some of our friends … spend millions of dollars on the hedging process and get their head handed to them,” Allison said.

Allison did not identify the banks he said were hurt by hedging activity. But some banks have reported losses on hedges during the second quarter. The $28 billion-asset Umpqua Holdings in Portland, Ore., recorded a loss of $4 million on the fair value of a debt capital market swap.

Separately on Tuesday, KeyCorp reiterated on that a recently discovered instance of fraud associated with a commercial customer would result in an after-tax expense of about $90 million. KeyCorp first disclosed its discovery of the fraud last week.

The fraud took place during the third quarter and did not affect second-quarter results. The fraudulent activity was not related to cybersecurity and is not expected to have a financially material impact, Kimble said.

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Interest rate risk Regional banks Earnings Interest rates Net interest margin Greg Carmichael KeyCorp Fifth Third Bancorp Regions Bank