Do banks use interest rate swaps to hedge interest rate risk?
The recent increases in the Fed Funds rate, from close to 0% in early January 2022 to around 4.5% in February 2023 are estimated to have caused the U.S. banking sector a loss of around $700 billion on security investments and a total of $1.75 trillion on both securities and loans.
Did banks use interest rate swaps to hedge their holdings of securities and loans? This is the question McPhail et al. are addressing in this paper. They measure the interest rate exposure of bank swap positions using regulatory (non-public) contract-level data on those positions. In particular, they focus on the positions of the largest 250 U.S. commercial banks, which amount to more than 8 million contracts and constitute nearly the entirety of swap positions in the U.S. banking sector. The authors can thus measure and evaluate the interest rate exposure of swaps both at the level of individual banks and the banking sector in aggregate. They find:
We find that the average bank has a large notional amount of swaps– $434 billion, or more than 10 times assets. But after accounting for offsetting swap positions, the average bank has essentially no exposure to interest rate risk: a 100-basis-point increase in rates increases the value of its swaps by 0.1% of equity. There is variation across banks, with some bank swap positions decreasing and some increasing with rates, but aggregating swap positions at the banking system level reveals that most swap exposures are offsetting. Therefore, as a description of prevailing practice, we conclude that swap positions are not economically significant in hedging the interest rate risk of bank assets.
Do Banks Hedge Using Interest Rate Swaps?
Authors: Lihong McPhail, Philipp Schnabl, Bruce Tuckman
From: Commodity Futures Trading Commission (CFTC), New York University
Do banks hedge against interest rate risk with their deposit franchise?
In this paper, Drechsler et al. argue that banks hedge their long-term loans and securities with the value of their deposit franchise, i.e., the total value of current and future deposit income. If interest rates go up, banks suffer losses on their asset holdings but benefit from below-market financing with deposits. If interest rates go down, it goes the other way. They can do this because banks have market power in the provision of deposits since depositors do not leave their bank even when they can get a better rate elsewhere. There are several reasons for this: some depositors invest in their relationship with their bank and find it a hassle to switch banks, other depositors do not pay attention to market interest rates. This market power allows banks to keep deposit rates low even when the Fed raises interest rates, increasing deposit income. If banks are well hedged their net interest margin (NIM) should not move with changes in interest rates. This is because the change in interest income (from loans and securities) will be the same as the change in interest expense paid on deposits.
But, hedging via deposits only works if depositors stick around and do not run on the bank.
Why do banks invest in MBS?
Authors: Itamar Drechsler, Alexi Savov, Philipp Schnabl
From: New York University, Wharton, University of Pennsylvania
