The Big Idea
You’re too sensitive
Tom O'Hara, CFA | October 28, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The Fed’s aggressive tightening campaign this year has helped push up bank income from floating-rate loans and securities much faster than bank cost of funds, helping lift earnings along the way. And while banks generally still expect asset income to rise faster than funding costs, the question becomes at what point to start taking steps to reduce that sensitivity and by how much. That shift would help hedge their earnings against potentially lower interest rates. The more interesting choices seem to come on the asset side of the balance sheet.
Banks remain very asset sensitive
Banks describe their assets and liabilities as rate sensitive if the coupon resets within a year. And banks measure net asset sensitivity by looking at net rate sensitive assets—total sensitive assets minus total sensitive liabilities—divided by the bank’s total assets (Exhibit 1). Nearly all the banks in the Amherst Pierpont tracking group show a net asset sensitivity, with the median being around 30. US Bancorp, for example, shows rate sensitive assets as 39% of total assets and rate sensitive liabilities as 9% of total assets, netting to 30.
Exhibit 1: Most banks are asset sensitive
Asset sensitive banks effectively have a short position in interest rates, where rising rates help the income and the overall value of the bank. Reducing asset sensitivity often involves adding net duration.
Methods for reducing asset sensitivity
One simple way that banks can add duration is through security selection. Banks have a range of plausible choices (Exhibit 2). For banks looking to add a lot of duration quickly, the pass-through market offers substantial size at currently attractive yields. When banks have added securities in recent weeks, those have mostly been Ginnie Mae MBS for the added benefit of 0% risk-weight. Separately, Fannie 6% 30-year pass-throughs look very attractive currently from an OAS perspective.
An interesting subset of the pass-through market is 100% New York pools. New York imposes a mortgage recording tax on loans used to purchase or refinance a property, making New York pools relatively slow and relatively more convex. The pay-ups relative to standard TBA pools ramp up very quickly in a rally compared to other story bonds.
Exhibit 2: Longer duration portfolio alternatives
Another strategy that banks should deploy is converting their floating-rate assets to fixed through a receive-fixed swap treated as a cash flow hedge. One of the largest loan growth areas for banks continues to be commercial and industrial loans (Exhibit 3). While business lending was fairly dormant during the pandemic years of 2020 to 2021, it has returned with a vengeance in 2022. Given the large proportion of C&I loans on many bank balance sheets, this could be one of the most expedient ways to add a significant amount of duration, and the cash flow hedge treatment is an attractive accounting outcome for derivatives.
Exhibit 3: Rising balances of C&I loans
Similarly, receive-fixed swaps may be used on the liability side of the balance sheet as a fair value hedge to convert fixed-rate debt to floating, helping to increase net interest income in a declining rate environment.
When is the right time to reduce asset sensitivity?
In meetings over recent weeks with several bank chief investment officers and senior portfolio managers, the general consensus is that the US economy will be in a recession within the next 12 to 18 months, which could be accompanied by falling interest rates. Further, most of these executives have expressed the view that banks should be and are now taking some steps to reduce asset sensitivity for a couple of reasons:
Bank earnings have been quite strong. One measure of this is the bank’s net interest margin, where NIM expanded year-over-year for all banks in the tracking group (Exhibit 4).
Exhibit 4: Rising net interest income
Strong earnings provide the banks with latitude to implement some down-rate protection now, possibly reducing earnings over the short-term but smoothing out their longer-term earnings arc as liability costs gradually catch-up to asset yields.
Another reason to start reducing asset sensitivity now and increasing balance sheet duration is that deposits have been ‘stickier’ than expected in base case projections. While loan-to-deposit ratios have declined in 2022, much of this is due to loan growth. Deposit growth has not kept up with loan growth, but deposits have still generally grown on an absolute basis (Exhibit 5). From an asset-liability management perspective, when banks are able to adjust their liabilities to a longer duration, this allows more flexibility to also extend asset durations and thereby help to reduce asset sensitivity. Note that most of this deposit growth occurred prior to the start of the Fed’s recent tightening cycle in March, and they’ve been generally flat since then.
Exhibit 5: A rising absolute deposit base, although mostly before the start of Fed hikes
Additional asset sensitivity metrics
Aside from measures of net asset sensitivity, another way that banks typically measure and report their asset sensitivity is to look at the impact of interest rate shocks on net interest income. For large rate shocks, the most frequently used is 200 bp, and these are reported by some banks on a gradual shock basis and by others (less commonly) on an immediate shock basis (Exhibits 6A and 6B). Using these shock scenarios, most of the banks in our tracking group are asset sensitive, with the median projected increase in NII of 3.50% for a gradual rate move and 8.38% for an immediate move (meaning the dollars of net interest income are projected to increase by these percentages).
Exhibit 6A: Net interest income impact of a gradual 200 bp rate move
Exhibit 6B: Net interest income impact of an immediate 200 bp rate move