By Isaac Wheeler, Managing Director, Balance Sheet Strategy at Derivative Path
The Federal Reserve Board recently announced that the Bank Term Funding Program (BTFP) will cease making new loans on March 11th. That announcement has prompted depositories to evaluate funding alternatives once their existing BTFP borrowings mature. Here are some derivative strategies that can help depositories fund both efficiently and achieve their interest rate risk objectives.
Swaps as a cost-efficient funding tactic
Depositories with derivatives capabilities have long combined interest-rate swaps with rolling, short-term wholesale borrowings to fund efficiently at longer terms. The strategy has only become more common recently as institutions have looked for cost-efficient BTFP alternatives.
Combining a swap and a series of rolling borrowings eliminates the term premium associated with conventional wholesale funding. That said, there is no free lunch in markets, and institutions that utilize the strategy understand that while they are eliminating the term premium associated with conventional borrowings, they are also losing the promise of term liquidity.
When hedge accounting is elected, the strategy also allows the economic value of the funding structure to flow through to other comprehensive income, something not typically achievable with conventional term funding. Hedge accounting creates accounting symmetry between funding and the investment portfolio – a crucial feature in an environment where unrealized losses on AFS securities remain in focus for depositories.
Consider collars to create optionality
One of the most attractive features of the BTFP was that borrowings could be prepaid at any time without penalty. While there are no free options in financial markets, depositories seeking fixed funding that still gives them some optionality in lower rates could consider collars as an alternative to swaps.
Collars consist of both a purchased cap and a sold floor. The purchased cap creates an upper limit on funding costs but allows funding costs to reprice lower should the Fed cut policy rates. Adding a sold floor to create a collar structure can eliminate any upfront premium but limits the amount of repricing benefit a depository can receive should rates decline.
A new mindset for a new era
The banking sector is fundamentally different than it was prior to March of 2024, and liquidity risk management practices are in the spotlight as the BTFP program ends. Uncertainty still looms large, and interest rate volatility appears here to stay. Fortunately, institutions with
maturing BTFP funding have several hedging alternatives available as they look to achieve their liquidity and interest rate risk management objectives.
