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A Case for Structured Funding during Times of Elevated Liquidity
2020-07-29
Advances and Letters of Credit

Mitigate risk of holding long-term assets without adding liquidity today 

July 2020 – Financial institutions today face complex challenges on three fronts: large deposit increases, low asset generation activity outside of residential mortgages, and fewer investment opportunities due to low interest rates. Some institutions are responding to the dearth of investment and commercial lending opportunities by keeping longer term residential mortgages on the books to “soak up” excess liquidity. While portfolio mortgages provide higher yield in support of a stronger bottom line, they also expose the institution to interest-rate risk.

The outlook for lending volume and liquidity to reach pre-pandemic levels is highly uncertain. With deposits at record high levels, how do financial institutions use wholesale funding to manage balance sheet risk without taking on excess liquidity?

With FHLBank Atlanta’s Forward Starting advance, institutions can secure a known interest rate for future funding without adding liquidity to the balance sheet today. The forward starting feature can be applied to any of the Bank’s structured advance products. It’s an effective way to mitigate interest-rate risk of holding longer-term assets while managing liquidity levels and reducing interest expense.

The example below examines the benefits of a forward starting Fixed Rate Credit advance.

Mitigate Risk without Adding Liquidity Today

  • Goal: Manage interest-rate risk associated with holding longer-term assets on the balance sheet
  • Solution: Forward Starting advance with two-year forward starting period and five-year fixed-rate period (total seven-year term). Secure hedge on loan portfolio on day one and take on advance funding at year three
  • Result: Savings of $142,000 in interest expense on a $10 million advance compared to a traditional five-year Fixed Rate Credit advance

As an example, a community bank in a mid-sized market has seen a dramatic increase in deposits over the last six months from individuals in the surrounding counties. The bank is active in both the residential and commercial lending markets. Residential purchase mortgage originations and refinancing have remained strong; however, commercial lending has mostly dried up due to contractions in the national and local economies. In addition, with interest rates at low levels not seen since the financial crisis, the bank has faced significant challenges finding investment opportunities to generate interest income.

To help manage its liquidity balances, the bank’s management team decided to keep more long-term residential mortgages in portfolio. While these mortgages generate healthy yields that provide a boost to net interest margins, they also expose the bank to interest-rate risk. How could the bank keep more mortgages on the books without exposing itself to a significant increase in interest-rate risk?

The management team decided to use a Forward Starting advance from FHLBank Atlanta to help offset the interest-rate risk of holding longer-term mortgages on the balance sheet. Instead of borrowing a traditional seven-year Fixed Rate Credit (FRC) advance and placing the funds on its balance sheet today, the bank borrowed $10 million using a two-year forward starting, five-year FRC advance. The total term of the advance is seven years. This structure creates the hedge the bank is looking for, but it allows the bank to avoid taking on additional liquidity immediately and to save two years of interest expense, a significant benefit compared to standard fixed-rate funding.  

 

7-year FRC

2-year Forward Starting, 5-year FRC

Amount Borrowed

$10 million

Interest Rate

0.96%

1.06%

Years of Interest

7

5

Total Interest Expense

$672,000

$530,000

Savings using Forward Starting Advance

$142,000

The bank can fund the new mortgage originations for the first two years from its robust deposit base, and then at the end of the two-year mark, will automatically receive the advance funds at a rate negotiated up front with FHLBank Atlanta. The rate on the Forward Starting advance is 1.06 percent, which is 10 basis points more than the rate on a seven-year FRC advance. However, since the Forward Starting advance is only funded for the last five years, the total interest cost is $530,000, which represents a $142,000 savings over a seven-year FRC advance.

Strategic Benefits of Forward Starting Advance

  • Manage Liquidity: The bank can create a hedge on long-term assets and potentially reduce interest-rate risk without adding to already elevated liquidity levels.
  • Keep Costs Low: The forward starting feature enables institutions to leverage a strong deposit base to fund lending and investing activity for the two-year forward period, then add funding from the advance in year three negotiated at today’s low rates. Because the advance is on the balance sheet for less time than a traditional advance carrying the same term, total interest cost is significantly lower.
  • Lock in Interest Rate Protection at Today’s Low Rates: Locking in funding at today’s low rates can potentially help mitigate interest-rate risk.
  • Easy to Explain: The strategy is easy to explain to regulators, ALCO, or the board of directors. 

A Forward Starting advance should only be issued with the good faith intention by the borrower to fund the advance. Additional fees and limitations apply for terminating the advance transaction prior to the funding date. For more information on the Forward Starting advance, call your FHLBank Atlanta relationship manager at 1.800.536.9650.

 

The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial, and accounting advisors before entering into any transaction. Interest and advance rates presented in this article are for illustrative purposes only. A Forward Starting advance should only be issued with the good faith intention by the borrower to fund the advance. Additional fees and limitations apply for terminating the advance transaction prior to the funding date.

 

 

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