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Year-end Funding Plan Check-Up

October 2017 - With the end of 2017 coming into view, now is a good time for financial institutions to revisit assumptions made earlier in the year and evaluate funding and asset/liability management plans based on the current environment.

The banking industry has continued its trend of gradual strengthening in 2017. Higher short-term rates, combined with continued growth in loan demand, helped banks generate profits of $48.3 billion in the second quarter, an increase of more than 10 percent over second quarter 2016 profits. Return on assets – a key performance benchmark for the industry – rose to 1.14 percent, the highest level since 2007. Rising rates also provided some relief in margin pressures, with industry-wide margins reaching a nearly four-year high of 3.22 percent in the second quarter.

While these results are positive, financial institutions continue to face uncertainties in the interest-rate environment and regulatory landscape. Below we take a close look at some of the factors with potential impacts to interest rates and provide funding strategies to consider for the year end.

2017 Interest Rate Environment 
Earlier this year, the Federal Open Market Committee (FOMC) resumed its campaign of gradually increasing the federal funds target interest rate with quarter-point rate hikes in March and June. Today the range stands at 1.00 to 1.25 percent. In addition, the FOMC at its June meeting outlined plans to begin reducing its more than $4.5 trillion bond portfolio, which it accumulated as part of its “quantitative easing” plan to reduce borrowing costs for businesses and consumers.

At its September meeting, the FOMC provided additional clarity around the central bank’s plans to shrink its bond portfolio, indicating that small reductions of $10 billion per month would begin in October and gradually increase every three months to $50 billion per month. The committee left the benchmark interest rate unchanged at a range of 1.00 to 1.25 percent, but reiterated its forecast of one more rate increase for 2017. In a new set of estimates, Federal Reserve officials also estimated that three quarter-point rate hikes would be appropriate in 2018, should trends in unemployment, economic growth, and inflation remain stable.

Interest Rate Effects
In March, short-term interest rates rose and have continued to climb steadily through September. Long-term rates experienced a brief rally in March but have since leveled off. As a result of these movements, the yield curve flattened in 2017 and spreads between 2-year and 10-year treasuries narrowed considerably.

daily-treasury-yield-curve

                                Source: U.S. Department of the Treasury, www.treasury.gov


Policy actions and market forces through the third quarter of 2017 have implications for funding and balance sheet management decisions. As the Federal Reserve accelerates its bond portfolio reduction in the coming quarters, there is potential for upward pressure on long-term rates. If the committee votes to raise the benchmark rate in December, as most analysts predict, short-term rates could rise. Depending on an institution’s balance sheet position and outlook on interest rates, funding the balance sheet with longer-term liabilities may provide an advantage in the current environment.

FHLBank Atlanta Funding Solutions
Over the last few months, many FHLBank Atlanta shareholders have borrowed fixed-rate advances with maturities ranging from 18 months to 24 months. Spreads between 3-month Fixed Rate Credit (FRC) advances and 18-month FRC advances have narrowed in 2017 along with the flattening of the yield curve. As a result, the interest rate premium for securing longer-term fixed-rate funding compared to short-term funding has declined.

frc-advance-pricing

                                      Advance rates are for illustrative purposes only.


The Bank’s FRC advances are simple, effective ways to manage liquidity and reduce interest-rate risk if short-term rates continue to rise. Shareholders frequently use FRCs to fund fixed-rate mortgages and investments and often blend these advances with retail deposits to reduce overall funding costs. Furthermore, shareholders that create a ladder of FRC advances at differing maturities – similar to laddered CD’s – obtain fixed-rate funding and interest-rate protection in a rising rate environment while maintain flexibility to reduce liabilities if asset levels decline.

The Bank’s Convertible advance can also offer potentially greater reductions in funding costs compared to FRC advances. The Convertible advance offers fixed-rate funding in exchange for selling the Bank the option to cancel the advance at a future date. The option can be European (one time only) or Bermudan (at regularly stated intervals until maturity). The advance rate is reduced by the value of the sold option, and shareholders may achieve lower borrowing costs compared to a traditional FRC to the option date. However, shareholders bear the risk of holding above-market funding beyond the option date if the Bank chooses not to cancel the advance.

Recent pricing indications for Convertible advances showing the savings compared to an FRC advance are below.

Term Rate as of Oct. 3, 2017 Savings
2-year FRC  1.75% -
Convertible: 5-year/2-year European 1.60% 0.15%
Convertible: 5-year/2-year Bermudan 1.55% 0.20%

 

Secure Year-end Liquidity

The fourth quarter is a good time to secure liquidity positions for the year end and the transition into 2018. If current balance sheet positions do not support adding longer-term funding, FHLBank Atlanta’s short-term FRC advance is an ideal solution for an institution to secure its year-end liquidity position and potentially reduce funding costs. FRC borrowings of up to six months can be executed conveniently online through FHLBAccess®.

Contact your FHLBank Atlanta relationship manager at 1.800.536.9650 to discuss year-end liquidity needs and funding strategies to support your balance sheet objectives in the current rate environment.


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.

Sources:

Torres, Craig. “Fed to Shrink Assets Next Month, Boost Rates by Year-End.” Bloomberg Web. September 20, 2017.

“Chairman’s Opening Statement Second Quarter 2017 Quarterly Banking Profile” Federal Deposit Insurance Corporation. August 22, 2017.

 

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