Optionality Options

By Reber, Jim | Independent Banker, November 2006 | Go to article overview

Optionality Options


Reber, Jim, Independent Banker


Structured deposit and investment deals proliferate

Good balance sheet managers have had to come to grips over the last 10 years with a necessary evil in the name of profitability: Optionality.

Stated another way, ever-increasing portions of a community bank's assets and liabilities can be converted to either cash or a different rate, at somebody else's whim. In still other words, more and more callability exists for banks of all sizes in the investment portfolio, loan portfolio and deposit mix. What separates well-run banks from the masses in large part depends on identifying the risks imbedded and their management.

The Regulators' Take

It has been a consistent theme among Federal Financial Institutions Examination Council (FFIEC) members that the presence of callability in the balance sheet is not a reason per se for concern. After all, commu nity banks increasingly rely on wholesale funding sources (see Table A). What is incumbent upon the banker is the ability to demonstrate reasonable assumptions about the impact of rate changes on his or her earnings. This has resulted in more and more community banks being required to manage their interest rate risk with third-party asset/liability models.

To prove that this is not a case of crying wolf, I would ask you to consider this: As of June 30, 2006, only about 15 percent of the bonds in bank investment portfolios were non-callable. It is more difficult to assess loan portfolios' callability, but it's safe to say that the vast majority has no prepayment penalty. These factors can produce a whipsaw effect: lots of cash in low and falling rate periods, and little or no cash in high or rising ones.

Deposit Options

Wholesale funding, which primarily (not exclusively) means Federal Home Loan Bank (FHLB) advances, can include structures with a fixed rate for the term of the borrowing as long as LIBOR stays below a certain rate, or "strike." If LIBOR does exceed this designated level, the advance becomes floating rate or can be paid off.

Of course, if LIBOR is above the strike level of say, 7.00 percent, any borrowing rate, fixed or floating, is likely to be on the high end. This could be a good call or a very bad one because these "strike" advances' original fixed rates are l ower than non-strike advances.

Even more common is the convertible advance. These are fixed rate originally, but the FHLB has the option of converting them to a floating rate on specific dates. If the FHLB exercises its option, the advance may also be paid off, similarly to the strike advance described above at its own discretion. Some borrowers refer to these as "putable" advances, and they represent a corollary to callable investments in that the bank is forced to refinance its debt in high-rate environments.

Another popular time deposit offering among commu ni t y banks is the "bump" CD. This gives the depositor a one-time option to "bump" the rate higher, without extending the original term of the deposit. This creates in essence a one-way floater, which of course is in the wrong direction for a bank's earnings.

One can see just from these three examples that fairly sophisticated modeling is required to accurately reflect the income and cash flow consequences of changing rates. The same can be said for the asset side of the balance sheet. We will next look at a couple of the newer developments in callable securities as examples of recent financial engineering. …

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