Regulators are paying closer attention to how financial institutions are managing rising interest rates, particularly on investment securities portfolios because as interest rates rise, the value of an institution’s existing fixed-rate investment securities portfolio will decline.
Accounting for Rising Rates
Many institutions currently account for investment securities in the available-for sale category. These securities are typically accounted for at fair value with market value changes flowing through Accumulated Other Comprehensive Income (AOCI), which is not included in regulatory capital. Institutions now have to consider changes brought about by new, complex Basel III rules that could potentially change how AOCI impacts the calculation of regulatory capital. The AOCI account will still include unrealized gains and losses from the investment securities portfolios, but the mark-to-market changes will flow through to common equity tier 1 capital. However, all but the largest institutions will have a one-time opportunity to “opt out” of including AOCI in regulatory capital. The irrevocable election to opt-out would reduce the mark-to-market volatility of their securities portfolio on regulatory capital and is consistent with existing accounting practices.
Community banks had until the first regulatory report filed after January 1, 2015 to determine how to handle the impact of AOCI on regulatory capital. Most community banks will likely elect to opt-out of including market value fluctuations for investment securities in AOCI and will continue using the existing approach to track the volatility. However, opting-out will not necessarily result in regulators ignoring the potential impact of AOCI on regulatory capital. In fact, many anticipate the opposite as 69% of Indiana and Michigan institutions already have negative AOCI accounts that would impact regulatory capital in 2015 if not for the opt-out provision.
Choosing to opt-out does not hedge against the potential portfolio impact from a rise in interest rates and does not alleviate regulatory concerns.
Risk Mitigation Tool
FHLBI Credit Services and Marketing staffs regularly talk with members to see how existing advance products can be enhanced to meet funding strategy needs. As a result of those discussions, FHLBI introduced the Symmetrical Fixed-rate Bullet Advance. Historically, FHLBI fixed-rate bullets have had a minimum prepayment fee of 25 basis points, even when the advance being prepaid is at a rate below current market rates. With a Symmetrical Advance, the member has an opportunity to realize a gain from a rise in interest rates when the advance is prepaid. If rates rise and the advance remains, a member would still have the benefit of an unrealized gain on a Symmetrical Advance, providing a hedge against unrealized losses in the investment securities portfolio. The prepayment fee calculation is the same as a traditional fixed-rate bullet advance if rates declined from the time of origination.
The Symmetrical Fixed-rate Bullet Advance can be used as a balance sheet management tool for other assets besides the investment securities portfolio. Symmetrical advances can assist members in extending liability duration with the anticipation of rising interest rates. In addition, the ability to prepay the advance and realize a gain after interest rates rise allows members the flexibility to restructure liabilities if funding needs change.
Symmetrical Fixed-rate Bullet Advance Features
- Term: Symmetrical advances will be offered on long-term fixed-rate bullet (non-amortizing) advances with maturities from 1 to 10 years.
- Rate: An additional spread will be applied to the fixed-rate bullet advance rate in exchange for the right to receive a prepayment credit in certain market conditions. The initial premium for a Symmetrical Fixed-rate Bullet will be 3 basis points above the like term non-symmetrical fixed-rate bullet advance rates, and is subject to change based upon market conditions.
- Minimum Advance Amount: The minimum advance amount is $10 million. However, advance special offerings may offer members the opportunity for smaller advance amounts.
- Prepayment: The member may elect, with at least 2 business days’ prior written notice to FHLBI, to terminate in whole this transaction. The early termination settlement amount will be based upon a formula similar to the existing prepayment fee calculation for long-term fixed-rate bullet advances as outlined in the Repayment Procedures section of the FHLBI Credit Policy. However, with a Symmetrical Advance, a member could be eligible for a prepayment credit, if the advance rate is below current market rates. The early termination settlement amount payable to the member/due to FHLBI will be based on the mark-to-market value of the advance, less a termination fee payable to the FHLBI.
- As a result of accounting constraints, the settlement amount due to the member, including termination fees, cannot exceed 10% of the advance principal balance being prepaid.