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Occasionally, there is information in the banking press concerning losses or significant reductions in earnings related to failed leverage strategies. Examiners sometimes become aware of such losses even if they don't make the financial press. Given the pressure to constantly improve the bottom line, often in times of strong loan competition, some banks implement leverage strategies as a way to achieve their earnings goals.
A leverage program is designed to enhance earnings by utilizing wholesale funding to purchase earning assets. Some banks, particularly community banks, which hold significantly more capital than required by regulations, may choose to increase the leverage of their capital by increasing earning assets and liabilities. By maintaining the same equity levels, this increase in earning assets should result in improved returns on equity. Nevertheless, this strategy does not always yield favorable results.
Types of Leverage Strategies
The main risk related to a leverage strategy is interest rate risk (IRR), which may impact earnings and capital. There are several types of leverage strategies, some more risky than others. A fixed-spread type of leverage strategy normally poses the lowest level of risk to the institution. Under this strategy, a bank obtains wholesale funding that matures on a specific date, which it matches with an earning asset, such as a loan or a debt security, whose maturity and cash flow frequency match or are very similar. The advance contains no call options, and the earning asset has no call or prepayment provisions. If the advance and earning asset have fixed rates, then a spread is locked in. If the advance and security have floating rates, which are tied to the same index or very strongly correlated indices on matching points on yield curves, then again a relatively fixed spread can be locked in. Given the low level of IRR in these types of strategies, the spread is normally limited.
Nevertheless, to increase the spread on leverage strategies, bank management often enters into strategies which involve optionality. A popular investment vehicle for leverage strategies has been mortgage-backed securities (MBS). While credit risk on these instruments is relatively minimal, especially those with GSE guarantees, IRR can be significant. Because of the prepayment option embedded in these investments, when interest rates decline, the prepayment speeds on MBS accelerate, requiring banks to reinvest funds at the prevailing lower market rates. If the bank funded a large portion of these MBS investments with fixed-rate advances, the spread on the leverage strategy will narrow or become negative.
Banks frequently fund leverage strategies with advances from the FHLB. When there is optionality in a leverage strategy, the risk to the bank is increased. For instance, if investment purchases are funded with floating rate or convertible FHLB advances, rising interest rates can have a negative impact on leverage transactions spreads. A convertible advance gives the FHLB the option to convert a fixed-rate advance to a floating rate. If the bank utilized this advance to fund the purchase of a fixed-rate longer-term security, the spread on the transaction will decline and possibly become negative. A leverage strategy that involves optionality on either one or both sides of the balance sheet only maintains its profitable spread if interest rate volatility is minimal over the life of the transactions; the risk associated with this strategy increases with the length of time it is in place.
Can a Leverage Strategy Be Profitable?
The goal of a leverage strategy is to augment earnings, particularly ROE. So the question is: have leverage strategies been profitable for banks over time? Overall, many banks have profited from these strategies, but others have experienced unfavorable impacts to earnings and capital due to these strategies. The banks that have profited are those that fully understand the risks involved and properly monitor and control the strategy to mitigate these risks. Banks that have experienced losses as a result of having to unwind an unsuccessful strategy are those that may not have had a full understanding of the risks involved and/or may not have implemented the proper monitoring and control mechanisms. Also, some banks that profited from a conservative strategy of limited size and duration have expanded these strategies in an attempt to further bolster their bottom line. Unfortunately, growth in a leverage strategy without proper forethought and the implementation of further control mechanisms has proven detrimental to many institutions.
Before entering into a leverage strategy, the board of directors and bank management need to consider the effects that this strategy will have on the bank's capital, liquidity, and IRR profiles. Some of the effects to be considered include:
Once the decision is made to implement the strategy, ongoing monitoring is necessary. It is important to identify all potential risks and be able to measure the possible effects on earnings and capital. Changes in the level or shape of the yield curve should be incorporated into these analyses. Additionally, stress tests should be performed to measure the effects under worst-case scenarios. Limits and contingency plans should be established. When limits are crossed, corrective actions, which may include the reduction or elimination of the leverage strategy, should be implemented.
On April 5, 2001, the staff of the Board of Governors issued SR 01-8, Supervisory Guidance on Complex Wholesale Borrowings.1 We recommend that bank boards and management that are considering or are already involved in a leverage strategy, particularly those which include embedded options, carefully read and consider this supervisory letter. As with all significant risks, the supervisory letter emphasizes the need for the bank's risk management systems to identify, measure, monitor, and control risks stemming from complex wholesale borrowings. According to the supervisory guidance, "If not thoroughly assessed and prudently managed, these more complex funding instruments have the potential over time to significantly increase a bank's sensitivity to market and liquidity risks. Maturity mismatches or the embedded options themselves can, in some circumstances, adversely affect a bank's financial condition, especially when the terms and conditions of the borrowings are misunderstood."
This SR letter emphasizes the importance of performing stress tests. According to the letter, these stress tests "should cover a reasonable range of contractual triggers and external events, such as interest rate changes that may result in the exercise of embedded options or the bank's termination of the agreement, which may entail prepayment penalties. In general, stress test results should depict the potential impact of these variables on the individual borrowing facility, as well as the overall earnings and liquidity position of the bank."
While bank boards and management may find that a leverage strategy is useful for their institution, they should make sure that it is executed in a prudent manner to ensure that it does not pose a significant risk to earnings or the value of the institution. Using wholesale borrowings to increase revenue can be a successful strategy as long as the size and complexity of the strategy are limited by the institution's ability to safely execute the strategy and to institute the proper controls. Finally, it is important to recognize when a leverage strategy has gone wrong and to implement corrective actions immediately.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.