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Hedging In An Unpredictable Market: Getting Started With Commercial Lending

Learn how hedging can help both your credit union and your business borrowers mitigate risk and maximize benefits in an unpredictable market. Plus, tips to get started.

In the current flat-to-inverted yield curve environment with rising interest rates, credit unions are seeking opportunities to increase income, mitigate risk, and retain business-owner members.

Hedging just might be the tool you want to add to your lending toolkit to get that boost. Hedging not only provides your credit union with these benefits, but it can also benefit your borrowers.

Imagine one of your borrowers is a small business retailer, offering personalized, printed apparel. The borrower decides to invest in an expansion of its real estate space to increase production. During the 18 months of construction, interest rates are anticipated to rise and the permanent financing rate is likely to fluctuate by completion of expansion. How can your borrower mitigate these risks? Offer them hedging.

Borrowers want fixed rates, credit unions want floating rates

With interest rates soaring, a hedge can provide the security business owners want. Credit unions can offer members the stability of longer-term fixed rates, while the credit union receives a floating rate. The credit union mitigates the interest rate risk and related credit risk, while also retaining a valuable member.

Royal Credit Union, a federally insured credit union serving 250,000 members in Minnesota and Wisconsin, executed its first hedge in 2021. The credit union was facing several business challenges, including managing interest rate risk and losing deals to competitors who offered longer-term rates.
Royal CU reached out to PCBB for help. After getting started with our hedging solution, their success rate rose to winning more than half of competitive deals, according to VP Business Lending Manager Michael Noone. Royal was able to achieve its loan portfolio growth and diversification goals, as well as increased member retention. [PCBB’s hedging solution] is an invaluable hedging tool that improves our ability to compete in our market and meet our borrowers’ needs, said Noone.

Key features to offer members in this rate environment

When you begin offering hedging at your institution, you can maximize benefits by paying careful attention to your pricing structure. Give members what they want, but set your price, considering the current yield curve. Here are some key features of hedging tailored to this type of rate environment.

1. Circumvent rising rates for your members with forward rate locks. Forward rate locks can be used to extend fixed-rate terms for financing, ranging from one week to 36 months into the future when financing is needed. These are primarily used for fixing the rate on existing loans, future commitments, and construction-to-permanent financing.

In a normal yield curve environment, forward rates are typically at premium rates versus spot rates. In the current flat-to-inverted yield curve environment, forward premiums are lower, more competitively priced, and offer opportunities to build in additional yield (depending on the forward period).

2. Provide other income sources. With slim net-interest margins, credit unions need to consider other sources of income. Hedge monetization provides an opportunity to serve members while collecting non-interest income that benefits the credit union as a whole.

Hedge monetization is an established practice that allows credit unions to get the full earnings benefit, regardless of related loans paying off before their maturity. Building in monetization for a fixed-rate hedge that fits your members’ needs is a win-win situation.

Hedging: the latest tool for the lending toolbox

No matter the rising rate environment or the direction the yield curve takes, hedging allows your credit union to help its members mitigate risk and take advantage of market opportunities. Some credit unions may think of hedging as an inaccessible tool that requires managing complex derivatives. That does not have to be the case. With the right solution, you can add hedging to your lender toolbox and even educate your members easily. A solution such as ours actually eliminates the challenges and costs that come with traditional hedging solutions.

Our latest guide Developing and Implementing a Loan Hedging Strategy discusses how to get started with hedging in detail. There are different hedging models that you will want to consider before you get started. This guide explores how to develop the right hedging strategy for both your members and your credit union, while also reducing the impact of volatility in the current market environment.

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Femi Audifferen has over 22 years of banking, finance, and capital markets experience. At PCBB, Femi is currently Senior Vice President of Hedging Solutions. In that role, he helps clients strategize, structure, and execute hedging solutions to mitigate interest rate risk. Prior to joining PCBB, Femi held several hedging strategy roles across a mix of regional and community financial institutions. He also holds the Financial Risk Manager (FRM) designation, a globally recognized certification for financial risk managers.

This article is sponsored by a recognized solutions provider in the credit union industry. Callahan & Associates does not endorse vendors or the solutions they offer, and the views and opinions offered here might not reflect those of Callahan. If you are interested in contributing an article on CreditUnions.com, please contact the Callahan team at ads@creditunions.com or 1-800-446-7453.
August 1, 2022

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