Countdown to the election: How regional and community banks can compete and effectively manage risk

We are officially a few weeks away from the U.S. general election, an event which often leads to a spike in market volatility. In fact, three of the five biggest Q4 moves in the 10-year Treasury yield have occurred in an election year.

With ongoing interest rate fluctuations and expected shifts in fiscal policy on the horizon, it’s imperative that financial institutions examine ways to properly leverage risk management tools to hedge against these uncertainties and protect their balance sheets.

The premise that hedging programs are tools to be implemented sparingly and only in times of extreme economic volatility is obsolete. The last few years have taught us that the best hedging programs are always running. For smaller to midsize banks especially it’s important to implement strategies to remain competitive against larger counterparts in today’s chaotic economic and political landscape.

Here is a playbook for regional and community banks to stay on a smooth path in turbulent times.

Impact of the election on market volatility

September’s Fed meeting produced the long-awaited decision on interest rates, although in the form of a more aggressive 50-basis-point reduction, the first cut in four years. If we believe the forward curve, more cuts are likely to come this year.

Despite the expected reprieve to deposit costs, the looming presidential election has the potential to be the next driver of interest rate risk. Changes to fiscal policy could bring about significant interest rate volatility, as the cost of servicing Treasury debt has nearly doubled over the past two years, and buyers may soon demand additional compensation for holding longer-dated government bonds.

Any change in the administration could also bring about a potential new regulatory regime. With several new capital and liquidity rules already being considered by regulators, a shift in leadership could accelerate or modify these proposals. Market participants will need to carefully monitor both fiscal and regulatory developments to gauge the impact on their balance sheets and interest rate risk position.

How can regional and community banks boost their risk management strategy?

Ongoing market volatility will only continue as we edge closer to the election, and for banks, credit unions and broader financial firms, employing proper risk management is key to surviving market uncertainty.

In today’s digitized financial system, technology is the centerpiece of a robust risk management program, especially for firms with extensive and complicated sources of interest rate risk. By integrating workflows and creating a single source of truth for derivatives data, users within the organization can more confidently and accurately execute on their financial decisions, especially with the data management challenges that come with complex hedging strategies. For banks, especially those that dip into the complicated world of hedge accounting, combining expert advice with technology can streamline an otherwise lengthy pre-trade approval process.

For market participants looking to capitalize on the recent interest rate action, such as private equity sponsors and portfolio companies that use floating rate debt and interest derivatives, employing automated financial solutions will reduce human error, generate time-saving efficiencies and optimize hedge strategies. The end result: a precision risk management program and newfound agility for the risk, trading and portfolio managers.

Technology that helps users track real-time hedge ratios and proactively prepare to execute hedges can make or break a bank’s earnings. Slow and manual processes in risk and accounting often prevent regional banks from capitalizing on fast-moving opportunities and create more risk in the process. Without the ability to quickly identify and approve hedges in a fast, holistic manner opportunities will often fall though.

Staying competitive during politically tumultuous times

Regional banks are no strangers to weathering difficult conditions. But the risks they face are changing. We’ve seen a variety of major economic shock waves over the last few years, from the COVID-19 pandemic to ongoing energy market shifts with two wars, and global supply and demand concerns impacting capital markets. Banks are adapting to new enhanced liquidity and capital rules. Against this already uncertain backdrop, the U.S. election could provide other shock waves, from interest rate volatility or additional regulations.

Today, banks are looking for ways to stay competitive, especially smaller banks with limited resources compared to banking giants with seemingly unlimited budget for technology and support.

The same technology used by banks to manage their hedging programs can also be used to avoid mispricing in loan originations, often an underappreciated source of interest rate risk. By using real-time, markets-based loan pricing, institutions are able to avoid mispricing in volatile markets, a critical error that can mean the difference between ROI and net losses.

Additionally, banks can also use market-based pricing to calculate the value of optionality in rate locks or prepayment options. Once priced accurately, banks can be both disciplined and thoughtful about giving options away that can make or break a bank’s profits while still meeting customer needs.

The state of the union for banks

Going into the November election and the runup to inauguration, banks are in a unique position. Market volatility is nothing new, but the speed of today’s markets has created an even more unstable environment that is forcing banks, specifically smaller institutions, to drill down into their risk management practices and technology. Risk resilience is imperative, and interest rate hedging should be an essential component of a bank’s operations, whether in recessionary or boom times.

Smaller banks must thoroughly consider how implementing data-driven, always-on hedging programs can help level the playing field against large counterparts and set them apart amid the upcoming election and its impact on the economy.

After all, the only thing that is certain is uncertainty.

Isaac Wheeler is Head of Balance Sheet Strategy at Derivative Path.