Interest Rate Risk Management

Interest Rate Risk Management • Scott Hildenbrand • March 26, 2013 • Managing Director • (212) 466-7865 • shildenbrand@sandleroneill.com • FMS East Coast Regional Conference

Interest Rate Environment • Changes in rates from 2009 to now • Which scenario is worse? Slow increase over time? Rates stay here for 2 years then…? Source: Bloomberg

Fed Funds Target Rate: 1986 - 2012 The past four Fed tightening cycles have seen rates rise on average 300+ basis points over 1.2 years

Thoughts and Questions • Most banks have little or no loan demand and strong deposit growth • Do I believe my interest rate risk results with regards to deposit behavior? • Available for Sale securities portfolio as a percentage of assets continues to increase • Average length of the bond portfolio continues to increase as well • Are Tangible Common Equity ratios in trouble? • Do I understand the potential impact?

Interest Rate Risk Modeling

Current Interest Rate Risk Model • Persistent low rate environment for the past 4 years – how much longer will we be here? • Every interest rate risk model run shows strong deposit base and ability to fund loan growth • Banks have gotten comfortable with current and projected liquidity levels • But… are we prepared for rising rates and potential deposit outflow? • How will you fund loan growth if the economy improves and deposit base shrinks? • Are you using your interest rate risk model as an effective “what-if” tool?

Stressing Deposit Pricing ESTIMATED IMPACT ON NII VOLATILITY • By changing the current beta assumption from 45% to 80% , NII would decline an additional 4.48% up 300bps and 5.97% up 400bps (assumes an immediate rate shock) • Prudent exercise to stress potential deposit competition in a rising rate/improving economy • This bank’s MMDA accounts represent only 16% of deposit base -4.48%change $1.6mm change -5.97%change $2.2mm change

Overheard at ALCO… ISSUE: Can we add 30 year fixed rate loans without significantly impacting the bank’s current interest rate risk position? OPTIONS:

Can We Add Fixed Rate Loans to the Balance Sheet?

Plan of Action Approach: • After looking at current IRR profile, the bank wanted to ensure from an interest rate risk and liquidity perspective that their deposit base would remain in an improving economy • Bank reviewed MM account balances at the end of 2007 and today. The growth they saw over this time period was concerning. • They ran two “what-if” scenarios in the interest rate risk model: • 25% of growth in MM accounts leaves the bank if rates rise 300bps • 50% of growth in MM accounts leaves the bank if rates rise 300bps • In both scenarios, the results showed significant margin contraction and stress on liquidity Action: • Instead of only using excess cash to fund new fixed rate loans, they decided to use only a portion of cash and fund the other portion with long-term fixed rate wholesale funding (a combination of Options 1 and 3) Results: • Using 50% cash and 50% wholesale funding gives an initial spread of 3.125% • Locks in long-term liquidity near all-time lows in rates • Protects TCE in a rising rate environment by combining economics and accounting (applying a cash flow hedge to long-term floating rate funding)

Forward Starting Swaps • Enter into a forward-starting pay-fixed interest rate swap to “fix the rate” on new and/or newly-restructured floating rate advances • The future rate is “locked in”, but there is no upfront cost or impact on current earnings • The market value changes of the swap designated as “cash flow hedges” also flow through OCI, a component of Tangible Equity • As rates rise, the swap increases in value and gains flow into OCI*, partially offsetting losses from the AFS portfolio • The Bank is required to post collateral against the market value of the swap throughout its life, with potential for an independent amount to be posted at inception Swap Starting X Years Forward Floating Rate Borrowing LIBOR + spread LIBOR + spread FHLB BANK SWAP DEALER Fixed Rate *Sandler O’Neill is NOT a licensed accounting advisor and this does not represent accounting advice. The Bank should consult their external auditors and/or accounting professionals for guidance on accounting treatment and impact of any proposed transactions.

Evaluating the Bond Portfolio: Impact on IRR and Capital

Current Investment Portfolio – Sector Analysis (1) Market valuation as February 28, 2013, as provided by the Bank

Current Investment Portfolio – Price Volatility Analysis Market valuation as February 28, 2013, as provided by the Bank

Current Investment Portfolio – Cash Flow Analysis

Current Market: Efficient Frontier This graph shows the MOST yield that can be earned for increasing levels of duration risk. The different curves are for investment allocations with and without credit risk.

Quantifying Impact to the Bank’s Tangible Capital Ratio Estimated Tangible Common Equity Ratio Estimated ratio reflects market value of investment portfolio as of February 28, 2013, as provided by the Bank Volatility reflects an instantaneous up 300bps shock

Immunizing Tangible Equity • AFS securities are one of the only instruments on bank balance sheets that are marked-to-market through equity (not through earnings) • One of the other instruments that are treated this way are interest rate derivatives that are designated as “cash flow hedges” under ASC/815 (codification of guidance originally issued under FAS 133) • In this interest rate environment, the preservation of tangible equity is one of the most-frequently stated goals that community banks cite for increasing their use of these derivatives • Common qualifying cash flow hedge strategies are entering into pay-fixed interest rate swaps or purchasing interest rate caps, which are designated as hedges against wholesale funding, such as: • Floating rate FHLB advances / repo • Short term FHLB advances, repo, and / or brokered CDs • Brokered MMDA and other index linked deposit products • If designated as effective cash flow hedges, the derivative is marked-to-market through OCI, a component of tangible equity , and as rates rise these instruments increase in value and gains flow through OCI, which can partially offset losses from the AFS portfolio Under Basel III as written, unrealized gains/losses on Cash Flow Hedges are backed out of Common Equity Tier 1 Capital unless the hedged item is fair-valued; under this rule, the benefit of these strategies still applies to GAAP Equity and therefore Tangible Book Value, but not to regulatory capital.

Protecting TCE in a Rising Rate Environment • Bank wanted to hedge a portion of potential negative impact of AFS securities portfolio on TCE • An immediate 300bps shock results in an approximate 2.00% change in the bank’s TCE ratio • Although this is an extreme scenario, an immediate rate shock illustrates the worst case impact to TCE • In order to get a cash flow hedge on the books, the bank needed to find floating rate funding to apply the cash flow hedge • Can restructure existing FHLB advances into floating rate funding, which can be done under debt modification accounting guidelines • The newly-restructured funding was then swapped back to fixed, creating synthetic fixed rate funding • In order to improve margin for the next two years, the bank chose to use a fixed rate swap with an effective date two years forward • Improves +300bps TCE from sub-6% to over 6.25%

Estimated +300bps Impact of $50mm Pay Fixed Swaps Estimated TCE Ratio Estimated +300bps impact is based on price volatility analysis performed by Sandler O’Neill Assumes an immediate parallel rate shock and a 35% tax rate

Applying a Forward Starting Swap Step 1: Restructure to a LIBOR-based 7 year floating rate advances Step 2: Pay fixed on 5 year swap starting 2 years forward *New Effective Rate assumes prepayment amortized over the duration of the new borrowing. Results may vary if prepayment is straight lined amortized to maturity or accreted as a level yield calculation. The Bank should consult their external auditors for guidance.

Accounting for Swaps and Caps Under ASC 815 There are three basic designations for a swap or cap on the balance sheet: • Not a hedging instrument • Gains/losses due to change in Fair Value of the instrument flows through earnings • This creates significant income volatility • Cash flow hedge • Applies to pay fixed swap or purchased cap/floor to “fix” the cash flows of a floating rate liability • If no ineffectiveness is recorded, the entire change in Fair Value of the hedge is recorded on balance sheet in Other Comprehensive Income (OCI) • Any ineffectiveness, caused by a not perfectly matched hedge, goes through income • Fair value hedge • Applies to pay fixed swaps to convert a fixed rate asset or liability to floating • Both the hedge and hedged item are marked to market through earnings, not OCI • Ineffectiveness is expected and will go through income

Hedge Accounting vs No Hedge Accounting Why not just purchase a cap outright with no hedge accounting? • If no hedge accounting is applied the gains/losses due to change in Fair Value of the cap will flow through earnings • Example assumes a 1.30% 5 year cap purchased in the first quarter of 2010 • Swings in price range from over 3% loss to 1.39% gain without any payout on the cap • Changes in market value will not flow through OCI if no cash flow hedge accounting is applied • Additionally, if there is a gain in the cap, it will be recognized far before actual LIBOR increases thereby creating a timing mismatch for the interest rate protection

Interest Rate Risk Management