Analysis, Markets

HSBC races to hedge against falling rates

By Nicholas Dunbar
Image via Bloomberg

UK banks are keen users of ‘structural hedging’ to smooth out the net interest income they receive on demand deposits. 

The idea is straightforward: accounts that pay zero or low interest behave like fixed-rate liabilities because balances tend to persist over time. Meanwhile, banks can earn a floating-rate return on this cash, profiting from the interest differential.

But that introduces interest rate risk into their earnings, particularly when rates fall rapidly. 

To protect against that, banks use interest rate derivatives that swap their floating income to a fixed rate, locking in the profit margin on their deposit balances. 

HSBC: how much are we talking?

The amounts are huge: HSBC, Barclays and Natwest collectively hedged almost $1tn of deposits in 2023, amounting to half their customer cash. Banks also use derivatives to hedge their balance sheet equity, which they treat as a fixed-rate liability.

However, when rates rise, as they have done since 2021, the derivatives cause the banks’ net interest income to lag while they wait for old, lower-rate swap contracts to roll off their balance sheets.

This is a particular challenge for HSBC, which as part of its hedging strategy accumulated a $294bn portfolio of securities in addition to interest rate swaps.

This portfolio, which included $102bn of US treasury bonds earning 2.4 per cent or less, was dragging down HSBC’s net interest margin, which at the end of 2023 was just 1.5 per cent. That compares with 2 per cent at NatWest and 4 per cent at Barclays. 

Under pressure from shareholders, HSBC made a decision last summer to ‘reposition’ the securities portfolio, swallowing $1bn of losses in its 2023 accounts in order to boost interest income in 2024 with the help of new, higher-yielding derivatives.

HSBC CFO Georges Elhedery told analysts: “We didn’t have enough maturing hedges in a quite attractive rate environment, so we then decided, ‘Let’s accelerate it by taking off some of the existing hedges.’” 

By December 2023, the bank had added $80bn of new hedges, ending up with a total notional amount of $487bn. 

With inflation proving to be sticky, and central bank rates having peaked, HSBC now points to the sensitivity of its net interest income to a downward 100 basis-point shock in interest rates. 

The negative impact of such a shock would be $3.4bn, according to HSBC, down from $6bn 18 months earlier. The bank wants to reduce that sensitivity further by increasing its hedge notional even more this year, while extending the average duration of hedging to more than three years. 

HSBC’s decentralised hedging issue

All this still leaves HSBC playing catch-up with other big UK banks. 

Barclays has $312bn of notional hedges but managed to earn an income of $4bn on its derivatives in 2023, amounting to 28 per cent of net interest income. 

Meanwhile, NatWest earned $4bn on its $263bn hedging portfolio. 

And, more galling for HSBC, both these competitors report much lower net interest income sensitivity to falling rates in their year-end accounts. 

HSBC’s challenge is that, up to now, hedging has been decentralised across different sections of the global giant’s sprawling balance sheet. 

Some deposits are immediately lent out as fixed-rate loans, which can be considered as a hedge. Other deposit cash ends up in the $294bn securities portfolio, called ‘hold-to-collect-and-sell’ by the bank, but not all of the portfolio has a hedging purpose. 

And that’s not all for HSBC

Finally, HSBC has a derivatives portfolio like other banks. Trying to centralise and improve the performance of this portfolio is a priority for the bank’s management team. 

In conversations with concerned analysts, HSBC points out that its large presence in Hong Kong (where it has $543bn of deposits) hampers its hedging strategy, because available hedging products are limited in Hong Kong dollars. This is partly offset by fixed-rate mortgage lending in the territory, which can be treated as a form of deposit hedging. 

HSBC is also playing catch-up in disclosure terms, still failing to report to investors the yield it earns on structural hedging, in contrast with Barclays’ and NatWest’s $4bn windfalls. 

Running a tightly centralised policy managed by a single treasury team, Barclays has given lengthy explanations to analysts, including an November 2023 ‘teach-in’ where the bank outlined its so-called ‘caterpillar’ hedging strategy. 

Such transparency is still a distant ambition for HSBC, Elhedery conceded to analysts: “Whenever things reach a status where we feel are disclosable and they will be meaningful for you, then we’re minded to disclose that.”









Nicholas Dunbar is founder of Risky Finance, a data service that tracks bank regulatory disclosures

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