Naturally, the answer to this imperative question is always a resounding yes.
Banks are special. Though there are many reasons for this, we would venture the opinion, that how they are impacted by interest rates is probably the most important one. There is hardly a single line item on either their balance sheet or their income statement that is not affected by interest rates.
And interest rates go up and down. They were low for a long time, then they went up, and now they are slowly inching down again. All of that makes the banks’ income more uncertain, and uncertain banks are so not what we want from a systemic standpoint. Once again, Silicon Valley Bank fits the example of what not to do. SVB did not mind their exposure to rising interest rates in 2022-23. Their vast portfolio of longer-term bonds lost value (rates up / prices down) and couldn’t be liquidated in a manner that would cover their shorter-term liabilities, for example, deposits outflows.
If only there was a way to smooth the net interest income out.
That’s where the caterpillars come in. This week, the FT brought a piece about how the caterpillar strategy—or as it is also known, structural hedging—is earning UK banks a lot of money, GBP 50 BN, and more importantly, steadies their income.
The idea is to get a substantial amount of interest rate swaps, pay floating leg, receive fixed leg. To start the caterpillar, stack the swaps’ maturities out until the desired medium-to-long-term maturity, for example, every quarter out to 5 years. Then every time a swap matures, replace it with another one with quarterly payments for 5 years. That way the bank receives fixed interest income and has floating interest expenses, so at least one side of the net interest income equation is stabilized. And once the caterpillar rolls, it rolls.
That is the mechanical version, which is the one favored by UK banks. Right now, it allows banks like Lloyds, Barclays, and NatWest to enjoy receiving the high yields of the previous 2 ½ years while their interest expenses decrease because rates are on the way down.
There is also a dynamic version, which has more fans amongst the big European banks. In that flavor, each swap is actively assessed and matched to liabilities at replacement.
Short of long (haha!), the caterpillar strategy is obviously more interesting in times when rates are high(er for longer) or on the way down. However, because it works on a longer horizon and requires a certain volume, the caterpillar is not often unwound once it is in place.
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.