Structural hedging: the weapon of Britain’s biggest banks as interest rates fall, and which lenders’ analysts predict will turn a profit

Britain’s biggest lenders enjoyed strong returns in the third quarter as the sector began to cash in on a tailwind that could boost returns in the years to come.

Lloyds Banking Group and Barclays recently reported much stronger-than-expected growth for the period, thanks to healthy revenues.

The former, whose brands include Scottish Widows and Bank of Scotland, posted £1.8bn in pre-tax profits, while the latter achieved the equivalent of £2.2bn.

Both companies partially attributed their results to “structural hedging,” a practice that has helped offset the effects of customers refinancing their mortgages at lower rates or choosing alternative savings accounts that pay higher returns.

But what is structural hedging, how does it help the profitability of banking giants and which banks will benefit the most?

What is structural coverage?

Hedges are essentially an insurance policy used by businesses to protect against dramatic cost increases or financial losses.

Airlines, for example, regularly purchase fuel at a fixed price for a specific period because gasoline represents a huge portion of their expenses, and a sudden increase in prices could seriously hurt their profits.

For British lenders, profits generally depend on net interest margin (NIM), the difference between what they pay out to savers and what they receive in loans.

Competition to offer the best deposits and mortgages, as well as other loans, can be fierce and severely impact a bank’s NIM.

Thus, to preserve profits against exposure to interest rate movements, banks will take out “structural hedges.”

This could take the form of interest rate swaps – a contract with another party to exchange interest payments, with one party typically paying a floating rate and the other a flat rate.

Alternatively, they could establish a fixed-rate bond portfolio that pays a constant percentage of interest over a predetermined period of time.

Structural hedging is especially prevalent at the current time, with UK interest rates trending lower after gradually rising from record lows between 2021 and 2023 due to soaring inflation.

British lenders typically cover a large portion of their deposits and loan portfolios, but typically avoid covering them in full.

For NatWest, more than 40 percent of its deposit base – equivalent to £175bn – forms part of the structural hedge of its product, which has an average duration of two and a half years, meaning it takes a full five years to re-price.

HSBC has even greater structural coverage: it expanded by $27 billion over the last quarter to $531 billion, mainly due to exchange rate fluctuations. Of them, $30 billion matures in 2024 and $115 billion next year.

How banks benefit from structural coverage

An important advantage of structural hedging is that lenders can cushion their turnover and profits against high volatility.

Analysts often incorrectly predict short-term interest rates due to unforeseen geopolitical and macroeconomic factors.

Even when inflation is falling, central banks may take longer than expected to cut rates.

While this may bolster lenders’ interest income, this income stream may be eroded if banks fail to cover themselves before interest rates fall.

So if a bank has a bond portfolio pegged at 5 percent, but rates hit 3 percent before maturity, its income and profits will be better protected.

Barclays estimates the drop in interest rates from 5 percent to 0.5 percent in 2008/2009 could have eliminated 90 percent of income from its rate-insensitive checking accounts.

Instead, the coverage meant their income fell by just under 5 percent during this period.

Will Howlett, financial analyst at Quilter Cheviot, said: “The real benefit comes in an environment like we’re seeing now where rates are falling, so banks’ hedges are moving to higher fixed rates while they pay at a lower rate in the variable tranche.’

Howlett also says interest rate hedging reduces the capital lenders need to hold against their bank exposures, which can “optimize balance sheet efficiency.”

This gives them more leeway to reward investors even more generously: UK banks paid £3.3 billion in dividends during the third quarter of 2024, a larger amount than any other sector, according to Computershare.

What are the disadvantages of structural coverage?

In a high rate environment, banks are sacrificing some profits in favor of the stability provided by hedging.

However, if banks opt for hedges with long maturities, this may hurt them when interest rates start to rise again.

As the old saying goes, rates rise like a rocket but fall like a feather, so lenders absorb more risk by not choosing short-term bonds or interest rate swaps.

“The longer the duration of the derivatives transaction, the less agile a bank can be to benefit if interest rates start to rise, so there are potential costs,” says Russ Mould, chief investment officer at AJ Bell.

And he adds: “Banks also do not cover their entire deposit and loan portfolios, since these transactions carry their own costs.”

Analysts back Barclays

In the three months to September, Lloyds Banking Group’s total net income rose 5 per cent to £4.3 billion from the previous quarter.

The FTSE 100 company enjoyed a slightly higher net interest margin thanks to structural hedging gains that compensated for customers refinancing mortgages and choosing different savings accounts.

Structural hedging also helped third-quarter profit and interest income growth at Barclays and NatWest Group, with both beating pre-tax profit forecasts by around £200m.

NatWest, which is 16 percent owned by the UK government, also saw its shares hit a nine-year high following the release of its results.

Standard Chartered credited the reduction of short-term hedges and the revaluation of structural hedges for helping to increase its treasury income by $281 million year-on-year in the July-September period.

The Asia-focused company’s announcement came as it reported underlying operating income rose by about $500 million to $4.9 billion, its best third-quarter result since 2015.

And HSBC attributed the positive fair value movements in the structural hedge to partly offset lower revenue in its corporate core arm, which includes its core treasury and legacy businesses.

“All the big UK banks use a structural hedge,” says Benjamin Toms, an analyst at RBC Capital Markets.

He adds: “The key difference is how mechanical each bank is in replacing existing swaps. A bank like Barclays is very mechanical and a bank like Lloyds is more tactical; NatWest falls somewhere in between.”

He believes Barclays will be the main beneficiary of this tailwind due to the “shorter average duration” of its structural coverage.

Quilter’s Howlett believes the largest domestic British banks – not just Barclays – will reap a bigger benefit compared to more Asia-focused banks such as HSBC and Standard Chartered.

“As interest rates fall,” says Howlett, “these banks will continue to implement successful hedging strategies and ensure they continue to see the benefit of higher interest rates, even if the Bank of England is lowering the rate.” general”.