The structural hedge: British banks’ biggest weapon as interest rates fall – and one that lender analysts can make a profit from

Britain’s biggest lenders enjoyed huge profitability in the third quarter as the sector began to benefit from tailwinds that could boost returns in coming years.

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

The former, with brands including Scottish Widows and Bank of Scotland, recorded £1.8 billion in pre-tax profits, while the latter achieved an equivalent £2.2 billion.

Both companies have attributed their performance in part to “structural hedging,” a practice that has helped offset the effects of customers refinancing mortgages at lower interest rates or choosing alternative savings accounts that offer higher returns.

But what is structural hedging, how does it contribute to the profitability of banking giants, and which banks will benefit most from its use?

What is a structural hedge?

Hedges are essentially an insurance policy used by companies to protect themselves against dramatic cost spikes or financial losses.

For example, airlines regularly buy fuel at a fixed price for a certain period of time, because gasoline represents a large part of their expenses, and a sudden price increase could seriously damage their profits.

For UK lenders, income generally depends on net interest margin (NIM) – the difference between what they pay to savers and what they receive in loans.

Competition to offer the best deposits, mortgages and other loans can be fierce and have a major impact on a bank’s NIM.

To protect profits against exposure to interest rate fluctuations, banks will therefore take out ‘structural hedges’.

This could take the form of interest rate swaps: a contract with another party to exchange interest payments, where one party usually pays a variable interest rate and the other an unchanged interest rate.

Alternatively, they could set up a fixed-rate bond portfolio that pays a consistent interest rate over a predetermined period of time.

Structural hedging is particularly prevalent at the moment as UK interest rates are on a downward trend, having gradually risen from record lows between 2021 and 2023 on the back of soaring inflation.

UK lenders often hedge a large proportion of their deposits and loan portfolios, but they usually avoid hedging it all.

For NatWest, more than 40 percent of the deposit base – equivalent to £175 billion – is part of the structural product hedge, which has an average term of two and a half years, meaning it takes a full five years to reprice.

HSBC has even greater structural coverage: it grew by $27 billion to $531 billion last quarter, mainly due to fluctuating exchange rates. Of this, $30 billion will mature in 2024 and $115 billion next year.

How banks benefit from a structural hedge

A major advantage of structural hedging is that lenders can absorb their turnover and profits against high volatility.

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

Even if inflation falls, it may take longer than expected for central banks to cut interest rates.

While this can increase lenders’ interest income, this revenue stream could be eroded if banks fail to hedge before interest rates fall.

So if a bank has a bond portfolio that is stuck at 5 percent, but the interest rate reaches 3 percent before maturity, their income and profits will be better protected.

Barclays estimates the interest rate reduction from 5 percent to 0.5 percent in 2008/2009 could have wiped out the income from the interest-insensitive checking accounts by 90 percent.

Instead, hedging caused revenues to decline 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 are seeing now where interest rates are falling – so banks’ hedges are rolling over to higher fixed rates while paying out at a lower rate. the variable leg.’

Howlett also says that capping interest rates reduces the amount of capital lenders need to hold against their bank portfolio exposures, which can “optimize balance sheet efficiency.”

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

What are the disadvantages of structural hedging?

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

However, if banks opt for hedges with long maturities, this could work against them if interest rates start to rise again.

As the old saying goes: interest rates rise like a rocket, but fall like a feather. Lenders therefore absorb more risk by not opting for bonds with a shorter term and interest rate swaps.

“The longer the duration of the derivatives transaction, the less agile a bank may be to profit if rates start to rise, so there are potential costs,” said Russ Mould, investment director at AJ Bell.

He adds: ‘Banks also do not hedge their entire deposit and loan portfolio as these transactions come with their own costs.’

Analysts back Barclays

In the three months ended September, Lloyds Banking Group’s overall net profit rose 5 percent to £4.3 billion on the previous quarter.

The FTSE 100 company enjoyed a slightly higher net interest margin thanks to structural hedge income to compensate for customers refinancing mortgages and choosing other savings accounts.

Structural hedging similarly helped drive interest income and profit growth in the third quarter at Barclays and NatWest Group, with both exceeding pre-tax profit expectations by around £200m.

NatWest, which is 16 percent owned by the British government, also saw its shares reach a nine-year high after publishing its results.

Standard Chartered credited the removal of short-term hedges and repricing of structural hedges with helping to boost government bond income by $281 million annually in the July to September period.

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

And HSBC attributed positive movements in the fair value of structural hedging to partially offset lower revenues in the industry, which includes its central treasury and legacy businesses.

“All larger British banks use a structural hedge,” notes Benjamin Toms, analyst at RBC Capital Markets.

He adds: ‘The key difference is in how mechanical each bank is in replacing existing swaps, with a bank like Barclays being very mechanical and a bank like Lloyds more tactical, with NatWest sitting somewhere in the middle.’

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

Quilter’s Howlett thinks the larger domestic UK banks – and not just Barclays – will reap a bigger boon compared to the more Asia-focused banks such as HSBC and Standard Chartered.

“If rates fall,” says Howlett, “these banks will continue to deploy hedging strategies to good effect, ensuring they continue to see the benefits of higher rates even if the BoE cuts nominal rates.”