The banking industry is under persistent margin pressure. Earlier this year, the implied forward markets were starting to point toward lower interest rates. With the warning lights flashing, it became increasingly important to hedge your bets, particularly if your institution supported asset-sensitive characteristics. Managing interest rate risk was—and still is—a top priority for all Seattle Bank members. Central Pacific Financial Corp. is one that took careful stock of the situation and timely advantage of available tools to ensure its ability to deliver value to its shareholders over the long term.

Central Pacific Financial Corp. is a Hawaii-based bank holding company with approximately $5.5 billion in assets that provides a full range of banking, investment, and trust services for businesses and retail customers through its main subsidiary, Central Pacific Bank. Central Pacific Bank is Hawaii's third largest commercial bank with 39 branch offices and more than 90 ATMs. Central Pacific Financial Corp. is traded on the New York Stock Exchange under the symbol "CPF" and is a member of the S&P Small Cap 600.

We recently had an opportunity to talk with Vice President and Investment Manager Dane Teruya regarding Central Pacific Bank’s overall approach to managing interest rate risk and, in particular, the strategy that positioned that institution to weather the market conditions facing our industry earlier this year.

Q: By way of some background for our readers, tell us a bit about Central Pacific Bank.

A: Service has been our guiding principal from the day we opened the doors of our first branch in 1954 on North King Street in downtown Honolulu. Today, we proudly carry on the legacy of our founders, who valiantly served our country in World War II as members of the highly decorated 100^th Infantry Battalion and 442^nd Regimental Combat Team.

Inspired by the vision of our founders, we focus on our core values of integrity, teamwork, commitment, courage, and respect, as we serve our customers on a daily basis. We believe it is a privilege to assist Hawaii’s citizens, businesses, and communities, and we eagerly greet each day as an opportunity to go beyond the accomplishments of yesterday in pursuit of service excellence. That is why it is our mission “To be the Best Community Bank Serving Hawaii.”

Central Pacific Bank is proud to be named the Small Business Administration’s Lender of the Year for Hawaii, an honor which our Business Banking team has achieved for the third consecutive year. In addition, our Wealth Management and Trust Division continues to build lasting relationships with both individual and corporate customers. In the area of commercial real estate, we have further solidified our leadership role in the marketplace, using service as our differentiator.

Q: As a public company, what is your commitment to your shareholders?

A: Central Pacific Bank strives to maximize the returns for its shareholders through solid earnings growth. Our focus on strong loan and deposit growth, solid asset quality, and ability to control expenses has allowed our institution to flourish.

We also look for strategic opportunities that will enhance our return to our shareholders. For example, our Board of Directors recently authorized a 2.1 million share repurchase plan in order to take advantage of market opportunities. This repurchase plan, combined with a 12.3% increase in year-to-date dividend, will serve to enhance shareholder value.

Q: Describe Central Pacific Bank’s approach to measuring and managing interest rate risk.

A: Central Pacific Bank utilizes Sendero’s Asset/Liability Management and Data Management System to measure and monitor its interest rate risk position. Our interest rate risk management system has allowed us to conduct static/dynamic rate shocks, what-if scenarios, capital leverage strategies, wholesale funding strategies, and derivative strategies on our balance sheet. It is especially critical to do so in today’s rapidly changing interest rate environment. The ability to measure and monitor our interest rate risk position has allowed us to take advantage of market opportunities and formulate strategies to improve financial performance under various rate environments.

Q: What is your interest rate risk profile?

A: Central Pacific Bank manages its interest rate risk profile through a natural hedge on its balance sheet, through such mechanisms as interest rate floor features within our loan portfolio or investments that contain features that coincide with our desired interest rate risk position. The ability to manage its costs of funds under various rate scenarios has allowed the bank to maintain a stable net interest margin, especially during difficult periods like today’s flat yield curve environment.

As a commercial real estate lender, the bank’s loan portfolio is primarily short in nature, floating either off Prime or three-month LIBOR. As a result, earnings volatility is positively correlated to changes in interest rates. As of December 31, 2006, our net interest income increased 2.6% with a +200 basis point increase in rates and declined 4.5% under a —200 basis point decline in rates over a 12-month timeframe.

Q: In 2006, Central Pacific Bank executed a variable rate advance with the Seattle Bank that contained an interest rate floor. In retrospect, with short-term interest rates having declined, the strategy seems to have paid off. At that time, what were the factors that led to this decision?

A: In 2003, our transactional deposits grew, primarily due to a flight-to-quality, as market rates were at an all time low. By 2006, short-term market rates rose 4.25%, resulting in a shift in depositor expectations. It was evident that our depositors were looking for alternative investment opportunities. As a result, we saw a shift in balances from transactional accounts to certificate of deposit accounts that reduced our ability to manage short-term changes in interest rates. In addition, during this period, we focused our efforts on growing our commercial real estate portfolio, which was primarily based off Prime and three-month LIBOR.

With the Federal Reserve taking a pause in June 2006 and given the bank’s then interest rate risk profile, management looked at alternative strategies to reduce our asset sensitivity. The variable rate advance with an embedded interest rate floor provided the protection we needed. The variable rate advance shortened our liabilities and included an option that did not involve any FAS 133 accounting requirements. Despite having to pay a premium for the floor, management was willing to accept the upfront costs as insurance towards declining rates.

Q: Did you look at other strategies that would have protected your institution in a declining rate environment? If so, what advantage did the floored variable advance offer over other options?

A: Yes, management first looked at changing our interest rate profile through adjusting our certificate of deposit composition. We looked at changing our CD acquisition strategy to be short-term, typically three to five months instead of the longer maturities. Second, management looked at purchasing a floor to hedge the then-current three-month LIBOR and Prime-based portfolios. Purchase of the floor option would immediately improve our interest rate risk profile under a downward rate environment. Third, we looked at a guaranteed spread advance at the Seattle Bank as a viable alternative to shortening our liabilities.

The drawback of the CD acquisition strategy is that it typically takes time to implement and, thus, would not allow the bank to capitalize on market opportunities. Purchasing the floor would require FAS 133 accounting requirements, and changing our wholesale funding portfolio didn’t give us the interest risk profile we were looking for. As a result, we implemented all three strategies. We shortened our CD acquisition strategy and took down a guaranteed-spread advance with an embedded floor

Q: In spite of the constant margin pressures affecting the banking industry, your margins have been well above those of your national peers. Insurance premiums—in this case, for the purpose of income protection in the event of rate declines—can impact short-term reported margins. As a publicly traded institution, how did you communicate this strategy to your management team?

A: Our management team evaluated implementing the variable rate floor advance and its impact on the bank’s net interest margin. Management’s willingness to forgo current income for future gain under a downward rate environment was critical to implementing the strategy.

Q: Notwithstanding Central Pacific Bank’s attractive, low-cost deposit franchise, could you describe the role that the Seattle Bank plays with your overall funding strategy?

A: The Federal Home Loan Bank of Seattle has allowed our bank to boost liquidity, manage interest rate risk, and fund loan growth through its financial solutions. We view the Seattle Bank as a business partner, helping us fund various community investment programs and issuing standby letters of credit. The Seattle Bank’s structured advances have allowed us to effectively manage our interest rate risk, maximize earnings, and deliver a return to our shareholders.

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