Back-to-back interest rate swaps explained in 3 minutes

Customer demand for long-term fixed-rate financing is a long-standing challenge for banks. While business cycles ebb and flow, there are always customers looking for long-term fixed-rate financing. This poses a problem for mid-sized and smaller banks. Meeting the customer's preference for fixed-rate financing often puts pressure on the bank’s balance sheet. Simultaneously, competition from money center banks, from other community and regional banks, and even from non-bank lenders that will offer long-term fixed-rate financing continues to grow.

What is an interest rate swap?

An interest rate swap is a contract between two parties to exchange interest payments. Each is calculated on the same principal amount (referred to as "notional amount") on a recurring schedule over a set period. One party typically pays a fixed interest rate, while the other party typically pays a floating interest rate. No principal (notional) amount is exchanged. The parties simply exchange, or swap, interest payments. A swap is a netted agreement, meaning that whichever party pays more interest in that period is the one who makes the payment.

What are back-to-back interest rate swaps?

Back-to-back swaps is a common term to describe when a bank executes an interest rate swap with a borrower and a second offsetting interest rate swap with a dealer counterparty.

Why should I consider using back-to-back swaps at my bank?

Swaps have always been a useful way for banks to manage risk. Currency, credit, commodity, and interest rate risk can all be hedged, separating out the different types of risk inherent in a transaction so that the customer, or the bank, is only taking on selected risk, not the whole package. Offering a swap with a floating-rate loan to your customer allows the bank to separate the credit decision (do I want to lend to this customer?) from the interest rate risk decision (am I comfortable taking fixed-rate risk?).

How do back-to-back swaps work?

With back-to-back swaps, the bank enters into two separate transactions with their customer:

1. A floating-rate loan
2. A fixed-rate swap

These transactions create an all-in fixed-rate structure.

For example, the customer borrows at 1-month Term SOFR or Prime, but because of the swap, effectively pays a fixed-rate on the loan. The bank then executes an offsetting swap with a swap dealer, leaving the bank with only the economic impacts of the floating-rate loan.

The swap rate includes a swap fee, which the bank earns to cover the costs to originate and service the swap and for the additional extension of credit.

The difference between the wholesale rate (reflecting the bank's credit quality and dealer mark-up) and the retail rate (reflecting where the bank gets done with their customer) is equal to the fee that the bank earns. Within two business days of executing the swap, the dealer pays the bank. The swap fee depends on the size of the transaction, how long or the tenor of the transaction, and the creditworthiness of the customer.

Who uses back-to-back swaps?

Here are a few practical examples of back-to-back interest rate swaps:

• A commercial real estate investor who wants long-term fixed-rate financing is provided a floating-rate loan and a swap
• A company wants to lock-in the rate on an "evergreen" portion of its credit line and the bank offers a swap
• A borrower who wants to lock-in a rate on future financing is offered a forward-starting swap

Size and term vary, but generally back-to-back swaps are $1 million or greater in notional and five years or longer in term.

Summary

Using back-to-back swaps, a bank can:

• Meet its customer's financing preference without taking on unneeded interest rate risk
• Provide the customer with a two-way prepayment on the swap versus a one-way prepayment, as typically found in fixed-rate loans
• Earn fee income enhancing the bank's return on capital
• Level the playing field with larger financial institutions offering swaps and non-bank lenders offering long-term fixed-rate debt

Since 2001, Chatham Financial has partnered with banks of all sizes to help launch, run, and grow successful customer back-to-back swap programs. As a result we are the largest and most experienced non-bank provider of back-to-back swap support to regional and community banks.