Evaluate swap strategies to manage your interest rate risk

Rising competition

Banks need to compete for loans. Twenty years ago, there were over 8,000 banks in the U.S. Today there's less than 5,000. Despite the competition being as fierce as ever, banks are not only competing for loans, they are also competing for investor dollars.

Oftentimes, the most profitable loans, in the most profitable relationships, require a long-term, fixed-rate loan solution. However, if you make a long-term fixed-rate loan, you are introducing interest rate risk to the balance sheet. What can you do to address this concern? How are your competitors dealing with this problem?

Derivatives

Derivatives are one way that community banks deal with this problem, and there are a few methods to consider:

Traditional interest rate swaps

This method, used by most banks who offer derivatives, is when the bank offers swaps directly to their customers through a back-to-back swap program.

Indirect interest rate swaps

In this situation, the community bank introduces a correspondent bank to the customer, who then offers the customer an interest rate swap. With an indirect swap, the community bank makes a floating rate loan to the customer, simultaneously, the correspondent bank enters into an interest rate swap with the customer. The customer, as a result, has a total fixed-rate solution. The community bank is not a party to the interest rate swap.

The three c's of indirect swaps

Indirect swaps are often put forth as a simple solution, but there are some things that community banks need to consider before moving forward:

1. Credit - A swap is a credit instrument that can be an asset or liability to the borrower, which means the correspondent bank requires security. The correspondent bank accomplishes this by requiring a senior position in the loan credit. In a borrower default, the correspondent bank has the first lien on the loan collateral.
2. Cost - While there are no out-of-pocket costs associated with putting the borrower into a swap with a correspondent bank, there are costs embedded in the swap rate that drive up the cost for the borrower and could potentially make the bank uncompetitive. These costs are often opaque — and can be significant.
3. Customer - The borrower enters into a derivative with a correspondent bank that they have no relationship. And the borrower is accepting unsecured exposure as well: if the correspondent bank defaults and owes the borrower on the swap, they have no recourse except as an unsecured creditor.

Future videos will discuss each consideration in more detail, but in the meantime, take a moment to review an article in Bank Director that discusses these considerations in more detail.