Adding lending tools to leverage PPP momentum
Many community banks received high marks from commercial borrowers for their support throughout the SBA’s Paycheck Protection Program (PPP) loan application process. These institutions had to react quickly and took advantage of their local decision-making and focus on meeting borrower needs. As some larger financial institutions stumbled through the process and frustrated existing clients, many community banks were able to establish relationships with these borrowers. Now these smaller institutions are thinking about how they can retain and broaden their new commercial relationships.
Interest rate hedging solutions can help community banks expand their lending tools to compete more effectively with larger organizations and provide borrowers with additional flexibility. Those institutions already equipped with interest rate hedging capabilities tend to utilize plain-vanilla structures like swaps, caps, and floors. With a swap, two parties agree to exchange interest payments based on a specified notional amount for a defined term. Typically, one party pays a fixed rate while the other party pays a floating rate based on an index such as LIBOR or Prime. In contrast, caps and floors are used to set upper and lower boundaries, respectively, on a floating rate index.
The two most common ways derivatives are used by banks are through loan-level and balance sheet hedging programs. Loan-level hedging is typically tied to a longer-term financing and may or may not involve the borrower in the transaction. In the first scenario, a bank provides the borrower with a floating rate loan combined with a pay-fixed swap to achieve the fixed rate financing. The bank can then use an offsetting swap with a dealer to eliminate the rate risk. This structure is commonly referred to as a “back-to-back swap.” In the second scenario, a bank can provide the borrower with a traditional fixed rate loan and utilize a swap internally to manage the risk. The only impact on the fixed rate loan to the borrower is that it would need to include “make-whole” language in the event of a prepayment.
Why would a bank and its borrowers want to take on the additional effort to use a swap? From the bank’s perspective, it can better manage its rate risk which may allow it to offer more competitive rates and longer-term loans. It can also generate fee income when using a back-to-back swap structure. Borrowers can also benefit by having more flexibility. They can hedge a portion or all of the loan for a certain period or the full term. Additionally, they can utilize a forward-starting structure that may better align with their underlying financing. Lastly, the swap contract will have a market value based on prevailing interest rates. If the borrower chooses to prepay the financing and terminate the associated swap, the market value could be positive and recognized as a gain. Borrowers do not have that potential upside with a traditional fixed rate loan.
Balance sheet hedging is another way a financial institution can create additional operating flexibility and be more competitive with borrowers. Interest rate derivatives are often used by community banks to lower funding costs, reduce asset duration, and minimize exposure to falling/rising rates. All these strategies are used by depositories for their own balance sheet risk management. However, these hedging strategies can indirectly benefit borrowers by allowing the bank to meet their specific financing needs. Without access to these hedging tools, the bank may need to pass on the business opportunity, absorb additional rate risk and/or change the mix of its product offerings which may not align with its strategic plan.
Interest rate hedging solutions provide many benefits to banks and their borrowers, but they also involve risks that need to be considered and mitigated. Counterparty risk has been greatly reduced since the market has moved to a fully secured bilateral structure. This means that both parties will post collateral (typically cash) to support the daily market valuation of the contract in the event of a default. Liquidity risk involves planning for the collateral posting that may occur throughout the contract to support the prevailing market value. This amount can be forecast at inception and ongoing with over a 95% confidence level. Accounting rules and regulatory compliance also need to be appropriately followed to avoid any negative impact. Lastly, financial institutions want to avoid any negative impact on their reputation. Training is key to ensure the bank and its borrowers understand the benefits, risks, and proper use of any hedging strategy.
To get started and build a successful hedging program, a bank should first focus on its foundation. This involves writing a hedging policy, establishing procedures, seeking Board approval, and training all stakeholders. While some community banks have the resources internally to address each of these areas, many institutions will partner with a hedging advisor. It is important to choose a trusted advisor that brings transparency, independence, and experience to the table. They should be able to assist with many or all of the implementation items mentioned above including the negotiation of an ISDA agreement with the appropriate dealer bank(s). The advisor should also be able to provide structuring guidance, competitive trade execution, accounting and regulatory support, and ongoing trade servicing.
Small and mid-sized banks are an integral component of any community. Many of these institutions have been fortunate to win new customers due to their successful involvement with the PPP program. As community banks look for ways to retain and deepen these new commercial relationships, interest rate hedging solutions could be a helpful lending tool.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0234