Back-to-back interest rate swaps explained in 3 minutes
Head of Sales
Financial Institutions | Denver, CO
Banks use back-to-back swaps to meet borrower demand for long-term fixed-rate loans. With back-to-back swaps, the bank enters a floating-rate loan and a fixed-rate swap with the borrower and then a second, offsetting swap with a dealer counterparty.
- Learn more about interest rate swaps
- Discover back-to-back interest rate swaps and how they work
- Understand who uses back-to-back interest rate swaps
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.
How can banks square the circle between their own needs and their customers' requirements? The answer lies in the use of interest rate swaps, and particularly, back-to-back swaps.
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:
- A floating-rate loan
- 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.
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.
Back-to-Back Swap Program Benchmark Statistics Report
Interested in seeing how your interest rate swap program stacks up relative to your peers? Perhaps your financial institution is not yet using swaps to win more commercial loan business, but would find value in reviewing and analyzing Chatham's Back-to-Back Swap Program Benchmark Statistics Report.
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Contact Chatham if you are looking to learn more about back-to-back interest rate swaps.
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.22-0119