Community banks and derivatives: knowing when to shift gears

Community bankers feeling an obligation to faithfully serve the needs of Main Street families and small business owners instinctively raise the red flag when Wall Street-designed interest rate derivatives enter the conversation. With a reputation for burdensome accounting rules and complex documentation, community banks cast aside derivatives in order to maintain a simplistic policy. However, when it comes to solving one of the bank’s biggest challenges – meeting commercial borrower demand for long-term fixed-rate financing – nothing gets the job done more neatly and efficiently than an interest rate swap. It is for this reason that many community banks have begun to test-drive solutions with interest rate derivatives under the hood, promising a hassle-free ride for the bank. Before getting behind the wheel of a vehicle with a derivatives-powered engine, it is critical for a community bank to understand how the transmission works, and consider how and when to shift gears to achieve the smoothest ride possible.

Park to first gear – Installing in-house hedging capabilities

There is no question that getting a car into first gear with clutch and stick shift is a simultaneously frightening and exhilarating experience when done for the first time. Getting started with interest rate swaps is none too different. When the business need – competing for a 10-year fixed-rate loan – is clearly visible, the desire to hit the ground running might tempt a community bank to forego some key foundation-building steps. These include Board education, establishing a hedging policy and complying with Dodd-Frank regulatory requirements. Jumping to a solution that pushes the derivative outside the bank in order to avoid these steps may provide a quick-fix, but leaves the bank without a new versatile tool in its risk management tool kit. Installing hedging capabilities inside the bank is the best way to “take the car out of park” and maintain appropriate control of the driving journey.

First gear to second Gear – balance sheet hedging

With the vehicle in motion, it now becomes easier to shift into second gear, which is making use of swaps to hedge interest rate risk in a holistic fashion. Rather than attacking the problem one commercial loan at a time, the bank can utilize its A/L model outputs to determine whether the aggregate risk profile needs adjusting (and if so, in which direction). Using this desired economic outcome as the roadmap, the bank can scour its balance sheet for the optimal items to designate in a hedge accounting relationship. If the commercial clients are not ready for ISDA documents, a bank in second gear can offer a traditional fixed-rate loan. This keeps the borrower out of a quick-fix derivative while the bank takes care of the hedging behind the scenes.

Second gear to third gear – Offering swaps to borrowers

As a community bank competes up-market, it begins to encounter clients who expect a derivative solution along with a commercial loan. Bankers joining the team expect to be able to offer swaps as a tool to customize and differentiate their product. This is the time to shift to third gear – establishing a borrower-facing swap program. Working with a partner, the community bank can ensure that borrowers entering swaps understand that they are a party to a derivative contract. Unlike the quick-fix, their contract is only with their local bank – not an unknown third-party. With the hedging product on the shelf for the right commercial borrowers, community banks can tap into the many flexibility features of swaps such as forward rate-locks and partial hedging, in addition to easily participating in swaps offered by the lead in a syndicated deal.

Third gear to Fourth gear – Optimization

Whether through organic growth or M&A, when a community bank is ready to merge onto the regional bank highway, shifting into fourth gear involves building out more in-house derivatives capabilities. Perhaps third-gear driving has been limited to a single correspondent counterparty, but now the bank finds itself competing with that same correspondent for loan and deposit business. Working with an independent partner gives the growing bank the flexibility to add new swap counterparties to the mix. From there, the bank can evaluate when it makes sense to bring on a product specialist to support bankers and borrowers while still leaning on a partner for trade execution and servicing.

Conclusion

When it comes to taking advantage of the powerful advantages offered by interest rate derivatives, engaging directly with vanilla interest rate swaps in a gradual progression through the gears provides for the smoothest ride with maximum control for community banks.