Competing for loans in a low-rate environment

Many financial institutions are dealing with the dual impact of having excess liquidity and limited loan growth due to the ongoing pandemic. The growing cash balances, which were sought after in late Q1 and early Q2 as a safety net for a rapidly changing market, have become a challenge to utilize and are pressuring earnings. Loan growth generally has been slowing since May, and most securities offer minimal yields without taking additional credit, duration, or optionality risk.

In the commercial loan arena, many borrowers are looking for long-term fixed-rate financings to take advantage of the historically low yield curve. With fewer loan opportunities available in the market, financial institutions need to be competitive and think about how best to meet their customers’ needs while at the same time managing their own rate risk. There are three proven interest rate hedging strategies that can be used to help both parties meet their objectives.

• Offer borrower swaps
  The bank provides its borrower with a floating-rate loan along with a pay-fixed swap to achieve a fixed-rate financing. The financial institution can then enter into an offsetting swap with a dealer bank to eliminate the rate risk. This structure is commonly referred to as a “back-to-back swap” and can also result in upfront fee income recognition for the bank. It’s typical to see swap fees in the 25-35 basis point range which can quickly become meaningful as many banks try to diversify their revenue mix.

• Hedge fixed-rate loans
  The financial institution provides its borrower with a traditional fixed-rate loan and utilizes a swap with a dealer bank to manage the rate risk. The swap can start at inception or have a forward effective date to allow the bank to maintain a higher initial yield which could be especially important in this low NIM environment. The only impact on the fixed-rate loan to the borrower is that it would need to include “make-whole” language to be consistent with the swap in the event of a partial or full prepayment.

• Hedge fixed-rate loan pools
  Rather than swap individual loans, the bank could aggregate fixed-rate borrowings and apply a macro hedge. The institution would create a closed pool of prepayable fixed-rate loans and hedge a portion of the pool based on a prepayment analysis. This structure is commonly referred to as a “last of layer” strategy and has become very popular given more flexible accounting rules. Similar to loan-level hedging, the bank could use a spot or forward-starting swap to achieve its preferred mix of fixed and floating-rate exposure.

There are over 400 community and regional banks using one or more of these hedging strategies to compete for new commercial loans. For those financial institutions that are considering these types of interest rate risk management tools, it can feel like a steep learning curve to get started. It’s important to first partner with a trusted advisor that is independent, transparent, and experienced. An advisor should be able to assist with training all stakeholders and completing the key implementation items. Additionally, an advisor can provide ongoing support with trade structuring, pricing execution, hedge accounting, and regulatory compliance.

During challenging times like these, financial institutions should be utilizing all available tools and resources to better compete for attractive lending opportunities. There are a variety of interest rate hedging strategies that can be effectively used to meet the specific needs of banks and their borrowers in this historically low-rate environment.