Considering costs when evaluating interest rate swap strategies

In a previous video, we discussed the two ways that community banks offer interest rate swaps to their borrowers: traditional interest rate swaps (offering swaps directly to a borrower) and indirect swaps (where a community bank introduces a correspondent bank to their borrower who then offers an interest rate swap). While put forth as a simple solution, there are important considerations that community banks need to account for when evaluating indirect swaps. We previously highlighted the credit considerations; below focuses on the costs that are embedded within indirect swaps.

Considering cost when evaluating swap strategies

There are no out-of-pocket costs associated with indirect or traditional swaps; however, the costs of indirect swaps are often opaque and embedded into the rate offered to your borrower. There are two implications to these embedded costs:

1. A higher rate for the borrower potentially making the bank uncompetitive
2. Could result in less fee income for the bank

Analyzing the economics of an indirect swap program

A CEO of a community bank who actively offers indirect swaps to borrowers contacted Chatham and was looking to analyze pricing. They wanted better visibility into the economics of a $6.8M transaction the bank had recently executed. After a thorough analysis, we determined that this bank would have generated $154,000 more in fee income on this single deal if they offered the swap directly to the customer. This bank could have recognized the improved economics in one of three ways (or a combination of the three):

1. More fee income
2. More loan spread
3. Lower fixed-rate for the borrower

In summary

Banks need to consider the impact of the embedded costs associated with indirect swaps and consider offering swaps directly to their borrowers. Traditional swaps have more favorable economics, and they allow the bank to maintain complete control of the relationship with their borrowers.