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Guide

Considering costs when evaluating interest rate swap strategies

  • ben lewis headshot

    Authors

    Ben Lewis

    Managing Director
    Head of Sales

    Financial Institutions | Denver, CO

Summary

Ben Lewis discusses the impact embedded costs associated with indirect swaps can have on a financial institution.

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.

We'd like to hear from you

Contact us if you are looking for an economic analysis on a recent or potential transaction involving an indirect swap.

About the author

  • Ben Lewis

    Managing Director
    Head of Sales

    Financial Institutions | Denver, CO

    Ben Lewis is a Managing Director and Global Head of Sales for our Financial Institutions team. He leads business development efforts in the Western U.S. and works with depositories helping them manage interest rate risk.

Disclaimers

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.

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