Evaluate swap strategies to manage your interest rate risk
- February 2, 2021
Financial Institutions | Denver, CO
SummaryIn this short video Ben Lewis discusses how derivatives help banks remain competitive in an increasingly unpredictable market by introducing the difference between traditional and indirect interest rate swaps.
Banks need to compete for loans. Twenty years ago, there were over 8,000 banks in the U.S. Today there's less than 5,000. Despite the competition being as fierce as ever, banks are not only competing for loans, they are also competing for investor dollars.
Oftentimes the most profitable loans, in the most profitable relationships, require a long-term, fixed-rate loan solution. However, if you make a long-term fixed-rate loan, you are introducing interest rate risk to the balance sheet. What can you do to address this concern? How are your competitors dealing with this problem?
Derivatives are one of the ways that community banks deal with this problem, and there are a few methods to consider:
Traditional interest rate swaps
This method, used by majority of banks who offer derivatives, is when the bank offers swaps directly to their customers through a back-to-back swap program.
Indirect interest rate swaps
In this situation, the community bank introduces a correspondent bank to the customer, who then offers the customer an interest rate swap. With an indirect swap the community bank makes a floating rate loan to the customer, simultaneously, the correspondent bank enters into an interest rate swap with the customer. The customer, as a result, has a total fixed-rate solution. The community bank is not a party to the interest rate swap.
The three c's of indirect swaps
Indirect swaps are often put forth as a simple solution, but there are some things that community banks need to consider before moving forward:
- Credit - A swap is a credit instrument that can be an asset or liability to the borrower, which means the correspondent bank requires security. The correspondent bank accomplishes this by requiring a senior position in the loan credit. In a borrower default, the correspondent bank has the first lien on the loan collateral.
- Cost - While there are no out-of-pocket costs associated with putting the borrower into a swap with a correspondent bank, there are costs embedded in the swap rate that drives up the cost for the borrower and could potentially make the bank uncompetitive. These costs are often opaque — and can be significant.
- Customer - The borrower enters into a derivative with a correspondent bank that they have no relationship. And the borrower is accepting unsecured exposure as well: if the correspondent bank defaults and owes the borrower on the swap, they have no recourse except as an unsecured creditor.
Future videos will discuss each consideration in more detail, but in the meantime, take a moment to review our latest article in Bank Director that discusses these considerations in more detail.
Interested in learning more about a traditional swap program?
Contact us today to get started.
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.20-0027
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