As community banks look for ways to differentiate themselves from their larger counterparts, which of the following advantages would be least likely to help win over a local client when competing for business:
- Community banks focus their attention on the needs of local families, businesses and farmers
- Community banks channel most of their loans to the neighborhoods where their depositors live
- Community banks offer nimble decision-making on loans because decisions are made locally
- Community banks match up their borrowers with an unknown third party from outside the community in unsecured derivative contracts
Obviously, you would never see the last point serving as a pillar of a community bank’s mission statement or displayed on the wall as you enter its Main Street headquarters. However, this continuing low interest rate environment has created a challenging predicament. Increasing demand from borrowers for long-term fixed-rate loans and the willingness of larger banks to meet that demand has forced community banks to find a way to remain competitive. And while the problem can easily be solved with plain-vanilla interest rate swaps, many community banks have sworn off derivatives as either too complicated or as the exclusive domain of the megabanks.
Enter Third-Party Swap Programs (“TPSPs”), which are pitched as tailor-made solutions for community banks looking to avoid putting derivatives on their books and explaining how they work to their borrowers. The folks pushing the TPSP concept emphasize that their solution gives community banks the best of all worlds: a floating rate loan and no derivative on the books of the bank while the borrower has fixed interest payments by signing a very simple 4-page addendum to the note. But how does this transaction work for the client who has picked a community bank over a megabank because doing business locally is a priority? To the extent that the borrower will be entering into a long-term contractual relationship with the Third Party sight unseen, here are three questions that community bankers should ask before setting up their borrowers on a TPSP blind date:
1. Is the TPSP contract between the borrower and the Third Party an interest rate swap?
One of the main selling points of TPSPs is the absence of ISDA documentation. While that might suggest no swap exists, all parties should look closely at their obligations before making a determination. Asking an auditor or regulator might also be a good idea. If the bank is booking a bona fide 15-year floating rate loan, then the borrower signs the note and is contractually obligated to make floating interest payments. If the addendum provided by the Third Party enables the borrower to make fixed payments over the life of the loan, then it would seem that the borrower and the Third Party are going to swap fixed for floating interest payments for the life of the loan. Since the borrower is depending upon the Third Party to cover its floating rate obligation, it is taking on 15-year counterparty risk to the Third Party. And as much as everyone loves to complain about the length and complexity of ISDA documents, they were designed to protect both parties to swap contracts. Here, the “simplicity” of no collateral being posted back-and-forth means that the borrower is a party to a 15-year contract that looks a lot like an unsecured interest rate swap with its blind date partner.
2. What are the risk/reward trade-offs in a TPSP transaction?
Assuming for a moment that the community bank is not a party to an interest rate swap through the TPSP, are there any other risks involved in this three-way deal? In order to make the Third Party comfortable entering into a 15-year agreement with an unknown entity, there is likely an arrangement where the bank will make a promise to vouch for its client. As simple as that sounds, a formal guaranty of the borrower’s obligations could be construed as a credit default swap (again, you may want to check with an auditor or regulator). Alternatively, the bank may need to subordinate to the Third Party its security interest in all the collateral that supports the loan, which could complicate future workout negotiations. Since the community bank is underwriting what amounts to derivative credit exposure for the benefit of the Third Party, it would be worthwhile to understand how the rewards and benefits of the transaction are accrued and shared. Even after carefully structuring the TPSP transaction to exclude itself from the “swap,” the community bank clearly holds onto reputation risk and might be asked to intervene if the Third Party is unable to meet its future obligations under the contract (when interest rates rise).
3. What are the risk/reward trade-offs if I do the swap myself?
For the community bank considering a TPSP based on the premise that it wants to avoid swaps at all costs, now may be a good time to re-visit the “why” to that decision. Derivatives have been the subject of negative press over the years, but beneath almost every headline was a story pointing to excess speculation and not derivatives themselves. Hedge accounting was scary when it was introduced 15 years ago, but there are now well-worn paths to using swaps as a prudent risk management tool and achieving favorable accounting treatment. A growing number of community banks have recently taken the step to add swaps and caps to their interest rate risk management toolkit. After doing so, there are a number of strategies utilizing a plain-vanilla swap that yield a win-win solution for both bank and borrower. In one frequently used example, the borrower’s only contract is an old-fashioned two-party fixed-rate loan contract with its local bank, while the bank takes care of managing and accounting for the hedge behind the scenes. This might elicit thanks, not only from the borrower for sparing them a 15-year blind date, but also from shareholders when they compare the economic outcome.
Bob Newman oversees the financial institutions advisory practice at Chatham Financial, which provides comprehensive interest rate hedging expertise to over 120 depository institutions in the United States.