Many community banks received high marks from commercial borrowers for their support throughout the SBA’s Paycheck Protection Program (PPP) loan application process. These institutions had to react quickly and took advantage of their local decision-making and focus on meeting borrower needs.
As some larger financial institutions stumbled through the process and frustrated existing clients, many community banks were able to establish relationships with these borrowers. Now these smaller institutions are thinking about how they can retain and broaden their new commercial relationships.
Interest rate hedging solutions can help community banks expand their lending tools to compete more effectively with larger organizations and provide borrowers with additional flexibility. The two most common ways derivatives are used by banks are through loan-level and balance sheet hedging programs.
Loan-level hedging is typically tied to a longer-term financing and may or may not involve the borrower in the transaction. In the first scenario, the borrower receives a floating-rate loan combined with a pay-fixed swap to achieve the fixed-rate financing. The bank can then use an offsetting swap with a dealer to eliminate the rate risk. In the second scenario, a bank provides the borrower with a traditional fixed-rate loan and uses an interest-rate swap internally to manage the risk.
Why would a bank and its borrowers make the additional effort to use a swap? From the bank’s perspective, it can better manage its interest rate risk, which may allow it to offer more competitive rates and longer-term loans, and it can also generate fee income. Borrowers can benefit by having the flexibility to hedge a portion or all of the loan for a certain period or the full term. The swap contract will also have a market value based on prevailing interest rates.
Balance sheet hedging is another way a financial institution can create additional operating flexibility and be more competitive with borrowers. Interest rate derivatives are often used by community banks to lower funding costs, reduce asset duration and minimize exposure to falling or rising rates.
These strategies are used by depositories for balance sheet risk management. However, these hedging strategies can indirectly benefit borrowers by allowing the bank to meet their specific financing needs. Without access to these hedging tools, the bank may need to pass on the business opportunity, carry additional rate risk and/or change the mix of its product offerings, which may not align with its strategic plan.
Risk side also needs to be considered
Interest rate hedging solutions provide many benefits to banks and their borrowers, but they also involve risks that need to be considered and mitigated.
Counterparty risk has been greatly reduced since the market has moved to a fully secured bilateral structure. This means that both parties will post collateral (typically cash) to support the daily market valuation of the contract in the event of a default. Liquidity risk involves planning for the collateral posting that may occur throughout the contract to support the prevailing market value. This amount can be forecast at inception and ongoing with a confidence level above 95 percent.
Accounting rules and regulatory compliance also need to be appropriately followed to avoid any negative impact. Many community banks partner with hedging advisors to address these areas. And because financial institutions want to avoid any negative impact on their reputation, training is key to ensure the bank and its borrowers understand the benefits, risks and proper use of any hedging strategy.
To get started and build a successful hedging program, a bank should first focus on the foundation. This involves writing a hedging policy, establishing procedures, seeking board approval and training all stakeholders.
While some community banks have the resources internally to address each of these areas, many institutions will partner with a hedging advisor. The advisor should be able to assist with many or all of the implementation items mentioned above, including the negotiation of an ISDA agreement with the appropriate dealer bank(s).
Small and mid-sized banks are an integral component of any community. Many of these institutions have been fortunate to win new customers due to their successful involvement with the PPP program. As these banks look for ways to retain and deepen these new commercial relationships, interest rate hedging solutions could be a helpful lending tool.
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