Banks all understand interest rate risk, so understanding how hedging managing risk is an easy one. However, there is currently a conflict with banks that on one hand say they don’t believe rates are going up so taking more fixed rate exposure is acceptable, yet have a rate view of that of the forward curve (which does show rates going up). This issue is compounded by the fact that these very banks mostly have loan growth for 2015 exceeding GDP (3%) which would indicate faster than expected expansion and indicates higher than expected rates. Regardless of this logical conflict, using an asset hedge to manage interest rates is easy to understand and is the first way that a hedge program can add value. However, there are four other ways that CenterState Bank adds value by utilizing our ARC hedge program.
To understand other ways hedging can add value, it pays to understand how we calculate value. While it gets more complicated, the simple mathematical modeling of value addition for financial performance is based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). The formula is as follows: Net Operating Profit After Taxes - (Capital * Cost of Capital).
Measuring value-add at the department, process or individual level is more difficult because allocating profit to sub-components of a bank’s business is tricky. However, these challenges do not stop us from attempting this exercise.
We have observed the risk structuring function at various banks (most call this the swap desk, and we’ll keep to that term). The objective of the swap desk is to work with the lenders to help market the bank’s loan and deposit products, address customers’ structuring needs and to identify, measure and price risk for both the customer and the bank.
The second way hedging or having a swaps desks adds value is by allowing your bank to “lock” a future rate, eliminating certain future variability. An example of this is pricing a single closing construction and term loan. A term loan on a stabilized and completed project is priced in the market anywhere from 55 to 95 bps lower than one priced concurrently with the construction loan. Banks that offer borrowers a construction loan and then bid separately for the term loan after construction is complete are garnering 55 to 95 bps lower loan spreads on the term loan (taking the exact same risk if they funded the original construction loan). The ability to offer a single closing construction through permanent financing adds tremendous value to a bank. The other instance of forward locking pricing that adds value is the ability to guaranty a specific rate in the future. This locking mechanism has its place where documentation, due diligence or approvals are pending. It also secures the customer early in the process thereby eliminating the competition. Here the advantage to the bank can be anywhere from 10 to 25 bps depending on the circumstances and length of the forward lock.
The third example of the value-add of the swap desk is the ability to defend existing loan business through extending, blending or combining loan volume. The ability to extend terms, absorb prepayment costs or adding various loans together or principal outstanding helps retain existing customers. The starkest example of value dilution is competing for existing business when it comes time for renewal. Instead, the right strategy to preemptively approach customers before their relationship comes up for renewal. This is often done by swap desks by extending, blending or add principal on existing loans before the termination of the commitment. Avoiding a bidding war will gain a bank anywhere from 45 to 75 bps. Without a swap desk, historically banks have resisted approaching borrowers before the end of the term because of the concern with margin cannibalization. That concern is largely offset if the loan is properly structured and the bank is compensated for any added risk.
The fourth example of the value-add of the swap desk is the ability to extend the length of the customer relationship and “stickiness” of the business. The ability to offer borrowers loan terms for 10, 15 or 20 years creates greater lifetime value of the relationship which gives the bank a longer set of cash flows. Equally important is the risk/reward trade-off. Most of the risk of a loan is between years two and five, by extending the loan out past five years, every year increases return relative to risk. Revenue stays the same, while risk drops each year. Thus, extending the loan from 10 years to 13 years increases a bank’s risk-adjusted return more than extending a loan from three years to six years.
Generally, the least profitable relationships are those that are negotiated most frequently. Relationships cemented through many years permit the bank to cross-sell more products, create more customer loyalty and often results in greater price insensitivity. We have seen customers pay anywhere from 25 to 50 bps higher pricing to stay with a bank with whom they have a long history rather than move the relationship to a new institution and get familiar with a new set of decision makers.
The fifth and final example of value-add of a swap desk is the institutionalization of structuring a financing solution for a long-term business versus a transaction or project. Transactions and projects are short and come and go, by definition. Each transaction or project is put to bid and is won or lost partly based on price. For banks that want to compete on price, bidding on transactions or projects makes sense. However, when a bank structures a solution for a long-term business, it provides value that supersedes any short term project. An example is to finance an investor today for a 20-year solution that he can use on multiple and sequential projects. The investor may only have a 2 or 3 year hold on any single project, but by structuring a 20-year solution he can use the financing for the next 7 to 10 projects, locking in very cheap funding in today’s interest rate environment and apportioning that funding cost to multiple loans as those loans are funded and prepaid with proceeds then apportioned to the next investment. This type of pricing strategy can add 25 to 40 bps to a bank’s average loan rate.
While every manager believes that their department is adding value to the organization, quantifying that value can be very tricky. With the hedge desk over the last two decades of observation and data, we have determined that on average the value-add is approximately 85 bps (distributed among the various loans, structures and situations). This value-add tends to increase as interest rates rise and decrease as rates fall.
We created the ARC Hedging product to boost CenterState Bank’s profitability. We have been successful at executing the above and can do the same for your bank. Think of it as an outsourced solution that gives your bank the same capabilities of Bank of America or Wells Fargo. To learn more, contact us today and we can get you more information to see if the program is right for your bank.
Submitted by Chris Nichols on November 19, 2014