Many community banks are starting to embrace loan hedging as an effective tool for risk management, loan production and fee income generation in commercial lending. CenterState Bank does, and it is one of the initiatives that has helped us originate $1B of new loans last year and achieve double-digit organic loan growth. Like us, many banks have concluded that using interest rate hedges on commercial loans has a number of benefits to the bank that include interest rate risk mitigation, credit enhancement, pricing discipline, increased borrower retention rates, higher cross-sell opportunities, greater loan production and generation of non-interest income. Community banks are commonly generating between 50 and 200 basis points of non-interest income on commercial loans through the use of interest rate swaps - on a $2mm commercial loan, the bank can generate between $10 and $40k of fee income. Community bank managers are now deliberating how to compensate commercial lenders for hedge fee production. We would like to share some basic decision-making frameworks and best practices.
Consider a $2mm hedged CRE loan, structured as a 10-year fixed rate on a 25-year amortization, priced at LIBOR + 2.50%. Based on current interest rates, the fixed rate to the borrower is 4.90%, which is equal to the sum of the swap rate (currently approximately 2.40%) and the 2.50% credit spread over LIBOR. A community bank can increase the swap rate to say 2.60% (from 2.40%) and add its 2.50% credit spread to price the loan at 5.10%. If the borrower accepts this rate, the 20bps increase in the hedge rate results in the bank generating approximately $28k in hedge fee income. This income may be recognized immediately in the period received. In the example above, if the borrower is willing to pay only 5.00% fixed (and not 5.10%), the bank may still generate $28k in hedge fee income or 20bps in the hedge rate, but the credit spread needs to be adjusted from 2.50% to 2.40% so that the math still works (2.60% swap rate plus 2.40% credit spread equals a 5.00% fixed rate to the borrower). Alternatively, the bank may decide to generate only 10bps in hedge fee income or $14k, and keep its 2.50% credit spread in which case the math would look like this: 2.40% swap rate, plus 10bps hedge spread, plus 2.50% credit spread equals 5.00% fixed rate to the borrower.
Since management is commonly tasked with maximizing value for shareholders and setting loan pricing strategy, how should the bank balance the hedge fee, credit spread and an acceptable all-in fixed rate for the borrower? Furthermore, how should commercial lenders be compensated (if at all) for the fee income that is generated by the hedge?
Dividing Income between Fee and Credit Margin
We are going to assume that the bank is using some variation of a risk-adjusted return on capital loan pricing model that is incorporating the term structure of interest rates. If this is not the case, then the exercise in calculating the return on assets (ROA) effect between credit spread and hedge fee becomes challenging. But assuming the bank is pricing the loan using a model that takes into account risk plus cost and can properly calibrate and measure ROA sensitivity to hedge fee versus credit spread, how should a bank apportion income between fee and credit margin?
We believe that banks should generate some hedge fee income on every commercial loan. Some bankers will argue that instead of fee income, the bank can recognize the same amount of income and resulting ROA by simply increasing credit spread. This is a spurious argument for the following four reasons:
- Borrowers see credit spread in the documentation and are likely to negotiate that spread aggressively, however, borrowers typically do not know the daily swap rates and, within reason, are willing to pay a premium with little resistance. Banks that do not charge some hedge spread to generate a fee are leaving value on the closing table - value that national and regional banks are all too willing to garner.
- While 10bps of hedge fee spread and 10bps of credit spread may be the same value for the bank if the loan stays for the contractual term, most loans do prepay before the contractual term. On prepayment, the credit spread goes away, but the fee income has already been recognized by the bank. Therefore, in the long-run fee income is more valuable to the bank than credit margin.
- Fee income is especially important for banks when interest rates are low but expected to rise over the course of the loan. Generating hedge fee income is a way to shift cash flows forward (recognizing more upfront and less in the future). When interest rates are low, credit margin business is challenging for banks because the cost of funding cannot be substantially lower than LIBOR (or the institutional cost of funding). When interest rates are low (as they are today) generating fee income is an important way to boost the bank’s ROA. The fee will be recognized in the first accounting period in which it is received, but never again for that loan. However, in subsequent periods when the fee is no longer boosting ROA, we expect LIBOR to increase but the bank’s cost of funding to lag, thereby increasing that loan’s net interest margin.
- Commercial loans are not on auto pilot for the contractual term. Instead, they are transferred, restructured, increased, divided and assumed. Each of these events allows the bank an opportunity to generate additional hedge income. While hedge fee income is not recurring, it also not singular. Banks that have a policy of not generating hedge income are missing multiple opportunities for fees on each loan.
Lender Compensation for Hedge Fees
For all the reasons stated above community banks should be motivated to generate hedge fee income. How should banks compensate lenders for hedge fee income generated? Most banks already have lender incentive plans that take into account revenue generated and many banks pay lenders based on loan fees generated. Hedge fee income should not be overlooked as an incentive tool and to align goals. Hedge fee income is easily measured and can be a substantially greater source of fee income than loan origination fees which are obviously resisted by borrowers because they are direct out-of-pocket costs (in contrast to hedge fee income).
It makes sense that banks that want to generate hedge fee income should align lender behavior that best benefits the bank. There are a number of ways that banks can create incentive plans for commercial lenders based on hedge fees generated. The three most common commercial lender incentive plans in the industry for hedge fee generation are as follows:
- Banks may pay commercial lenders a set dollar amount per million in loans booked through a hedge. We have seen this number in the range of $500 to $1,000. In our example on the $2mm dollar above, if the bank recognized 20bps in hedge fee income or $28k in fees, the lender would earn $2k of that (assuming the lender compensation is $1k per million). Therefore, the bank is sharing approximately 7% of fee income with the commercial lender. The advantage of this structure is that it is simple to calculate. The disadvantage is that the bank needs to ensure that some minimum amount of hedge fee income must be recognized because under this structure the lender is motivated to use a hedge but not to maximize fee income for the bank (if in the above example only $4k in hedge fees are generated, then the lender earns 50% of the bank’s gross fee).
- Banks may also pay commercial lenders a percentage of the fee income. In our example above, the bank could set the lender’s incentive compensation to 7% of the fee income generated and the lender would then receive the $2k compensation for that same loan and hedge fee. The advantage of this structure is that the bank’s and lender’s interests are more evenly aligned. However, lenders may be incented to maximize fee income and minimize the bank’s credit spread to maximize their fee payout. Therefore, banks must maintain some control over the fee/NIM balance, or cap the maximum hedge fee income to create desired behavior.
- Another plan that we have seen used effectively is a hybrid of the above. Here management insists on a minimum hedge fee for all deals and pays the lender a standard incentive. In our example above, management sets a minimum of 10bps spread for all hedges and shares $800 per million with the lender. Management then allows lenders to include additional fee income and pay extra on any hedge fee above the minimum (for instance it could be 20% of fee income generated above the first 10bps of hedge spread).
We favor simplicity in incentive pay but every bank is different, and a bank’s strategy should be framed in concert with the hedge program used, the ability of lenders to drive value and sophistication of the market. Community banks may work with their hedge provider to formulate the appropriate strategy.
As more community banks embrace the merits of hedging commercial loans, more management teams are tackling the issue of lender incentive compensation for hedge fee generation. We strongly feel that every commercial swap should generate some fee income for the bank and lenders should be motivated to make that happen. Management should give serious thought to how much fee income should be generated and how lending staff should be compensated for their efforts.
Submitted by Chris Nichols on April 03, 2017