Until approximately ten years ago, interest rate loan hedging (using swaps) was prevalent for national and larger regional banks, but most community banks avoided loan hedging for various reasons. In the last ten years, more community banks have started to offer their borrowers some form of loan hedging option. In the last quarter, 13.4% of all commercial banks reported some derivative on their balance sheet, and 8.9% of all commercial banks reported some interest rate swap exposure. However, the reason that many community banks have started deploying interest rate swaps, caps and floors is not so obvious. While loan hedging serves to reduce interest rate risk for both lender and borrower, the reasons that community bank have recently started embracing swaps is explained primarily by competitive factors, the shape of the yield curve and other profit and risk considerations.
Community Bank Motivation to Hedge
While important, reducing interest rate risk on loans may be accomplished through a variety of products and strategies. The growth in the number of banks offering loan hedging, and the growth in the volume of such swap programs is explained primarily by six other factors as follows:
- Improve Credit Quality: Community banks sense the danger of repricing certain customers on a short-term basis. Borrowers with current debt-service-coverage ratios (DSCR) under 1.5X (the vast majority of small commercial borrowers in today’s market) do not demonstrate positive cash flow with 300bps increase in the loan rate. With capitalization rates low, advance rates high, and the DSCR for the average commercial borrower of 1.2 to 1.3X, the credit risk of loan repricing is greater than ever. Further, there is a capital cost to these credits as borrowers that can withstand higher rates, may not survive when rates are then shocked an additional 200 basis points from the then future higher rates. Stressing these loans after rates rise, will result in a higher capital cost for the lender even if the borrower is able to make the debt service payments. By giving the borrower certainty in their interest rate payments, credit is enhanced, and cash flow volatility is reduced for the borrower.
- Competitive Pressures: With interest rates at lows never seen before, and the yield curve flattening, many commercial borrowers are seeking the longest term fixed rate available to them. Banks that can accommodate borrowers’ demand have an improved chance of winning more high-quality loan business. As more competitors start offering hedge products, community banks are pressured to offer a competing solution. As borrowers become aware of their hedging alternatives and become introduced to the product by competition, offering a loan hedge program can be a sensible solution in certain circumstances.
- Protect Existing Loans: Existing borrowers can be extremely profitable clients for community banks. Existing borrowers typically pay higher loan margins (everything else equal, margins are 20 to 30 basis points higher on existing credits than on new loans). Existing borrowers are also lower credit risk because of the bank’s knowledge of the credit and experience with the quality of the principals. Finally, existing borrowers have higher cross-sell success because the passage of time allows greater opportunity to grow share of wallet. It is not surprising that community banks are offering hedges more and more frequently to their best existing customers. Losing a new loan to a competitor may be a positive or negative ROE event for the bank (depending on the winning price/structure), but losing an existing loan to a competitor is always a highly negative ROE event for a community bank.
- Instilling Lending Discipline: Community banks face pressure to train lenders to maintain consistent underwriting standards and to instill sensible pricing methodology. One positive aspect of a well-designed loan hedging program is that it highlights the importance of pricing loans to credit, interest rate risk and the term structure of rates. For example, banks commonly do not measure nor appreciate the risk of locking in loan rates months before the loan closes. Lenders that are taught to use hedging programs quickly appreciate the inherent risk in this practice after witnessing the cost and negative convexity associated with such practice.
- Decrease Loan Prepayment Speeds: One of the biggest determinants of loan profitability is prepayment rate - stable loans with longer maturities are more profitable for banks. Very few short-term loans demonstrate positive ROA for banks, despite higher pricing and fees prevalent in the market for these loans. The amount of resources expended by banks in sourcing, originating and underwriting credits makes the initial day the loan is booked to be the least profitable in the life of that credit. Every periodic loan interest payment the borrower makes then serves to increase the value of that credit to the bank. Community banks have come to the same conclusion that national banks reached many years ago – stable, longer-term and slower prepaying loans enhance profitability and loan hedging is a good way to create that type of loan.
- Generate Fee Income: One of the main reasons that national banks hedge loans for their clients is to generate fee income. Fee income for smaller commercial loans is typically between 50 to 200bps of the loan amount and is commonly recognized immediately in the period received. This is a substantial amount of non-interest income available to lenders at a time when short-term interest rates make a net interest margin-driven banking model very challenging. A bank offering loan hedging and generating substantial fee income can be more aggressive on loan pricing and still meet its ROE hurdle.
Putting It Into Action
More and more community banks are finding loan hedging programs an indispensable tool in not just managing risk, but generating additional income and meeting their loan structuring and pricing strategies. Loan hedging cannot be a solution to every community bank customer, however, not having a loan hedging solution and not having some experienced lenders trained on such a program can be a competitive disadvantage for the more sophisticated community bank. Given the shape of the yield curve, the lowest level of rates in recorded history and the need for greater cash flow certainty, every borrower should at least consider fixing their long-term cost of capital.
Submitted by Chris Nichols on July 07, 2016