Rising rates, regulatory pressure on interest rate risk, competition and the best way to hedge long-term, fixed rate loans is causing a puzzle for many banks. Luckily, we love solving puzzles and take an interest in new and challenging conundrums especially related to banking. A client recently asked us to solve an oldie but a goodie: what is it that a man can do standing up, a women sitting down, and a dog on three legs? The answer is, shake hands. There are some good puzzles in the banking industry, and another customer recently posed one to us that we would like to share with you. In fact, this puzzle is one of our all-time banking favorites.
Limiting Interest Rate Risk
We frequently talk to bankers and borrowers about hedging their risk. In a rising interest rate environment, borrowers do not want to take the risk of adjustable-rate loans because of concern of contracting interest coverage ratio. Lenders do not want to offer fixed-rate loans because of concern of contracting net interest margin. This is where a hedge is involved which converts the loan from an adjustable rate to fixed rate for the borrower. Effectively one party (lender) pays a fixed amount of interest to receive a variable amount of interest, and this results in a variable-rate asset for the bank (but retains a fixed payment obligation for the borrower). The conundrum is this: what counterparty would want to take the opposite side of this trade? That is, who would want to receive a fixed rate and pay the variable rate? In an increasing interest rate environment, this seems like an unsafe position for the variable-rate payer.
We answer this conundrum in two ways. First, with a simple analogy. A milk farmer knows that he will sell a certain number of gallons of milk over the next two years. The milk farmer knows his cost of production and would like to lock-in his revenue. There is a futures market where the farmer can lock in revenue for a specified number of gallons of milk per month for the next 24 months. The counterparty to this futures trade is a cheese maker who knows her revenue per pound of cheese. The cheese maker would like to lock-in her major cost of production by eliminating the possibility that the cost of milk will increase. The cheese maker will buy milk over the next two years by taking the opposite side of the farmer’s futures contracts.
Both the milk farmer and cheese-maker have eliminated some of their operational risk. As long as the farmer’s cost is appropriately predicted and the cheese maker’s revenue is properly forecasted, then both counterparties are stabilizing their cash flow. Regardless of where the price of milk goes over the next two years, both the farmer and cheese-maker have eliminated some of their operational risks. This futures trade is an example of two end-users hedging their natural positions.
Let us now transpose our analogy to the banking world. Banks have predominately short-term funding sources and find it risky to offer long-term fixed-rate assets (loans). However, there are plenty of financial entities such as insurance companies and pension funds that have fixed cost of funding in the form of annuities and predetermined pension obligations. Insurance companies and pension funds have the exact opposite concern from the banking industry and cannot naturally book adjustable-rate loans (or other short-term assets).
In the above example, Borrower A approaches an insurance company for an adjustable-rate loan, and Borrower B approaches a bank for a fixed-rate loan. Neither lenders’ cost of funding is properly positioned to address the requested loans. There are three immediate and feasible outcomes in the above scenario: One, both lenders can refuse to take on the business. Two, the lenders can refer the borrowers to each other. Three, the two lenders can exchange interest rates to effectively alter the duration of the loan. The third option is exactly what an interest rate swap is meant to do. A swap is nothing other than a series of futures contracts for a predetermined time. By entering into a series of futures contracts where the insurance company pays a variable rate to the bank, and the bank pays a fixed rate to the insurance company. Both lenders mitigate their interest rate risk. Very much like the milk producer and the cheese maker.
The only outstanding piece of the puzzle is what is the correct interest rate to use for the futures contracts? The correct interest rate for the exchange of fixed versus variable is the markets’ expectation of where short-term rates will be in the future. The futures market is determined by all market participants buying and selling futures contracts in the open market finding an equilibrium of future prices. The average of future interest rates for the life of the contract is also called the swap rate.
We are big fans of financial conundrums and hedging versus speculating is a big puzzle in today’s rising interest rate environment. While many banks and borrowers understand the benefits of hedging their risk, some wonder why anyone would take the opposite, and seemingly, risky counter position. Well, it’s very much like shaking hands – you just need to solve that puzzle.
Submitted by Chris Nichols on February 27, 2018