What Hedging Is Doing To Banks

The Impact of Swap and Hedging Strategies

When banks decide to adopt a loan hedging product the initial management strategy is to reserve it as a defensive tool only. Typically bankers decide to adopt a swap program because borrowers demand longer fixed rates, competition is willing to accommodate such structures (often with a swapped solution) and extending loan duration in a rising interest rate cycle does not make sense for prudent ALM purposes. However, soon after successfully deploying the ARC loan hedging program many bankers conclude that the product serves the bank best as both a defensive and offensive tool to win new business, retain existing accounts and to cross-sell additional bank services.  CenterState Bank’s ARC Program allows a community bank to make a fixed rate loan to the borrower while accruing an on-balance sheet floating rate – all without a derivative.  Most banks decide on the ARC Program because of its simplicity, low-risk process, and ongoing customer-facing support.  After winning a few loans through the ARC Program, and witnessing the tangible benefits of hedging for both the borrower and the bank, bankers can attest that the tool can be indispensable for certain customers in today’s very competitive market. 

CenterState Bank’s ARC Program allows a community bank to make a fixed rate loan to the borrower while accruing an on-balance sheet floating rate – all without a derivative.   Most banks decide on the ARC Program because of its simplicity, low-risk process, and ongoing customer-facing support.  After winning a few loans through the ARC Program, and witnessing the tangible benefits of hedging for both the borrower and the bank, bankers can attest that the tool can be indispensable for certain customers in today’s very competitive market. 

CenterState Bank’s ARC Loan Hedging

The graphic below demonstrates what most bankers see as the compelling proposition for the ARC Program.  This graphic explains the immediate benefits to a bank in hedging commercial loans.

 

Swap and Hedge Strategies for Banks 

 

Higher Overall ROE

A loan hedging program has two important advantages that increase the ROE on a loan (all else being equal).  First, a loan hedge eliminates interest rate risk for the bank.  Eliminating risk increases return assuming yield is the same.  In fact, because the swapped loan may be a more differentiated and tailored product, it can command premium pricing, thereby, providing even higher ROE for the bank.  Second, a hedged loan has a longer maturity and creates a stickier client.  A longer loan pays more interest for the same amount of acquisition and maintenance costs, increasing ROE.

Higher Lifetime Customer Value

Typically, a swapped loan has a longer stated contractual maturity than a non-swapped loan.  Further, the prepayment speeds on hedged loans are much lower than on non-swapped loans.  Finally, the longer the loan stays at the bank, the more opportunity there is to cross-sell the client more of the bank’s products.  This all leads to much higher (almost 3X) lifetime customer value.

Greater Fee Income

Hedged loans have a robust ability to generate non-interest income for the bank.  Not only is the fee income substantial, but the bank can recognize that income immediately.  The best part is that the borrower does not come out-of-pocket for the fee amount.  The borrower pays the fee over the life of the loan, but through the ARC Program, the bank receives the monetized value of that fee immediately.  These hedge fees can easily triple loan non-interest income.

Lower Credit Risk

Swapped loans can be substantial mitigate a community banks’ future credit risk. In today’s environment, there are three unusual risk factors that are creating a future credit risk for the lender.  First, capitalization rates are at historic lows creating stretched real estate valuations.  Second, advance rates are at historic highs creating very higher loan leverage.  Third, interest rates are still at historical lows but are expected to increase over the next few years.  The ARC Program allows a bank to fix the loan rate for 10, 15 or even 20 years, eliminating the borrower’s repricing risk, thereby decreasing probability of default in the future.

Conclusion

The loan hedging product adoption trajectory follows a similar pattern – initially, bankers are circumspect and adapt the ARC Program for just the few loans that absolutely require such a solution to retain the customer.  As with most new products, community bankers prefer to go slow and adopt only when they become comfortable and familiar with the product, the process and the impact on the bank’s business.  The tangible advantages of swapping certain loans from floating to fixed is very compelling, and the ARC Program makes it easy for community banks to effectively compete against national banks, insurance companies and other larger lenders that offer longer-term fixed rates.  Once the ARC Program is adopted, it becomes evident that proactively offering the program to suitable clients leads to higher loan ROE, greater lifetime customer value, substantial fee generation and lower loan default risk.