Interest Rate Swaps Can Generate Revenue and Reduce Risk for Community Banks
When interest rates are low, banks look for new opportunities to generate revenue. Because profit margins continue to get squeezed, banks must find ways to manage interest rate risk while meeting the demands of their customers. Interest rate swaps are becoming more popular in community banking, because they allow banks to provide customers a long-term fixed rate while managing interest rate risk. However, swaps do involve some risks. Community banks need to fully understand interest rate swaps and evaluate the risks to determine if it makes sense for the organization.
Plain, vanilla interest rate swaps
According to Federal Deposit Insurance Corporation information, net interest income makes up 75 percent of revenue for banks under $1 billion. So with funding costs at their lowest, customers are demanding fixed-rate, long-term loans, which can leave the bank in an unfavorable interest rate risk position. An interest rate swap allows the institution to keep the loan customer without incurring the long-term interest rate risk. It allows the banks to maintain competitive pricing with the larger institutions and could potentially expand lending opportunities.
An interest rate swap allows the institution to keep the loan customer without incurring the long-term interest rate risk.
Swaps come in a variety of structures; however the simplest varieties may be just what a community bank needs. There are two kinds of plain, vanilla interest rate swaps: one-way and back-to-back.
In a one-way swap, the borrower enters into a fixed rate loan with the bank, and the borrower is not involved in the swap. The loan is structured to include a prepayment penalty which would cover any costs to unwind the swap. The bank then enters into an interest rate swap with a counterparty (an institution on the opposite side of the transaction), whereby the bank pays the counterparty a fixed rate and receives a variable rate, minimizing interest rate risk.
The terms must be matched to qualify for hedge accounting, in which the entries for the ownership and the opposing swap are treated as one, which reduces the volatility on the financial statements.
For example, a bank offers a small business a $1 million, fixed rate loan at 5 percent for a 10-year term. The bank then enters into a swap with a counterparty with the notional amount equal to the amount of the original loan, where the bank agrees to pay the counterparty a fixed rate of 5 percent for 10 years. The counterparty agrees to pay the bank a variable rate, which reduces interest rate risk should rates rise. So in the end, the bank essentially receives cash flows on the outstanding balance as if the loan were a variable rate loan.
In a back-to-back swap, there are two swaps involved. The borrower enters into a variable rate loan with the bank and a swap with a counterparty in which the borrower pays the counterparty a fixed rate and receives a variable rate. The borrower must qualify to enter into a swap.
In this example, the bank offers the small business a $1 million loan at a variable rate. The borrower enters into a swap directly with a counterparty and agrees to pay the counterparty a fixed rate but receives the same variable rate that it is paying on the loan. The bank enters into an additional swap agreement (with a fixed rate) directly with a counterparty so the bank has two derivatives instead of one.
This option has become popular because in some cases the counterparty is able to structure the deal so that the community bank can get some fee income or other compensation at the beginning of the transaction.
Cashflow hedge accounting
Although two types of hedge accounting (fair value and cash flow) can be used in interest rate swaps, the interest rate swaps discussed here are considered a cash flow hedge. A cash flow hedge reduces the exposure to variability in the cash flows of a recognized asset or liability. Under cash flow hedge accounting, if the hedge is deemed (and documented) to be effective, the fair value adjustment is reported in other comprehensive income.
However, if it is not effective, the ineffective portion would be recorded in the income statement. Most organizations enter into arrangements that qualify as cash flow hedges; however it is important to consult with the bank’s auditors before entering into a swap to avoid unintended accounting consequences which can cause income statement volatility.
Accounting for these types of transactions can be complex, but given the low volume of transactions, banks may use outsourced service providers for accounting help. However, it is still important for the bank to fully understand the accounting and the associated risks. In order to qualify for hedge accounting, the bank must do an effectiveness assessment at the inception (and on an ongoing basis) for the swap to be considered effective. The effectiveness assessment should include:
- A description and evaluation of the hedging relationship
- The bank’s risk management objective and strategy for entering into the hedge, including: the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, the method that will be used to assess the effectiveness, and the method that will be used to measure hedge’s ineffectiveness
Having the right documentation is imperative to entering into a swap agreement. As with any complex transaction, the bank’s overall objective should be documented and approved by the board of directors. Formal designation and documentation is required at inception, and must incorporate policies, procedures, and internal controls related to all hedging activities.
Interest rate swaps can include counterparty and regulatory risk, which may make some institutions shy away from using them. However, community banks under $10 billion in assets are exempt from some of the Dodd-Frank registration requirements and more rigorous regulatory requirements.
Interest rate swaps can be structured in many ways, but even the most basic can offer a competitive tool for community banks. If the risks and requirements are properly explored, swaps can provide an option for community banks to compete with the larger financial institutions.