When speaking to community bankers about derivatives, I like to test the audience’s receptivity to what has been called “the eleven-letter four-letter word” through a word association. I’ve noticed a change in the last decade.
If we go back 10 years, to the post-crisis era, the responses would have come back mostly negative with words like, “risky, complex and dangerous.” However, at a recent gathering of finance executives at community banks, it was clear that attitudes about swaps have shifted after a decade of ultra-low rates and margin pressure. Given the choice, not one respondent said they would avoid derivatives at all costs. Roughly half said they were already utilizing the instruments, while the remaining half expressed concerns about the accounting.
For banks looking to add derivatives as a way to manage interest rate risk, there are a wide variety of firms offering very different products and programs that can reduce the burden on a resource-constrained institution. These solutions can be grouped into three distinct methods for a community bank entering the derivatives “waters:”
1. Dipping Your Toe in the Water
When bankers tell me that their institution is “conservative” or “cautious,” I wonder if they realize what good company they are in! I have heard the “toe in water” analogy used countless times; it typically suggests doing the bare minimum to access some of the available benefits. Banks who don’t want to get wet tend to gravitate toward correspondent and bankers’ banks offering the Indirect/Third-Party swap model.
These programs keep the bank out of a derivative altogether — but because they focus exclusively on commercial loans, users do not gain access to cost-saving funding strategies. While the bank stays dry, they push their borrower into the pool by putting them into an unsecured derivative with an out-of-town counterparty. The costs of these programs are built into the swap between the borrower and the correspondent; the best way to quantify it is to compare the spread on the resulting floating-rate loan with that of the other two methods, both of which move from staying on the sun deck to getting into the pool.
2. Diving in at Your Own Risk
Establishing a relationship with a derivatives counterparty is one of the essential steps to installing hedging capabilities directly at the bank. Several swap counterparties serving community banks offer additional support beyond simply acting as a trading partner and liquidity provider. This method, the Captive Counterparty swap model, usually includes accounting and valuations support and therefore makes it difficult to trade with more than one partner.
Perhaps the biggest challenge with this model is that the advice comes from “across the table” — sometimes from a bank that competes in the market for deposits and loans. Some captive counterparty providers decline to support commercial borrowers for loan swaps because of potential conflicts, placing an enormous burden on community bank relationship managers. All derivative counterparties work for a “bid/offer” spread when they transact a swap, and then typically add a disclosed surcharge to the swap for any advisory and support provided. Understanding both components is the key to quantifying the costs for this method.
3. Swimming with a Lifeguard on Duty
The final method to getting started with swaps begins with engaging an Independent Partner to watch over and guide your bank through the entire process. Starting with education for management and board, negotiating ISDA (International Swaps and Derivatives Association) swap documents and setting up appropriate policies and procedures, the independent partner can efficiently help build the foundation for both balance sheet hedging and borrower swaps. Providing advice on accounting and support for commercial relationship managers and borrowers occurs on the same side of the table as the bank, making it free from any conflict or bias.
The independent partner can provide a completely transparent breakdown of all transaction costs, above and beyond the mid-market breakeven market swap rate, because they are typically paid a disclosed fee outside of the swap transaction. Swaps and derivatives were created three decades ago to tackle the challenges created by uncertain and volatile interest rates. Community bankers who are increasingly open to accessing their benefits should carefully consider who to partner with before jumping into the deep end.