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Hedging Commercial Loans with Interest Rate Swaps
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Hedging Commercial Loans with Interest Rate Swaps

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Looking in detail at some examples of interest rate swap transactions, Martin McConnell, banking consultant at Provident Risk Management, identifies the advantages a swap structure can generate and …

Looking in detail at some examples of interest rate swap transactions, Martin McConnell, banking consultant at Provident Risk Management, identifies the advantages a swap structure can generate and best practices to overcome the challenges involved in introducing interest rate swaps into a bank's commercial lending business.

If your bank is considering a derivatives strategy, or is currently hedging against risk, but is looking for more direction and better results, then this webcast is a must-see presentation.

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  • 1. Hedging commercial loans with interest rate swaps
    PRESENTER:
    Martin McConnell, Banking Consultant
    Provident Risk Management
  • 2. Interest Rate Swaps and Commercial Loans
    US and European regional banks have used interest swaps as
    a core of their commercial lending business for more than
    twenty years.
    Commercial clients are presented a fixed rate financing composed
    of two complimentary transactions.
    2
  • 3. Interest Rate Swaps and Commercial Loans
    The Credit Transaction:
    A floating rate note indexed to LIBOR or Prime
    Credit Spread is priced based on asset quality
    Credit spreads are not eroded by changing interest rates
    The Rate Transaction:
    An interest rate swap
    Bank pays the floating rate on the note
    Borrower pays a fixed rate
    Borrowers cost of funds on the financing is fixed for the life of the hedge
    Bank hedges away any exposure to rising rates
    3
  • 4. Back to Back Swaps
    The Fixed Rate financing structure combines a swap and a variable rate note
    The Borrower’s cost of funds is fixed for the life of the hedge
    The bank earns a credit spread over LIBOR
    The bank’s interest rate exposure is hedged
    4
    Loan
    LIBOR + Spread
    Variable Rate
    Funds
    Fixed
    Bank
    Borrower
    LIBOR + Spread
    LIBOR + Spread
    Fixed
    Hedge Provider
  • 5. Why Use Back to Back Interest Rate Swaps
    5
    Credit Risk and Market Risk
    Generate Fee Income
    The Back to Back Swap Structure eliminates a banks exposure to changing interest rates
    Use of swaps allows a bank to impose a higher level of discipline in pricing loans based on credit quality
  • 6. Why Use Back to Back Interest Rate Swaps
    6
    Competition
    • Community banks, regional and super regional banks offer swaps;
    • 7. Many banks are currently shut out of the long term fixed rate loan market due to rate fears;
    • 8. Swaps are flexible and can be customized for borrowers
    • 9. Back to back swaps create non interest fee income: 25 to 40 bps per transaction
  • Why Use Back to Back Interest Rate Swaps
    7
    Accounting
    The recent FASB Exposure Draft on Accounting for Financial Instruments and Derivatives proposes loans are carried at Fair Value (market to market)
    Accounting for Back to Back swaps is based on mark to market valuation
    Positions offset and eliminate earnings volatility
    Reporting is transparent and simple
  • 10. Barriers to Entry
    8
    What resources are needed to create a back to back swap program:
    Swaps Policy and Procedures
    Swap Valuation Model
    Valuation Reports: Income; Counterparty market to market
    Credit Policy and Credit Exposure Model
    Credit Adjusted Fair Value Model (CVA)
    Swap Documentation
    Banker Training and Support
    Banks do not need to make an investment in new hires or in house
    technology to build a back to back swap book.
  • 11. Removing Barriers to Entry
    9
    PROVIDENT
    FINCAD
    Credit Exposure
    Calculations
    Banker Support
    Independent
    Valuations
    ISDA Documentation
    Policies and
    Procedures
    CVA Model
  • 12. Commercial Loan Swap Case Study
    10
    Community Bank has $400 million in assets.
    Community Bank is making a $3.5 million dollar loan to a
    German Logistics Company.
    Purpose of the loan is to fund the acquisition of real estate
    Loan Pricing: LIBOR plus 3.00%
    Loan Term: 5 years
    Principal Amortization: 20 years
  • 13. Pricing and Independent Valuation
    11
    Banks needs to have access to independent market valuations to:
    Keys to independent pricing:
    Market standard pricing models
    Open access: Systems should provide management and auditors open access to models, and market data
    Independent Market Data-Data source should be highly visible and verifiable
  • 14. Commercial Loan Swap Case Study
    12
    Borrower Pays Fixed
    Community Bank Pays Floating
  • 15. Documentation and Credit Risk Management
    13
    An effective Back to Back swap program will provide for effective credit
    Risk management and documentation.
    Credit:
    Evaluating Credit Exposure
    Securing Credit Exposure
    Documentation of credit approval
    Documentation:
    Prepare ISDA Documentation
    Negotiate ISDA Documentation
    Documentation should be executed and in hand prior to executing a hedge
  • 16. Credit Approval
    14
  • 17. Potential Credit Exposure
    15
  • 18. ISDA Documentation
    16
  • 19. Loan Documentation
    17
  • 20. Hedging
    The Swap is set up to match the terms of the loan and priced
    Borrower Credit exposure on the swap is approved and cross collateralized
    ISDA documentation has been executed
    When locking in the Borrower’s rate, the bank will simultaneously enter an offsetting swap to hedge away all market risk and lock in fee income
    18
    Loan
    LIBOR + 3.50%
    Variable Rate
    Funds
    5.37%
    Bank
    Borrower
    LIBOR + 3.50%
    LIBOR + 3.50%
    5.02%
    Hedge Provider
  • 21. Swap Valuation
    19
  • 22. Fee Income
    20
  • 23. Credit Adjusted Valuation
    21
  • 24. Accounting and Earnings Volatility
    22
  • 25. Keys to implementing a Commercial Loan Hedging Program
    23
    Bankers who want to use interest rate swaps to improve competitiveness and grow loan production are the key to a successful commercial loan hedging program.
    Credit officers need to understand how swaps create exposure, have policies and procedures for calculating approving and recording approval.
    Swap and loan documentation must be coordinated to ensure exposure is cross collateralized.
  • 26. Keys to implementing a Commercial Loan Hedging Program
    24
    Banks must be able to independently value swaps and have access to a full range of valuation reports.
    Fair Value Insight provides a complete suite of valuation reports at transaction, counterparty and portfolio level, including credit adjusted valuations.
  • 27. Contacts
    25
    FINCAD:
    Phone: 1-604-957-1200
    Email:info@fincad.com
    Website: www.fincad.com
    PROVIDENT:
    Phone:1-704-552-3881
    Email:info@providentrisk.com
    Website: www.providentrisk.com