The Cost of Swaps For Banks

Developing Lending Tools

We believe all banks should have a hedging program to manage interest rate risk while providing a variety of loan structures to satisfy the borrower’s, not the bank’s needs. One question that often comes up is what are the costs of launching a commercial loan swap program?  There are many reasons for bankers to consider offering a swap program for its better clients, including, generating fee income, enhancing credit quality, interest rate risk management, client retention, and loan growth.  However, there are real costs to a community bank in selling, booking and processing swaps on its balance sheet.  We do not know of any other research that has analyzed and quantified the costs to a community bank associated with the training, capital, liquidity, collateral, accounting, education and consulting required for a swap program.

 

Methodology and Analysis

 

In quantifying the costs of using a swap program, we assumed that a community bank uses interest rate derivatives without central clearing, in connection with commercial loans, and utilizing one of the various swap programs provided by broker-dealers or derivative consultants.  We calculated direct recurring costs, indirect upfront costs, and annual indirect costs.  We assumed average bank efficiencies and average transactions costs.

 

We calculated the annual direct costs for processing, collateral, accounting, consulting and documentation risks.  We also considered the upfront costs of launching a swap program and the ongoing indirect costs of training.  Our analysis appears in the table below.

Cost of Swaps 

 

There are a few key elements for banks to consider:

 

  1. We have seen banks that have booked one swap and discontinued their program, and we are in contact with community and regional banks that have booked over 500 swaps and are seeking relief from the processing costs of these swaps.  The cost to process a single swap settlement payment is approximately $25.  There are two payments per period (which are typically monthly) – one with the broker-dealer and one with the customer.  This represents a major risk of a swap program because these costs continue for years after the fee revenue from the swap is recognized.
  2. Banks are required to allocate capital for interest rate swaps.  The easiest way to calculate the cost of this capital is to consider a conversion factor matrix for calculating potential future credit exposure.  That factor is 30% for interest rate swaps over 10 years.  Assuming 8% capital and 11% required return on capital, a $1mm swap has a cost to the bank of $2,640 per year.  This represents one of the largest costs of a swap.
  3. Banks need to post collateral for derivative exposure.  The collateral has two forms: initial margin and variation margin.  Initial margin is approximately 3.5% of the swap amount for 10-year swaps, and we calculated future variation margin using a potential future exposure measure of 50% confidence level Value-at-Risk calculation.  We then use 41bps opportunity cost to a bank of posting Treasury securities rather than being able to hold a higher yielding MBS. 
  4. We have used various valuation and accounting services.  The lowest cost that we have seen for valuation and accounting entries from an outsourced provider is $200/q.  Some consultants will include that charge in their overall hedge consulting fees. However, it is important to consider that a 10-year swap has 40 periods of measurements and accounting entries.  Unfortunately, hedge consultants will not commit their services for the expected life of the swap. Therefore, the consultant may leave or the bank may stop running a swap program, but the valuation and accounting requirements continue until the maturity of the swap.
  5. Most community banks are not in a position to handle the documentation, marketing, and ongoing reporting associated with a swap.  Consultants are typically hired to perform this function.  This service can vary in cost but 6bps of the swap amount per year is the minimum cost we have witnessed.  Banks need to consider that consultants are paid upfront for the entire life of the swap (6bps times 10, paid up front out of the hedge fee).  Therefore, if the consultant discontinues the engagement in year two, or if the consultant goes out of business, the entire 10yr fee has already been made by the bank.  The upfront cost is higher if the community bank decides to proceed with internal hire rather than a hedge consultant.  
  6. One important cost that community banks typically do not consider, but is a major issue at national banks is the cost of legal challenges by users.  Swap documentation is complicated, voluminous and amorphous.  Some borrowers will challenge the cost to unwind their hedge position.  While community banks can forgive internal prepayment provisions, the unwind cost of the swap is a hard cost that must be paid to the broker-dealer.  If a bank cannot collect this unwind amount from the borrower, that cost is borne by the community bank.  Unfortunately, the unwind cost increases when credit issues arise and collateral values deteriorate (that is the nature of the correlation between credit, interest rate and property values).  Banks are left with a choice of taking reputational risk trying to enforce incomprehensible documents or taking the unwind cost themselves.  If that unwind is relatively small, it is in the bank’s interest to take that hit.  This is a real cost that will be incurred (albeit infrequently) and we calculate it at $300 per $1mm per year.
  7. Finally, there are the normal upfront costs of a swap program such as legal review, training of executives, processing personnel, and internal accounting (even if the actual MTM and hedge accounting are outsourced, internal entries must be made, and people must be trained).  There are also minimal ongoing training costs for sales and executives if any swap program is to be successful.

 

Considering all of the above costs on an individual swap, we can now measure the costs of launching and maintaining a swap program.  It certainly does not make sense to start a program if a bank intends to offer just one swap.  As the anticipated volume increases, the average cost per swap decreases.  We can also anticipate and calculate additional efficiencies as swap volume increases.  The table below shows our estimate cost over an entire 10-year period for a swap assuming various volumes for a community bank.  

 

Cost of Swap

 

The average commercial swap at a community bank will generate approximately 1% to 2% in hedge fees.  The economics do not show that a swap program is net positive strictly from an income/cost analysis.  If community banks do choose to offer a swap program for their customers, it is not because of the net profitability of the swap directly.  Instead, other benefits drive the decision, such as marketing, credit enhancement or competitive pressures.

Conclusion

 

There are various good reasons for community banks to pursue commercial loan swap programs. However, bankers need to assess the need, the cost, and the benefit before making their decision.  The real downside with swap programs is the mismatch between the immediate benefit and recognition of the hedge fee, versus the long term of the swap costs.  Unless the community bank can forecast dozens or hundreds of swap opportunities, the direct and indirect costs outweigh the tangible income benefits.