Back-to-Back Interest Rate Swaps Explained in 3 Minutes

Customer demand for long-term fixed-rate financing is a long-standing challenge for banks. While business cycles ebb and flow, there is always a segment of customers who require 5+ year fixed-rate debt. At the same time, competition for these quality assets continues to grow across banks of all sizes and from many non-bank lenders.

This poses a problem for mid-sized and smaller banks. Meeting the customer's preference for fixed-rate financing often puts pressure on the bank’s balance sheet. Simultaneously, customers who are offered only floating-rate debt might take their business elsewhere.

What is an interest rate swap?

An interest rate swap is a contract between two parties to exchange interest payments. Each is calculated on the same principal amount (referred to as "notional amount") on a recurring schedule over a set period of time. One party typically pays a fixed interest rate, while the other party typically pays a floating interest rate. No principal (notional) amount is exchanged. The parties simply exchange, or swap, interest payments. A swap is a netted agreement, meaning that whichever party pays more interest in that period is the one who makes the payment.

What is a back-to-back interest rate swap?

A back-to-back swap is a common term to describe when a bank executes an interest rate swap with a borrower, and a second offsetting interest rate swap with a dealer counterparty.

Why should I consider using back-to-back swaps at my bank?

Swaps have always been a useful way for banks to manage risk. Currency risk, credit risk and interest rate risk can all be hedged, separating out the different types of risk inherent in a transaction so that the customer, or the bank, is only taking on selected risk, not the whole package. Offering a swap with a floating-rate loan to your customer allows the bank to separate the credit decision (do I want to lend for 5+ years to this customer) from the interest rate risk decision (am I comfortable taking 5+ years of fixed rate risk?).

How do back-to-back swaps work?

Back-to-back swaps work as follows: the bank enters into two separate transactions with the customer: 1) a floating-rate loan and 2) a companion fixed-rate swap with its customer. These transactions create a synthetic fixed-rate structure. For example, the customer borrows at floating rates, but because of the swap, effectively pays a fixed-rate on the loan. The bank then executes an offsetting swap with a swap dealer thereby leaving the bank with only the economic impacts of the floating-rate loan.

Back-to-Back Interest Rate Swap Diagram

The swap rate includes a swap fee, which the bank earns to cover the costs to originate and service the swap with the customer and for the additional extension of credit.

The difference between the wholesale rate (reflecting the bank's credit quality and dealer mark-up) and the retail rate (reflecting where the bank gets done with their customer) is equal to the fee that the bank earns. The dealer pays the bank this sum within two business days of executing the swap. The swap fee depends on the size and structure of the deal and the customer’s credit.

Who uses back-to-back swaps?

Here are a few practical examples of back-to-back interest rate swaps:

  • A commercial real estate investor who wants long-term fixed-rate financing is provided a floating-rate loan and a swap
  • A company wants to lock-in the rate on an "evergreen" portion of its credit line and the bank offers a swap
  • A borrower who wants to lock-in a rate on future financing is offered a forward-starting swap

Size and term vary, but generally back-to-back swaps are $1 million or greater in notional and 5 years or longer in tenor.

Summary

Using back-to-back swaps, a bank can:

  • Meet its customer's financing preference without taking on unneeded interest rate risk
  • Earn fee income enhancing the bank's return on capital
  • Level the playing field with larger financial institutions offering swaps and non-bank lenders offering long-term fixed-rate debt

Wondering how your bank would compare to your peers? Request Chatham's benchmark stats report.

 

Since 2001, Chatham Financial has partnered with banks of all sizes to help launch, run and grow successful customer back-to-back swap programs. As a result we are the largest and most experienced non-bank provider of back-to-back swap support to regional and community banks.


Disclosures

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit https://www.chathamfinancial.com/legal/notices/.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 18-0188

About the Author

Ben Lewis

Ben Lewis works in Chatham’s Hedge Advisory group advising financial institutions in the western United States. He manages relationships with community and regional financial institutions to help hedge their balance sheet interest rate risk through the use of derivatives as well as enable them to offer derivative products to their qualified commercial borrowers. Previous to serving financial institutions, Mr. Lewis worked with private equity funds in hedging leveraged buy outs, commercial real estate investors hedging their debt, and general corporate clients to identify and manage foreign currency, commodity, and interest rate risk through the use of derivatives.

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