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Going Long: Four Ways to Mitigate the Risk of Long Term, Fixed-rate Lending

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For any Financial Institution that wants to use deriva- tives to mitigate the interest rate risk associated with longer term, fixed-rate lending, the path forward can be daunting. • Where do you start? • Which approach is right for your FI? • How will it work? • Who should be involved? • What about training, documentation, and regu- latory compliance? As with any new program, an understanding of the product and how it satisfies a particular customer need is essential to program success. What is it, then, that your borrowers want, and how can you best meet their needs? Long Term Fixed-rate Financing Generally speaking, your commercial loan cus- tomers seek long term, fixed-rate financing. They want to borrow as much as they need, for as long as they can, at the lowest possible rate. Your FI, on the other hand, has legitimate concerns with this arrangement. Rising interest rates can turn the yield on such fixed-rate loans from agreeable to regrettable with even a modest movement of rates. Your FI needs appropriate inter- est rate protection and would much rather offer a floating-rate loan in this situation. But floating-rate loans are far less attractive to borrowers because of the inherent interest rate risk the borrower would in- cur. Wouldn't it be nice if there was a solution that delivers what each party truly wants? Four Solutions that Enable Longer Term, Fixed-rate Lending There are four ways an FI can satisfy the market need for long term, fixed-rate financing, without imposing undue risk on the FI or its borrowers. Going long need not be daunting, nor managed only by exception, but can instead be a regular part of your FI's lending ac- tivity. It is important to note, though, that not all solu- tions are alike. Customer hedging programs can differ along key dimensions that are worth exploring further. This bulletin provides insight into the four methods used by FIs to safely originate longer dated fixed-rate loans. It examines how each approach might impact your FI and your borrowers. Although there are many variations, the four main approaches in the market to- day are: Back-to-Back Swaps, Fixed-rate Loan Swaps, Third Party Swaps, and Matched Funding Swaps. Going Long: Four Ways to Mitigate the Risk of Long Term, Fixed-rate Lending 1 FI Bulletin

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