Despite the breadth and complexity of Dodd-Frank regulation of derivatives, there are comparatively few key regulations that affect an interest rate swap offered by a typical community bank. This article provides an overview and a ray of hope that these regulations can be mastered by a community bank.

Less than 3% of banks under $1 billion in assets are engaging in interest rate swap transactions. Only 7% of all banks in the U.S. are doing so. Yet, virtually every community banker complains about losing good loans to larger banks offering long term fixed rate loans. Larger banks are only able to offer those fixed rate loans because they hedge the interest rate risk represented by a fixed rate loan with a corresponding interest rate swap. One would think that community banks would scramble to compete effectively by doing their own interest rate swaps.

A key reason for bankers’ hesitation is a misinformed concern about the regulatory and accounting burdens. Some bankers mistakenly believe that their regulators forbid them from engaging in any derivative transactions such as an interest rate swap. Let’s examine each of these common fears and compare to regulatory reality.

Concern 1:  Our regulators either forbid us from doing swaps or strongly discourage us from doing so. The reality is that the regulators say specifically in their Advisory on Interest Rate Risk Management (January 6, 2010) that banks may use derivative instruments to mitigate interest rate risk exposures such as repricing risk arising from making a long term fixed rate loan. The regulators do require the bank’s board and senior management to understand the bank’s hedging strategy, including potential risks and benefits. The regulators do not require the board or senior management to themselves to be intimately familiar with hedge accounting or other technical details. Interest rate risk is a hot topic with bank examiners and we expect banks will be asked to explain their strategy (or lack of strategy!), particularly if they are making fixed rate loans.

Concern 2: We can’t possibly understand or properly comply with the host of regulations applicable to interest rate swaps! The reality is that the wave of regulations enacted in the last few years primarily apply to large institutions (those over $10 billion in assets). Currently, there are really only 5 regulatory compliance tasks for community banks: 

  • Swap program design and management. A bank must prepare policies and procedures for its swap program, including corporate governance components, design risk measurement and monitoring systems, design internal controls and have regular independent review of the program. You don’t need a team of lawyers to do this (sadly for this author!); there are competent consulting firms who specialize in developing such programs for inexperienced community banks and providing the necessary training.  
  • Ensuring your customer is qualified to enter into a swap.  You must ensure that your customer fits into one of several very specific categories, such as having $1 million net worth. The process is similar to qualifying your customer for a loan. 
  • Making sure your swaps are exempt from “clearing” requirements.  This is also a straightforward process of obtaining specific representations from your customer and confirming that your customer is not one of several unusual types of entity.
  • Swap data reporting. Swap regulation requires the reporting of data related to interest rate swaps. The reporting process is straightforward, but most community banks let their swap dealer counterparty handle this reporting or, for swaps the banks do directly with their customer, they typically outsource the data reporting function as the regulations explicitly allow.  
  • Risk-based capital adjustments and margining.  If a community bank is owed money on a swap (i.e., it is “in the money” and thus an asset), that is generally a happy result for a bank but it may, depending on regulatory developments, also require the bank to hold a modest amount of capital against that asset. The regulators are also working on rules that may require community banks to post modest collateral to secure swaps they enter into with swap dealers (the big bank counterparties). We do not expect the compliance burdens to be significant when and if these rules are enacted.

Concern 3:   Swap accounting is too complicated and would make our financial statements too erratic! While it is true that the software tools and spreadsheets that are used in swap accounting are based on complicated methodology, the process is also highly standardized and objective. And, as to the concern that “marking to market” swaps will create volatility in financial statements, the reality is that changes in swap values are almost always entirely offset by mirroring changes in the loan value. The actual effect on a bank’s financial statements is negligible.

While there are several strategies banks can employ to manage their interest rate risk, including the very user-friendly outsourced swaps discussed in other articles, interest rate swaps are generally the most effective. We submit that the learning curve and regulatory compliance associated with swaps is much less than feared and well worth the benefits.

This article was originally published in the Western Independent Bankers Lending & Credit Digest.