A fairly common strategy for regional and community banks is to offer variable rate funding to their commercial clients and simultaneously arrange an interest rate swap to affect a synthetic fixed rate loan. Typically, these banks also arrange coincident, offsetting swaps with independent derivatives dealers. In this way, the banks are able to add to their bottom line without introducing any duration risk to their overall portfolio, while at the same time satisfying their customer’s funding preferences. For the trade to be reasonable and appropriate, the strategy would have to compensate the bank appropriately for bearing the counterparty credit risk associated with the swaps.
The strategy is commonly known as a back-to-back swap strategy. We assume the transaction is driven by the customer’s desire for term funding, while the bank prefers variable funding. Interest rate swaps can serve to allow both parties to satisfy their respective objectives. Moreover, the swaps can be engineered to generate an up-front cash flow to the benefit of the bank in an amount that serves to accelerate earnings that the bank realizes. This process will be demonstrated by the example.
The strategy requires three components: (1) A variable rate loan extended to a bank customer, (2) an interest rate swap between the bank and the customer (the bank customer pays fixed; the bank pays floating), and (3) an interest rate swap between the bank and a derivative dealer (dealer pays variable; the bank pays fixed). The table below summarizes the feature of an example of a back-to-back swap.
Note the equivalency of the principal and notional amounts, the fact that all start and end dates are in common, and the reliance on the same variable interest rate benchmark for the various components of the trade.