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Interest Rate Swaps

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New Broad Treasuries Repo Rate “Best Practice” Benchmark

On June 22, the Alternative Reference Rates Committee (the “ARRC”) identified a broad Treasuries repo financing rate (the “Broad Treasuries Financing Rate”) that, according to the ARRC, in its consensus view represents best practice for use in certain new U.S. dollar derivatives and other financial contracts.

The work of the ARRC grew out of the past instances of manipulation of the LIBOR market which caused a loss of confidence in LIBOR – particularly as it had previously been determined and reported – as a reliable interest rate benchmark.  That led the G20 to instruct the Financial Stability Board to review broadly-recognized interest rate benchmarks and devise a plan to ensure that the construction of these benchmarks are sound and used appropriately in the markets.  According to the Working Group on Alternative Interest Rates initiated by the Federal Reserve in furtherance of the plan, the goals were two-fold: (1) strengthen the integrity of existing benchmark rates, and (2) develop alternative reference rates that would be free of many of the risks (including manipulation) associated with existing benchmarks.  The Broad Treasuries Financing Rate would be one such alternative rate.

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Swaps, Dodd-Frank and the Community Bank

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.

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June 10 Deadline for Clearing Interest Rate Swaps

All community banks that currently engage in interest rate swaps (or are considering doing so in the near future) should be aware of the June 10, 2013 deadline for compliance by all financial institutions with the clearing requirement for interest rate swaps.

As background, Section 723 of the Dodd-Frank Act added section 2(h) to the Commodity Exchange Act and thereby established a clearing requirement for interest rate swaps.  (The term “clearing” refers to the process by which an intermediary is interjected between a bank and its swap counterparty.  A cleared swap is subject to continuous collateralization of swap obligations, real time reporting, additional agreements and other regulatory constraints.  It is generally a more cumbersome process than the typical “bilateral” swap directly between a bank and its counterparty, which is a purely private contractual arrangement.)  Under Dodd-Frank, it is illegal for a bank to enter into a certain swaps without clearing it unless an exception or exemption applies.

Generally speaking, the types of interest rate swaps that are subject to clearing are “plain vanilla” fixed-to-floating interest rate swaps based on LIBOR.  (Other types of derivatives are subject to clearing, but these are generally not relevant to the average community bank.)  The “big players” (swap dealers, major swap participants and certain private funds active in the swaps market) became subject to clearing requirements on March 11, 2013.

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Losing Good Loans to Larger Banks? Try an Interest Rate Swap

Many community banks are reluctant to consider interest rate swaps due to perceived complexity as well as accounting and regulatory burdens. But, in a record low interest rate environment, the most desirable customers almost universally demand something that is hard for community banks to deliver: a long-term, fixed interest rate. Large banks are eager to accommodate this demand and usually do so by offering such a borrower an interest rate swap that, together with the loan facility, delivers the borrower a net long-term, fixed rate obligation and the lending bank a loan with an effective variable rate.

The alternatives to using swaps are not appealing. A community bank can limit its product offerings to only variable rate loans or short-term, fixed rate loans and thereby lose many good customers to larger competitors. The bank can offer a long-term fixed rate on the loan and then (a) sell the loan and lose ongoing earnings and the customer relationship, or (b) borrow long-term funds from the Federal Home Loan Bank to match that asset with appropriate liabilities, a choice that significantly erodes profit on the loan and uses up precious wholesale liquidity.

If a community bank wants to compete using interest rate swaps, then there are three general methods for packaging an interest rate swap with a typical loan offered by a community bank. There are several regulations that apply to swaps, including changes to the Commodities Exchange Act enacted by the Dodd-Frank Act and the numerous related rules and regulations promulgated by the U.S. Commodity Futures Trading Commission (the “CFTC”). If the community bank is under $10 billion in assets, then all three swap methods described below should qualify for an exemption from regulatory requirements that interest rate swaps be cleared through a derivatives exchange. Avoiding clearing requirements saves considerable costs and operational effort.

The first is a one-way swap in which a community bank simply makes a long term, fixed-rate loan to its borrower and then executes an interest rate swap with a swap dealer (such as a broker-dealer affiliate of a larger commercial bank) to hedge against rising interest rates. In a one-way swap, the community bank is subject to fair value hedge accounting, which requires the bank to mark the swap to market on its balance sheet and run changes in fair value through its income statement.

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