I regularly work with both lenders and commercial borrowers. In the last 12 months, I have noticed that interest rate swaps are becoming a part of more and more financing arrangements. While I am not an economist, there are a handful of reasons why including swaps or derivatives in a financing arrangement should be part of more conversations between banks and commercial borrowers.
In this post, I am considering a “plain vanilla” interest rate swap. A simple example of this would be a bank offering a 10 year fixed interest rate loan to a borrower. The bank then swaps this fixed interest payment with someone (maybe another lending institution, swap bank, or even back to the borrower) in exchange for a variable rate payment – usually tied to LIBOR plus some amount of basis points. At the end of the swap period, the difference in interest payments between the fixed and the variable interest rate is paid out to the appropriate party.
Increasing Competition Among Lenders
Many of my commercial clients complain that banks only want to lend money to people who don’t need it. This is not entirely the decision of lenders. Today’s regulatory environment has forced banks to tighten their risk tolerances. The net result of this is that it seems there are more loan demand than there is loan supply.
I think of it as Venn Diagram. One circle is borrowers who need financing. The other circle is businesses with acceptable risk. Where those two circles intersect, banks and borrowers are doing business. If your project falls into that middle part of the diagram, congratulations! You will have lots of banks competing over your business.
This competition is a problem for lenders. I have seen banks offer extreme terms just to “win” some of these “good loans.” Many banks just cannot compete with lenders who are willing to cut deep into their profits just to secure a deal. This is not good for banks, and when banks struggle or consolidate, it ultimately harms borrowers, too. Continue Reading A Perfect Storm: Why are Rate-Swaps or Commercial Loan Hedging Arrangements on the Rise?