Small banks play swaps middlemen in bid to boost fee income

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Several small and midsize banks have started facilitating interest rate swaps to drum up fee income during a period of low interest rates, lower loan yields and fierce competition.

In the simplest form of an interest rate swap, one party converts floating-rate payments to fixed rate and a counterparty does the opposite. While the interest payments change hands, the principal remains with the entity that holds the loan.

The service is often offered to provide borrowers with a hedge against fluctuating rates. More banks are functioning as intermediaries for the two sides and generating fees for their work.

“We have more banks than ever doing this for their clients,” said Chris Nichols, chief strategy officer at CenterState Bank in Winter Haven, Fla. “We continue to see strong demand and expect that to extend well into this year.”

Reliable industrywide swap fee data is unavailable because banks do not report it uniformly.

Nichols said the $17.1 billion-asset CenterState’s correspondent banking operation handles such programs for about 300 small banks, noting that activity in that area nearly doubled in 2019 from a year earlier.

Demand — stoked by a flat yield curve, low rates and borrowers’ needs for long-term financing — makes swap services viable at a time when many banks are trying to find more ways to generate fee income.

Noninterest income, as a percentage of total revenue, rose to 24.8% in the third quarter from 23.7% a year earlier at banks with less than $20 billion in assets, based on the most recent data from the Federal Deposit Insurance Corp.

Banks can earn 0.75% to 1.25% of a loan’s amount by instituting a swap program for borrowers, Nichols said, adding that big credits can generate “substantial” upfront fees.

Valley National Bancorp in Wayne, N.J., generated about $10 million in swap volume in the fourth quarter tied to roughly $400 million in loans, Chief Financial Officer Michael Hagedorn said during the $38 billion-asset company’s recent quarterly conference call.

At Fulton Financial in Lancaster, Pa., income tied to commercial loan interest rate swaps increased by more than 50% in the fourth quarter from a year earlier. Overall fee-based income rose by 8%, CFO Mark McCollom said during the $22 billion-asset company’s call.

The $2 billion-asset First Bank in Hamilton, N.J., earned $349,000 in the quarter by offering the service. The $4.9 billion-asset Bridge Bancorp in Bridgehampton, N.Y., swapped more than $180 million in loans during the fourth quarter.

TriState Capital Holdings in Pittsburgh generated $11 million in swap fees last year, with nearly a third coming in the fourth quarter.

“We continue to grow the population of clients who want access to this product,” James Getz, TriState’s chairman, president and CEO, said during the $7.7 billion-asset company’s earnings call. “It continues to strengthen as we integrate it more indelibly into our growing lending business.”

A challenge with swaps is the volatility of the business.

Valley’s fourth-quarter volume was 23% lower than its typical quarterly production, Hagedorn said.

“Swaps are a little lumpier in nature,” Sean Burke, chief financial officer at Investors Bancorp in Short Hills, N.J., said during the $25 billion-asset company’s quarterly call. Still, he said the expectation is for increased volume this year.

Still, investors are generally embracing the business as a way for banks to diversify income streams, said Damon DelMonte, an analyst at Keefe, Bruyette & Woods.

“More banks simply need to be less dependent on spread income,” DelMonte said. “Anecdotally, swap fee income is up materially, and the need for more noninterest income is an important reason.”

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