Guest blog: Derivatives governance – to swap, or not to swap?

Derivatives governance – to swap, or not to swap? by Patrick Alderman, Director at Link Group.

Interest rate swaps (“IRSs”) and the housing sector have history. When the topic arises it is often accompanied by a sense of trepidation. Margin calls put staggering pressure on many when interest rates fell after the 2008-9 financial crisis. And the use of IRSs comes with additional risks compared with fixed rate loans. Boards must have sufficient expertise to establish and adhere to the level of risk acceptable to their organisation.


Managing interest rate risk


It is important to manage exposure to changes in interest rates. Most loan agreements contain interest cover covenants; therefore reducing interest rate volatility is a key objective. In general, there are two ways to manage interest rate risk: by doing fixed rate funding, or entering into a floating rate loan with an accompanying IRS.

An emerging trend in the commercial lending market is a desire by banks to disaggregate the funding and interest rate risk within newer loan agreements, and this is taking shape in the form of loan-linked ISDAs (“LL ISDAs”). Consequently, the housing sector is faced with the prospect of IRSs being used more widely in addition to fixed rate loans.

Whichever product is used to move between fixed and floating interest rates, it will be characterised by interest rate risk. However, these products may vary in terms of the second order risks that can emerge as interest rates change over time. The table below provides an overview of the spectrum of products available and the risks associated with them.

Product Second order risks
Fixed rate loans Accounting for breakage costs on early termination
Loan-linked ISDAs Accounting volatility arising from mark-to-market accounting

Counterparty credit risk

Standalone ISDAs Accounting volatility arising from mark-to-market accounting

Counterparty credit risk

Margin calls

As the movement towards LL ISDAs gains momentum, it seemly a timely opportunity for boards and senior management to re-evaluate the risks associated with IRSs.

Marking to market


From an economic perspective, the interest rate risk on a fixed rate loan is similar to a floating rate loan with an accompanying pay-fixed IRS. The primary difference is how a change in its market value is accounted for. If interest rates fall relative to a fixed rate loan, its value to the borrower decreases. This change in value is not normally included in the financial accounts but will be reflected as a ‘breakage cost’ in the event the borrower decides to refinance or re-fix the loan.

In contrast, if interest rates move relative to the fixed rate within an ISDA or LL ISDA the effective change in the mark-to-market value of the derivative is recorded as a gain or a loss at the end at each accounting period. The mark-to-market value for an IRS is calculated from current rates and market expectations of future rates. Break costs on fixed rate loans are calculated in a similar way and often specifically refer to the approach adopted in ISDA agreements.

For housing associations, this means that using ISDAs or LL ISDA could result in an increase in the volatility of their surpluses recorded in their financial statements, although this could be managed with hedge accounting. As a result, it is likely that the use of IRSs would require additional accounting support.

Changes in the mark-to market value of a derivative are also significant in terms of the exposure to second order risks such as counterparty credit risks and security requirements.


Counterparty credit risk


Another fundamental difference between a fixed rate loan agreement and an IRS under an ISDA (or LL ISDA) is that an IRS results in the bank committing to pay interest on one of the legs of the swap, and this (potentially) exposes the bank’s counterparty in the ISDA agreement to the bank’s creditworthiness.

Typically, as part of their treasury policy and procedures, housing associations will have credit limits relating the exposure they are prepared to accept with a bank for deposits. This will normally be codified in terms of a maximum amount and deposit term. IRSs are slightly more nuanced. There is no exchange of principal on IRSs, so the credit risk only relates to the net interest payments over the term of the swap, rather than any capital repayments. For example, if you enter into a pay-fixed swap to hedge a floating rate loan and rates increase, you are protected against that rise in rates. However, if the swap counterparty defaults, the protection falls away any you are subject to the higher market rates. It’s not unlike taking out an insurance policy and the insurer then becoming insolvent when you need to make a claim. In the case of an IRS, the term limit will need to be tied to the interest rate risk appetite of the organisation, which may be as long as the term of any of its debt. As the length of the credit risk in IRSs is likely to be longer than for deposits, it is important this is reflected in any treasury management policy and procedures, in addition to the total counterparty exposure.

A challenge with a single LL ISDA is that it only provides access to a sole banking counterparty, and therefore a credit risk concentration. Board and management may wish to consider multiple ISDAs that enables them to diversify the credit risk associated with any IRS portfolio.

Security, collateral and margin calls


Under a standalone ISDA, counterparty credit risk is addressed in a credit support annex (“CSA”). The CSA outlines any collateral which needs to be posted in response to a change in the value of the derivative. In practical terms, standalone ISDAs normally have one-way CSAs whereby the bank receives collateral if the position moves out-of-the-money for its counterparty but the counterparty remains unsecured if rates move in the other direction. It is possible to arrange a two-way CSA, but this is a question of whether the additional protection against the credit risk is worth the increased cost. LL ISDAs do not normally have an associated CSA which means the borrower will not be subject to margin calls, but is potentially exposed to credit risk in the same way as it is in a one-way CSA. Under an LL ISDA the bank gains credit support by having access to the security charged as part of the loan agreement.

Standalone ISDA CSAs normally have an unsecured threshold up to which the counterparty is not required to post any collateral, and above which ‘margin calls’ will occur at a set frequency, usually monthly. The prospect of a margin call presents the counterparty with contingent liquidity risk. It is contingent because it is determined by market movements in the underlying risk factor relating to the derivative, in the case of an IRS, interest rate movements. However, the risk of significant margin calls can be managed by placing limits on the factors that drive the exposure to interest rate risk on IRSs.

The exposure to interest rate risk on an IRS can be measured by the price value of a basis point (PVBP). This represents the change in the mark-to-market of the IRS in response to a 0.01% movement in interest rates. The PVBP is driven by two primary factors: the timing of cashflows on the IRS (duration) and the notional amount. Therefore, treasury policies and procedures can be developed to include limits around the duration and notional of an IRS portfolio, and thus mitigating against the risk of large movements in the value of IRSs.

The potential liquidity risk that does arise can also be assessed by stress testing the IRS positions, for example, considering a 2% parallel shift in the interest rates. The likelihood of these shocks can also be informed by considering historical and implied interest rate volatility. Managing this risk then comes down to ensuring policies and procedures specify that a liquid buffer in place to meet any margin requirements, while also budgeting for the potential funding cost of the collateral.

Embracing change


There is a variety of tools an organisation has when evaluating how to manage its interest rate risk. Moving across the spectrum of options, while each product increasingly provides greater flexibility it also adds complexity. For most people, derivatives are complicated – even if they are effective. The challenge for boards and senior management is to ensure they have the appropriate level of knowledge and expertise when using sophisticated financial instruments.



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