Derivatives: Lender's Secret Touch; the Much-Maligned Instruments Give Borrowers More Alternatives, and Lenders Better Pricing

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The much-maligned instruments give borrowers more alternatives, and lenders better pricing

How differently banks treat depositors and lenders. If a customer wants to invest $100,000, we can offer him a vast array--CDs, commercial paper, bankers acceptances, treasuries, agencies, munis, mutual and more. On the other hand, if a customer wants to borrow $100,000, if he is lucky he gets two choices, floating-rate or fixed-rate debt.

A bank should--and can--be able to offer more choice to borrowers. This is possible by integrating the resources available in the capital markets into loan structures.

Capital markets as competitive tool

First National Bank of Maryland, with assets of $9 billion, is not a large bank. Since we don't have the critical mass to be a low-cost provider, our aim is to be a high-quality, relationship-based bank. To meet the competitive challenges in our market, we recognized that all areas of the bank would have to work together to support the relationship managers.

My own area, Treasury/Capital Markets, was already involved in providing support to the large commercial and corporate relationship managers in areas such as fixed-income investments, foreign exchange, and interest-rate-risk-management services. Our challenge was to adopt these services to our core commercial customer base.

In 1992 the bank organized a team of capital market specialists who were charged with providing interest-rate-risk management services to business customers in order to provide a variety of loan products for small business and middle-market customers. By 1994 our services were available for loans of $500,000 or greater. By the start of 1995 we dropped the minimum to $250,000 and our goal for 1996 is to lower that level to $100,000.

Diversifying borrower risk

To understand how First Maryland uses capital-market products in the commercial loan market, one must first understand diversification.

Like most banks, First Maryland offered commercial borrowers either an exclusive fixed-rate or floating-rate option. By accepting either option, the borrower made an intermediate-to-long-term decision, usually at the closing date of the loan.

Consider this from another angle. If you had a customer with $100,000 to invest for five years, would you recommend that he invest it all in overnight funds or all in five-year treasuries? Is it not likely that he would take into consideration the impact on his cash flow of future interest-rate movements? Would experience not dictate diversification?

My point is that this lesson, learnt on the liability side of the balance sheet when dealing with depositors, means as much on the asset side. Interestingly, many banks already offer such diversity of choice to residential mortgage borrowers. So, let's return to our borrower:

(a) If a five-year fixed-rate was selected, the borrower has all of its eggs in the five-year segment of the interest-rate marketplace; essentially the borrower is short five-year Treasury notes.

(b) If a floating-rate was selected, the borrower has all of its eggs in the overnight segment of the interest-rate marketplace--essentially the borrower is long Fed funds or Eurodollars.

Whether this borrower chooses the fixed or floating option, subsequent interest-rate movements may well prove his decision wrong. As a result, borrowers with tight cash flow might be affected to the degree that debt-service coverage is jeopardized; healthy borrowers might attempt to renegotiate the rate or term, in a heads-I-win-tails-you-lose strategy.

Diversification allows borrowers to balance floating and fixed exposures and to control the timing of rate-selection decisions. This is healthy for both the bank and its client.

Derivatives make it happen

Implementing diversification into lending requires the most dreaded word in today's financial dictionary...DERIVATIVES. …