How Loan Hedging Impacts Lender Compensation

Community banks are starting to embrace loan hedging as an effective tool for risk management, loan production, and fee income generation in commercial lending. These banks have concluded that using interest rate hedges on commercial loans has several benefits to the bank that include interest rate risk mitigation, credit enhancement, pricing discipline, increased borrower retention rates, higher cross-sell opportunities, greater loan production, and generation of non-interest income. Community banks are commonly generating between 50 and 250 basis points of non-interest income on commercial loans using interest rate hedges – on a $1mm commercial loan, the bank can generate between $5k and $25k of fee income depending on loan term. We talk to community bank managers who are formulating how to increase commercial lender compensation using hedge fees. We will share best practices in this article.

Specific Example Around Lender Compensation

Consider a $5mm hedged CRE loan, structured as a 10-year fixed rate on a 25-year amortization, priced at SOFR + 2.40%. Based on current interest rates, the fixed rate to the borrower is approximately 6.19%, which is equal to the sum of the swap rate and the 2.40% credit spread. A community bank can increase the swap rate by 25bps and add its 2.40% credit spread to price the loan at 6.44% (25bps higher all-in fixed rate). If the borrower accepts this rate, the 25bps increase in the hedge rate results in the bank generating approximately $86k in hedge fee income. This income may be recognized immediately in the period received. But if the borrower is willing to pay for the fixed rate loan, why not charge that higher amount in the credit spread (increasing the 2.40% to 2.65%, as an example)? The section below explains the reasoning of why banks choose to embed basis points in the hedge fee vs. credit spread.

Dividing Income between Fee and Credit Margin

Since management is tasked with maximizing value for shareholders and setting loan pricing strategy, how should the bank balance the hedge fee, credit spread and an acceptable all-in fixed rate for the borrower? Furthermore, how should commercial lenders be compensated (if at all) for the fee income that is generated by the hedge?

We are going to assume that the bank is using a form of loan pricing that is incorporating the term structure of interest rates and that banks are pricing loans to achieve ROA/ROE goal. How should a bank apportion income between fee and credit margin?

We believe that banks should generate some hedge fee income on every commercial loan. A few bankers argue that instead of fee income, the bank can recognize the same amount of income and resulting ROA by simply increasing credit spread, but this is not the case for the following four reasons:

1. Borrowers see credit spread in the documentation and are likely to negotiate that spread aggressively; however, borrowers typically do not know the daily swap rates and, within reason, are willing to pay a premium with little resistance. A hedge fee is not an out-of-pocket cost to the borrower. Banks that do not charge some hedge spread to generate fee income are leaving value on the closing table – value that national and regional banks are all too willing to recognize on their loans.
2. While 10bps of hedge fee spread and 10bps of credit spread may be the same value for the bank if the loan stays for the contractual term, most loans do prepay before the contractual term. On prepayment, the credit spread goes away but the fee income has already been recognized by the bank. Therefore, in the long-run fee income is more valuable to the bank than credit margin.
3. Fee income is especially important for banks that are intent on adding new loans (for growth or replacement). Generating hedge fee income is a way to shift cash flows forward (recognizing more upfront and less in the future). When loan portfolios grow or turn over, credit margin business is challenging but the multiplier impact of fee income bolsters ROA/ROE.
4. Commercial loans are not on autopilot for the contractual term. Instead they are transferred, restructured, increased, divided, and assumed. Each of these events allows the bank an opportunity to generate additional hedge fee income. While hedge fee income is not periodically recurring, it also not singular. Banks that have a policy of not generating hedge income are missing multiple opportunities for fees on each loan.

Lender Compensation for Hedge Fees

For all the reasons stated above community banks should be motivated to generate hedge fee income. How should banks compensate lenders for hedge fee income generated? Most banks already have lender incentive plans that consider revenue generated and many banks pay lenders based on loan fees generated. Hedge fee income should not be overlooked as an incentive tool and to align goals. Hedge fee income is easily measured and can be greater source of fee income than loan origination fees which are resisted by borrowers because they are direct out-of-pocket costs (in contrast to hedge fee income).

It makes sense that banks that want to generate hedge fee income should align lender behavior that best benefits the bank. There are several ways that banks can create incentive plans for commercial lenders based on hedge fees generated. The three most common commercial lender incentive plans in the industry for hedge fee generation are as follows:

1. Banks may pay commercial lenders a set dollar amount per million in loans booked through a hedge. We have seen this number in the range of $500 to $1,000. In our example on the $5mm dollar above, if the bank recognized 25bps in hedge fee income or $86k in fees, the lender would earn $5k of that (assuming the lender compensation is $1k per million). Therefore, the bank is sharing approximately 6% of fee income with the commercial lender. The advantage of this structure is that it is simple to calculate. The disadvantage is that the bank needs to ensure that a minimum amount of hedge fee income must be recognized because under this structure the lender is motivated to use a hedge but not to maximize fee income for the bank. If in the above example only $40k in hedge fees are generated, and the lender still earns $5k, the bank is paying out 12.5% of the bank’s fee income.
2. Banks may also pay commercial lenders a percentage of the fee income. In our example above, the bank could set the lender’s incentive compensation to 6% of the fee income generated. The advantage of this structure is that the bank’s and lender’s interests are more evenly aligned. However, lenders may be incented to maximize fee income and minimize the bank’s credit spread to maximize their fee payout. Therefore, banks must maintain control over the fee/NIM balance or cap the maximum hedge fee income to create desired behavior.
3. Another plan that we have seen used effectively is a hybrid of the above. Here management insists on a minimum hedge fee for all deals and pays the lender a standard incentive. In our example above management sets a minimum of 10bps spread for all hedges and shares $800 per million with the lender. Management then allows lenders to include additional fee income and pay extra on any hedge fee above the minimum (for instance it could be 20% of fee income generated above the first 10bps of hedge spread).

We favor simplicity in incentive pay but every bank is different, and a bank’s strategy should be framed in concert with the hedge program used, the ability of lenders to drive value and sophistication of the market. We are willing to collaborate with community banks to help them formulate a strategy that is appropriate for their geography, culture, and overall compensation structure.

Conclusion

As more community banks embrace the merits of hedging commercial loans, more management teams are tackling the issue of lender incentive compensation for hedge fee generation. We strongly feel that every commercial hedge should generate some fee income for the bank and lenders should be motivated to make that happen. Management should give serious thought to the hedge fee income potential for the bank’s loan portfolio and how lending staff should be compensated for its efforts.