Structured Loans

When a bank makes a loan combined with a swap or similar transaction, the question is how it explains the estimated loss and the termination payment to the customer.

A loan combined with derivatives

A structured loan is an ordinary loan combined with a derivative transaction such as a swap or an option, which are derivatives¹. The Bank of Japan's material calls the category of products that combine a loan with a derivative "structured lending," and gives credit-linked loans and others as examples. Structured loans here mean products of that kind.

Examples of structured lending include credit-linked loans, reverse floater loans and CMS loans. All three have domestic interest rates as a risk factor, and the credit-linked loan adds credit².

• Credit-linked loan: the table lists credit as a risk factor in addition to domestic interest rates. In a bond example (a credit-linked note), repayment of the principal is waived if the reference company defaults³.
• Reverse floater loan: in a bond example, the coupon rises when short-term rates fall and falls when they rise⁴.
• CMS loan: in a bond example, the coupon is the 10-year swap rate minus a fixed margin, set one year before the interest payment⁵.

The material's examples are bonds, and it gives no formula for the interest on a loan.

For how to break down structured products as a whole, including bonds and loans, see What Are Structured Products?

Adding an interest rate swap to a floating-rate loan

If a floating-rate loan is combined with an interest rate swap in which the borrower pays a fixed rate and receives a floating rate, the borrower's total payment is fixed. In an interest rate swap, one party pays a fixed rate on a notional amount and the other pays a floating rate on the same notional amount⁶.

Consider a hypothetical example in which Company F borrows 1 billion yen from a bank at a floating rate of the benchmark rate plus 1.0%. Company F enters into an interest rate swap with the same bank on a notional amount of 1 billion yen, paying a fixed rate of 1.5% a year and receiving the benchmark rate. Interest and swap payments fall on the same dates, and the comparison uses one year of payments.

Figure description

Company F pays the bank interest on the 1 billion yen loan at the benchmark rate plus 1.0%. In the swap with the same bank, Company F pays 1.5% a year on a notional amount of 1 billion yen, and the bank pays the benchmark rate on the same notional amount. The benchmark-rate portion of the loan interest and the benchmark rate received on the swap offset each other, so Company F's payment is fixed at 2.5% a year (1.0% + 1.5%).

When the benchmark rate is below 1.5%, Company F pays more than it would have without the swap. When the rate is above 1.5%, it pays less. At every level, the total payment is fixed at 25 million yen a year.

The reverse floater type

Reverse floater structured products have a coupon that rises when short-term rates fall and falls when they rise. The Bank of Japan's bond example sets the coupon at "fixed 1.7% × 2 − 1-year LIBOR" and adds a guarantee that the coupon does not fall below 0% (a zero floor)⁴.

Consider a hypothetical example in which Company F borrows 1 billion yen in a loan, modeled on the bond example, whose interest is "3.4% − benchmark rate" (floored at 0%). The table compares one year of interest with a loan at a fixed rate of 2.0% a year (interest of 20 million yen).

As the benchmark rate falls, the reverse floater's interest rate rises by 1 percentage point for every 1 percentage point fall in the benchmark rate (in this example, 10 million yen on 1 billion yen). The break-even point against the fixed-rate loan is a benchmark rate of 1.4% (3.4% − 2.0%). Below that rate, Company F pays more than on the fixed-rate loan, and above it, Company F pays less.

If you add the interest on the floating-rate loan (benchmark rate + 1.0%) and the interest on this type (3.4% − benchmark rate), the benchmark-rate terms offset each other and the total is a constant 4.4%. This calculation holds where the 0% floor does not bind, that is, for benchmark rates of 3.4% or below.

When you terminate early

The Financial Services Agency (FSA)'s supervisory guidelines list points for checking whether a bank has a system for explaining early termination to customers. The points include whether, when a derivative transaction cannot in principle be terminated early, the bank explains that, and, when early termination produces a termination payment, whether it explains that and gives an estimated amount under a worst-case scenario⁷.

Under a bank transaction agreement or similar terms, some events cause a loss of the benefit of the time limit (the right to repay on the agreed schedule). When one occurs, the borrower may lose that benefit on the derivative transaction as well as on the loan. The borrower may then become obliged to pay a termination payment⁷.

If Company F terminates the interest rate swap early, that can also produce a termination payment.

What the supervisory guidelines ask of banks

The FSA's supervisory guidelines make a loan transaction that includes a derivative transaction such as an option or a swap a subject of the points for checking a bank's explanation system, and they include the case in which only the derivative transaction is carried out⁸. The Banking Act requires banks to put in place, as internal rules and a system, measures such as explaining important matters in light of the customer's knowledge, experience, financial position and purpose of the transaction. Banks are also prohibited from telling customers falsehoods or giving a definitive judgment on uncertain matters⁹.

The table below shows the main points that the guidelines list for a bank's explanation system when a loan transaction includes a derivative transaction¹⁰.

A system in which the bank confirms with the customer that the explanation was received and keeps a record in writing (such as a confirmation form) is also one of the points for checking banks¹¹. For the duty to explain and the suitability principle, see Suitability and the Duty to Explain.

Risks of structured loans

The borrower's risks are that the interest burden can rise with the movement of the index of the derivative combined with the loan, and that early termination can carry a termination payment. As in the two Company F examples, the burden can fall or rise depending on the direction in which rates move.

On the lender's side, the Bank of Japan's material takes up the pre-purchase review and approval procedures of financial institutions that hold structured products. The material lists, as something to do before purchase, using scenarios to check how movements in risk factors such as interest rates would affect period profit and loss (yield and interest margin)¹³. The same material says that, when approval procedures differ by accounting category (bonds, deposits placed, or loans), some financial institutions have only the credit review department review structured loans (such as CMS loans) in advance. The material suggests that requiring consultation with the risk management department or the ALM committee, whatever the category, is one option¹⁴.

This material does not describe the whole of the risk of a bank that makes a loan, and it does not cover the borrower's credit risk or the swap counterparty risk.

Notes

1. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), page 3, "１．仕組商品とは" (1. What structured products are) (page 3 of the PDF). ↩

2. The same material, the table on page 3. The structured lending ("仕組貸出") row lists the credit-linked loan (domestic interest rates and credit), the reverse floater loan (domestic interest rates) and the CMS loan (domestic interest rates). ↩

3. The same material, pages 13–14, the section on CLNs in item (4). The example is a condition under which the principal is not repaid if the reference company (Company A) defaults. ↩

4. The same material, page 6, "（２）リバース・フローター債" ((2) Reverse floater bonds). It describes a floater bond whose coupon rises (falls) when short-term rates fall (rise), and sets the example as "固定 1.7% × 2 − 1 年 LIBOR" (fixed 1.7% × 2 − 1-year LIBOR) with a zero floor. ↩ ↩²

5. The same material, page 8, "（3）CMS（constant maturity swap）債" ((3) CMS (constant maturity swap) bonds). The example coupon is "10 年スワップレート − α" (10-year swap rate − α), set one year before the interest payment. ↩

6. Japan Exchange Group, "スワップ（用語集）" (Swap (glossary), in Japanese), the main text. ↩

7. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc., in Japanese), III-3-3-1-2 (2) ① イ, item b (pages 217–218). ↩ ↩²

8. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc., in Japanese) (October 2026 [Reiwa 8]), III-3-3-1-2 (2) ① イ (the katakana item i) (page 217). ↩

9. The same guidelines, III-3-3-1-1 (1) (page 215). It cites Article 12-2, paragraph 2, and Article 13-3 of the Banking Act, and the text above follows that description. ↩

10. The same guidelines, III-3-3-1-2 (2) ① イ, items a to c and g (pages 217–219), and (2) ③ イ (page 223). Item c covers transactions made for hedging, item g covers the explanation about concerns over the effect on lending, and ③ イ covers confirming the customer's intention to contract. ↩

11. The same guidelines, III-3-3-1-2 (2) ① イ, item d (page 219). ↩

12. The same guidelines, III-3-3-1-2 (2) ① イ, item h (pages 219–220). ↩

13. Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), pages 15–16, "３．シナリオ分析" (3. Scenario analysis). ↩

14. The same material, page 32, "（２）購入時の決裁手続き（続き）" ((2) Approval procedures at purchase (continued)). ↩