Community bankers are currently paying close attention to commercial loan pricing given near-record tight credit spreads and increasing interest rate risk. The vast majority of commercial loans in the market are priced to an index plus a credit spread. Determining the appropriate credit spread that will win the business and provide sufficient return to the lender is a key element of RAROC (risk adjusted return on capital) analysis. However, the underlying index to which the credit spread is also added an important element in loan pricing and risk management. A banker has many choices when it comes to an index - swaps, Libor, Prime, Treasuries, FHLB and others. In this article, we cover how, and why, to choose the right index for your loans that will limit risk and maximize return.
Community banks tend to use a full array of indices to price loans. Some banks use Prime rate to price all commercial loans; others use Treasury yields as their sole index for all loans. Many banks will consider different indices depending on the structure of the loan, commitment term, and borrower sophistication. Still, other banks use an unusual set of algorithms to set commercial loan pricing. We know one bank that prices its loans on the following formula: current Prime rate minus the treasury yield, plus that same treasury yield – for example the five years fixed loan rate would equal Prime minus five-year Treasury rate over the 5-year treasury rate (or approximately 4.25% today).
How should banks choose their loan index and what concepts are important in considering the right index for a specific loan?
Choosing the correct index to price loans is important because it may enhance the yield for the bank, serves to mitigate market or reset risk, and can help lenders better market the loan to borrowers. The underlying index for pricing loans is the base to which the bank will add a credit spread to arrive at an all-in rate for a loan. We typically consider six variables in choosing an index for commercial loans.
Fixed or Variable?
The most important consideration in setting the correct loan index is the number of times the index will reset. If the rate on the loan is fixed and the bank will set pricing only once at inception, then the index consideration is simple. In that case, the index is ultimately less relevant than the fixed rate mutually acceptable to the bank and borrower. In fact, we know a banker who humorously arrived at an acceptable fixed rate on a particular loan by using a formula incorporating the price of milk. However, the most common index for fixed rate loans in the market are the following in order of popularity: 1) swap rate, 2) Treasury rate, and 3) FHLB rate.
Each has its benefits, but the swap index is by far the most popular because it is widely quoted, most liquid, easy to obtain in the public domain and relatively easy for the borrower to validate. The FHLB rate is less transparent for borrowers, not as widely quoted and can contain the supply/demand consideration of advances which may make the bank using the index less competitive in some cases.
The Treasury rate is widely understood and quoted but can also suffer from supply/demand considerations causing the community bank to sometimes underprice risk. For example, the 10Y Treasury could go on “Special” or be in demand in the marketplace for technical reasons causing a depressed yield. To get around this issue, typically the constant maturity rate is quoted, which is an interpolation of common loan terms based on the daily Treasury yield curve. Some insurance companies still prefer to quote fixed rates off treasuries.
However, the majority of fixed rate loans (we estimate between 75% and 80%) are priced on the swap index. The advantage of the swap rate is that the index is the best predictor for bank’s cost of funding and has the highest correlation to banks’ actual cost of funding going back more than 20 years. Below is a graph showing the 10-year Treasury yield in the white line and 10-year swap yield in the yellow line from 1990. While the two rates move in sync and the yields are close, the swap rate has historically been a better predictor of banks cost of funding.
An index should be aligned and acceptable to both the borrower and lender. For example, using a tax-exempt index for a taxable loan will produce unacceptable pricing. Similarly, using mismatched tenor for index and loan may also cause problems – pricing variable rate loans on a long-term index will produce suboptimal results. Banks should match the index to the tenor of the reset period of the credit facility. For example, a three-year reset should be indexed to a three-year swap rate. A monthly reset should be tied to a one-month rate such as Libor. This is another reason to use Libor over Prime since Libor captures the interest rate risk each month, while Prime usually resets only when the Fed Funds Target Rate resets.
We still see some banks using Prime to price fixed rate loans. This practice can have some unintended and negative results for banks.
The source of information for the index is important. While a bank may want to set its index, most borrowers prefer a public source that they can access themselves in a newspaper or on the internet. Not all reference rates are created equally. For example, certain newspapers will publish rates, as will Reuters, Bloomberg, and ICE (Intercontinental Exchange). The more centralized the source for the index the greater the uniformity of that rate. We prefer official index sources such as Bloomberg and ICE.
Relationship to Cost of Funds
For variable rate indices, it is important for banks to choose an index that tracks the cost of funding. Otherwise, the bank may be in a position where the index decreases and the bank’s cost of funding may increase. For variable rate indices, the LIBOR rate is by far the best index for lenders to use. Better than Prime and better than fed funds. The graph below shows the correlation of our bank’s cost of funds to LIBOR from 1991. That correlation is almost 90% (better than the correlation to Prime – which has an 87% correlation). For banks that do not feel comfortable with LIBOR, Prime is an acceptable variable index.
An index must be verifiable – the borrower, lender, participant or servicing agent must be able to get the same rate on the same referenced time. That means that administered rates (like Prime) are less desirable than market set rates (like effective fed funds and LIBOR).
Frequency of Reset
For variable or adjustable rate loans, banks should strive to adopt an index that resets with the same frequency as the cost of funds. A bank’s cost of funds can vary daily. Therefore, an index with more frequent resetting is preferred. Prime and target fed funds reset up to eight times a year (not daily). One month LIBOR does reset 12 times per year. Below is a graph that shows Prime rate in the white line and one-month LIBOR rate in the yellow line from 1985. As demonstrated in the yellow line, LIBOR resets more frequently (and as noted above has historically followed banks’ cost of funding closer than Prime).
Part of effective loan pricing is to match the right index to the right loan structure in order to manage risk as much as possible for both the bank and the borrower. Bankers should consider the right index for each specific loan in order to avert unintended negative consequences.
We recommend using the Libor curve for floating rate loans and the swaps curve for longer reset loans in order to optimize each of the above considerations. This methodology will also have the byproduct of reducing both operational and legal risk since documentation will be standardized.
If you want to reduce the risk in your portfolio, consider standardizing your indices and training your lenders on the day count, governance and administration of each index. In addition to reducing risk, your lender will also come across as more knowledgeable and be in a better position to bring value to the borrower.
Submitted by Chris Nichols on July 26, 2017