It is normal for stock markets to fluctuate, interest rates to vacillate, oil priced to decline and China’s economic growth forecasts to be adjusted (those numbers are mostly made up anyway). However, the recent behavior in the above mentioned markets is much more volatile than anything experienced over the last few years, and this turmoil is going to change lending and borrowing behavior. Loan terms, floors, rate resets and debt levels have already been chanced. Community banks need to understand how recent developments will affect their balance sheets, borrower behavior, and how competition will respond. In this manner, smart loan officers can educate their customers and arrive at the optimized structure for both the borrower and the bank.
Banks were anticipating a slow steady flattening of the yield curve where short term rates would increase. Instead, the last few weeks has seen longer term rates decline to their historical lows. This is going to create additional pricing pressures on loan margins and change competition. For instance, floors become more valuable and caps (both periodic and lifetime) less so.
Below is a graph showing the current US dollar yield curve (term structure of interest rates). Over the last 6 weeks, the yield curve has flattened approximately 50 bps between the 1-month and 10-year points and approximately 45 bps between 1-month and the 5-year point. Based on today’s rates and average loan pricing, banks earn approximately 53 bps more on a 5-year fixed rate loan than on a variable rate loan, and approximately 101bps more on a 10-year fixed rate loan than on a variable rate loan. Not much compensation for a lender that is taking that many years of interest rate exposure!
The recent drop in long-term rates will lead to the following three behaviors by borrowers: First, borrowers will show a greater tendency to prepay existing fixed rate loans that were booked without meaningful prepayment provisions. Borrowers will attempt to refinance at lower rates and competition will be all too willing to accommodate that behavior. Second, floating rate loans will become less desirable by borrowers because the incremental cost of obtaining a fixed rate loan will diminish. Further to this point, many banks insist on floors which gives the bank a longer duration asset, but the borrower gets the worst of all worlds (higher rates in the short term and rate uncertainty in the long-term). Third, borrowers will pressure lenders for longer fixed terms because the extra cost of interest rate protection has declined in the market.
The above will lead to lengthening asset duration for banks and lower net interest margin. Predictably, community banks will see their larger competitors that use hedges offer lower rates, and longer fixed rate terms, to try to win business.
What Does the Future Hold?
While the Federal Reserve’s Open Market Committee (FOMC) is still telling us that they plan to remove accommodation at a gradual pace, the FOMC has very little control over the long-end of the yield curve. If yields on 5-year and 10-year terms continue to decline, the pricing pressure on banks will only increase. We can look to other nations and other central banks to get an appreciation of the pricing pressures borne by those lenders.
Below are graphs showing the current term structure of interest rates in Germany, Japan and the UK. In these developed nations – albeit with economic realities very different than in those in the US - banks earn no additional yield on the 5-year point of the curve compared to lending variable, and practically, no additional yield on the 10-year point of the curve compared to lending variable.
While we do not portend that rates in the US will continue to decline and mirror the term structure of Japan or Germany, we have already seen a shift in that direction and community banks must be prepared for the possibility of additional yield curve flattening.
How Should Community Banks Respond?
The same 5-year fixed rate loan that in December 2015 could earn the bank a yield of 4.00% is now going to yield the bank 3.55%. The duration of the loan has not changed, the credit risk may not have changed, and the bank’s cost of funding has not decreased, however, margins have just been compressed by 45 bps. If a bank felt uncomfortable booking fixed rate assets 6 weeks ago, the environment has become substantially less appealing for that same loan today.
Banks that insist on loan floors on their floating rate loans risk mispricing transactions. The same goes for loans that base their index off Prime and will not go negative to Prime. Banks that will not go below “Prime Flat” will find themselves some 55 basis points or more above market for a quality loan in most all markets. While we don’t think negative rates are a probable event, it is worth thinking about at some level (see inset box).
As borrowers scramble to lock in lower rates, banks that do not accommodate borrower request for credit may see customers lock in those lower rates with competitors. Recognizing that all banks that hedge interest rate risk (national and super-regional banks) are at a huge advantage being able to offer a lower fixed rate and obtain the same floating rate they would have had before the market turmoil. Stated another way, national banks are more easily able to pass along the lower market rate to the borrower and maintain the same floating rate on their balance sheet through an interest rate hedge. While banks that do not hedge must pass along the lower market rate and earn that lower rate for the life of the loan.
If you did not like the idea of booking fixed rate loans a few weeks ago, you are finding it even less appealing today because the market is offering less premium to take duration risk. Community banks must develop a strategy to pass along the market’s lower cost of long-term rates to the borrower, without taking an ever lower premium to hold the duration risk. That strategy may involve match brokered or retail funding, off or on-balance sheet hedging, innovative lending products, or some combination of the above. If the yield curve continues to flatten, the traditional business generating net interest margin will become untenable and unprofitable for many banks.
Submitted by Chris Nichols on February 24, 2016