How To Choose the Right Index For Your Bank’s Loans

The Right Index for your Bank's Loans

Many banks continue to struggle to identify the appropriate index to price loans. This has been a hot topic this week with the introduction of the Secured Overnight Funding Rate (SOFR) as a possible replacement to Libor. Most of the national and regional banks still prefer LIBOR, while community banks favor Prime, and still, other banks use Treasuries. So which is the better index?  We identify the primary objectives in choosing an appropriate index as we consider almost 30 years of community bank performance and make our recommendations on which commercial loan index community banks should use.

 

Criteria

 

There are four primary criteria for choosing an appropriate loan pricing index, as follows:

 

  1. An index should be a proxy for a bank’s cost of funding (COF). Ultimately, a bank would prefer to quote borrowers a spread over that specific bank’s COF and thus preserve an income spread regardless of what happens to the bank’s COF.  However, few borrowers are willing to accept such a specific index and allow non-market conditions to control the loan rate.  Therefore, most borrowers insist on a market-driven index.   
  2. The index should be robust in structure and accommodate disparate borrower needs. It is common for commercial loans to have commitment terms out to 30 years and have various amortization periods.  An index must be able to handle the terms and structures prevailing in the loan market.
  3. It should be readily observable and widely quoted. Borrowers and lenders should be able to find common published sources for the index and find these quotes in the public arena.  For example, indexes like 11th district COFI and even FHLB advance rates are not widely quoted and may not appear in financial publications.
  4. The index must also be forward-looking. Commercial loans may be floating, fixed or forward starting; an appropriate index must have a futures market to allow participants to price different term structures.

 

Analysis

 

We analyzed the COF for all existing banks (5,660 FDIC-insured institutions) from 1990 to the present and compared the COF to three indexes – 1-month LIBOR, Prime, and 3-month Treasury bill.  We ran our analysis with a 6-month lag for each of the three indexes that we observed.  Surprisingly, Prime had the lowest correlation to banks’ COF (R-squared of 0.88), and LIBOR had the highest correlation (R-squared of 0.91), while 3-month Treasury was in the middle (R-squared of 0.90).  The correlation between LIBOR and COF for banks $100mm to $10Bn in assets is a very high 0.96, and below is a graph showing that relationship. 

 

Bank Funding Correlation

 

 

Even more surprisingly, is that the smaller the bank, the higher the correlation between COF and LIBOR.  Many community bankers will point out that they do not use LIBOR to set their funding costs, so how can that correlation be so high for community banks?  The answer is that the ten biggest banks control 52% of the banking industry, and the 50 biggest banks control 75% of the industry.  All of these large banks do expressly use LIBOR to price their deposits.  Therefore, through competitive pressures all banks in the country de facto price their deposits to LIBOR. Therefore, LIBOR is a superior index for the first criteria – proxy to banks’ COF.

 

All three indexes that we analyzed are robust in structure and can accommodate borrower needs.  For decades, each index has been quoted daily.  There is now discussion around alternatives to LIBOR, and we have written about the possible transition from LIBOR.  We will update readers on the future of LIBOR as information becomes available from the reports published by the Alternative Reference Rates Committee.   While LIBOR and Treasuries can be quoted for fixed rates out to 30 years, Prime is only a short-term index.  This creates a major drawback to using Prime in fixed-rate loans.

 

All three indexes are readily observable and widely quoted.  All three are found on the internet from paid and publicly available sources.  However, the total gross outstanding in US LIBOR is estimated at $200 trillion in 2016 by Financial Stability Board - this is many times the total outstanding in Prime and Treasuries markets.  LIBOR continues, for the time being, to be the more widely quoted and used index.

 

However, the real advantage of LIBOR over Prime or Treasuries is the ability to structure forward rates.  LIBOR forwards are traded for 30 years and beyond.  The forward market in Prime and Treasuries is much more limited.  The LIBOR market can accommodate amortizing, floating, fixed, forward loans, that pay monthly, quarterly, semi-annually or annually.  The lack of such a robust forward market for the other two indexes is a major challenge in using them for commercial loans.

 

At CenterState, we have developed a process for quoting borrowers fixed-rate loans using a publicly available LIBOR index and our process allows us to quote any commercial structure and permit the borrower to track rates in the market until we close the loan.  We will disclose our technique in a future blog.

 

Conclusion

 

We continue to see some banks struggle over appropriate loan indexes.  Analyzing decades of historical bank performance, and considering the three alternatives of Prime, LIBOR and 3-month Treasuries, it appears that LIBOR has historically been a better proxy for banks’ COF. Further, the flexibility that LIBOR provides in being able to structure commercial loans on a fixed, floating and forward bases, creates the better index alternative. 

 

We will continue to follow the future of LIBOR as mandated by the Alternative Reference Rates Committee and advise readers if the index remains viable for community banks (our last update on how to prepare can be found HERE). In addition to having to have an active futures and swap market off SOFR, banks will need to feel confident that SOFR tracks their funding costs.  Until all this occurs, Libor remains one of the best indices for banks to use for both transactional execution and for balance sheet benchmarking.