How a Flattening Yield Curve Exposes Your Borrowers

Protecting Your Borrowers

An East Coast bank booked a $600,000, owner-occupied CRE loan for a five-year term in 2015 at 4.75% fixed.  We know the borrower well, and last month another bank that we work with refinanced that loan on a 10-year term at a 4.61% rate. The borrower received more certainty and a better price.  This refinancing scenario plays out in commercial banking regularly.  However, few bankers quantify the impact of this refinancing activity, and few consultants offer solutions on how banks can address this issue. In this blog, we talk about the current market opportunity to either take borrowers from your competition or to put a structure in place to better retain quality customers.

The Opportunity (or Risk) of a Flattening Yield Curve

Over the last two years, the yield curve between and overnight floating rate on a loan and a ten-year fixed rate loan has flattened approximately 1.17%. This can be seen below as the average loan from July of 2015 is compared to an average priced loan as of today. As can be seen, not only has the average credit spread tightened some seven basis points, but the pricing curve has shifted up on the short-end and down in the long-end. 

Using the yield curve to price loans

For aggressive banks, this means that offering a maturity past five years to another bank’s existing borrower is an easy sell. For example, if we know that you have five years or less on your maturity, we will come in and offer a seven, ten or 15-year maturity to your borrowers and even if we match your credit spread, we can still offer the borrower a lower rate. Conversely, banks that want to keep their customers should know that quality customers are now highly susceptible to offers for longer-term fixed rate loans. For smart bankers, a flat yield curve presents the ideal opportunity to gather quality customers.

By similar extension, now is also a great time to pick up lending teams since refinancing quality borrowers is so easy. Often, the only thing that is keeping a borrower at a particular bank is the lending relationship. If that lender moves, there is very little keeping that quality borrower at the bank. Back in 2015, a lender moving banks could be expected to bring over about 20% of their book of customers within the first year. Now, that number is closer to 45%. That means the acquisition of lending teams is more accretive than ever.

Quantifying the Loss

Prepayments and refinancing activity is very common in the banking industry.  We estimate that for the average community bank, between 20% to 30% of the commercial loan portfolio prepays annually.  This rapid loan prepayment is a serious drain on bank earnings but can be easily prevented.  In our loan observation above, the first bank lost an earning asset and was left with an inferior 5% ROE on the loan for the two-year period.  On the other hand, the second bank booked a lower yield, but will very likely obtain a 15% ROE on that same borrower – you read that correctly, the second bank booked a lower yield on a ten-year credit but because of the prepayment structure applies for the full ten-year period, the ROE is substantially higher.

The graph below shows the results from our loan pricing model, where we calculated the ROE for the specific $600mm owner occupied CRE credit but varied the expected term of the loan from one year out to 12 years.

Loan Profitability

Because of the high direct and indirect costs of acquisition and booking, a new credit relationship (for our bank, underwriting cost alone is $6,150) the loan earns a negative ROE (risk-adjusted return on capital, or RAROC) in the first year and by the second year, the ROE is only 5%. The loan becomes more profitable as it is seasoned and the ROE levels out after ten years or even improves.  This particular loan produces a ROE that is above the banking industry’s cost of capital (11%) only after four years.  In the first three years, the loan reduces shareholder value.

The Solution

Bankers focus much time and many resources on loan pricing, amortization, term, and credit quality.  One aspect that is often overlooked is the high cost of loan prepayments and its impact on ROE.  There are some things that we recommend bankers do that will dramatically increase ROE by reducing prepayment speeds.  Here are the top five:

  1. Pick the right customers.  Customers that want short-term loans have stated intent to prepay ahead of schedule or customers that finance short-term projects are less profitable for banks (all else being equal). 
  2.  Book longer term credits.  Loan commitments under five years are not as profitable as 7 or 10-year commitments (again, all else being equal).
  3. Understand your client’s needs.  Once a loan is booked, bankers must continue to call on the relationship to ensure that the customer’s needs are being met.  Restructuring or repricing a loan is positive for the bank versus receiving a loan payoff.  Develop a strategy of proactively offering existing clients options to reprice, extend commitment terms or restructure facilities based on their changing needs.
  4. Cross-sell sticky products.  Certain products and services, such as treasury management, payroll, and international solutions make customers much less willing to switch banking relationships.
  5. Do not book loans without prepayment provisions!  This is by far the most common mistake we see in banking today.  A loan without a prepayment provision is not a relationship credit; it is a borrower waiting for a better offer.  Many bankers will tell us over and over again that prepayments are not common in their market – this is simply not true because in every market we travel to we see borrowers willing to commit to prepayment provisions with the right loan structure.  We also see the national and larger regional banks insist on prepayment provisions on their term loans.  

Conclusion

Banks may win and lose loans over 25bps in pricing, 5% more on LTVs, or the presence of certain guarantees.  All of those parameters typically hardly move the needle on the relationship’s ROE.  The much bigger driver—one that is actually perfectly aligned between borrower and lender—is the expected length of the credit relationship. Most borrowers and lenders want a longer relationship.  By committing to longer terms and using properly structured prepayment provisions, banks can easily gain 5% or even 10% higher ROE.

In this age of data, it is too easy to find the details of a loan for any given borrower or property. We see every UCC filed by banks in the nation. We take that information and match it up against partnership and business formation records so now we have the borrower’s contact information. We then take that information and can pull both business and personal data to help us make a judgment on credit. We match that up against marketing data and now we know their age, marital status, educational level, alumni affiliations, social media activity, and potentially 3,000 other pieces of information. If we can see that information, you can bet your bank vault that other banks can as well. Basically, a large percent of your client list is public information and available for the taking.

Don’t let other banks take your good clients leaving you with a portfolio of weaker credits. Protect your quality borrowers though proper loan structuring. Be sure your lenders are educated and are willing to proactively restructure loans in order to protect your bank, its shareholders and, most importantly, its employees.