Many bankers and investors think rising rates will automatically translate into larger net interest margins (NIM) and greater profits. While first quarter data will likely show the first increase in aggregate loan yield since 2007, it remains to be seen how much of that increase gets translated into wider NIM for community banks at the end of 2017. Historically long asset durations, floors and potentially price sensitive deposit customers may keep NIM at lower levels than everyone thinks.
In fact, maintaining acceptable net interest margins (NIM) may prove challenging for community banks over the next few years. As short-term interest rates rise, community banks must be strategic in targeting commercial loans that help main profitable NIM. The graph below shows the relationship between short-term interest rates (Prime) and NIM for banks between $100mm and $10B in assets.
The empirical evidence suggests that between 1990 and 2017, rising short-term interest rates did not help community banks’ increase NIM. For this group of banks, NIM is currently 3.68%, and if short-term interest rates do rise, as expected, NIM could actually be under pressure. While current industry dynamics and financial indicators point to a falling NIM in today’s rising rate environment, there are three commercial loan strategies that community banks may consider to bolster or maintain NIM over the next few years.
Community Bank Asset Duration
A valid and easy proxy for a bank’s asset duration is the ratio of long-term assets divided by total assets. Long-term assets are generally defined as those assets that reprice in five or more years. The graph below shows this ratio for banks between $100mm and $10B in assets between 1992 and 2016. This ratio for this specific group of banks is currently 31%, after hitting an all-time high of 32% in 2014. By historical standards, community banks have extended asset duration significantly.
Strategies for Maintaining NIM
We see three specific commercial loan origination strategies deployed by banks that we believe will work well to preserve or perhaps increase NIM as short-term interest rates rise.
1) Revisiting Commercial Loan Floors
We recently visited with a borrower to discuss their loan terms, and the borrower expressed his satisfaction with his “locked” loan rate. The lender on our team quickly pointed out that the loan is priced on a floating index. The borrower was incredulous “how could the loan be floating if my interest rate has stayed the same for the last three years?” The loan is priced at Prime with a floor of 4.00%, and the very next interest rate hike will bump the rate off the floor. Once this was explained to the borrower, he was very intent to change his pricing index as quickly as possible.
Interest rate floors do not help bank’s NIM unless the loan remains on the books as interest rates surpass the floor level. Most commercial borrowers that finance long-term assets such as CRE, or long-term equipment, or owner-occupied general purpose term loans do not want to (or cannot) take the risk of rising interest rates. Those same borrowers that have accepted a variable rate loan have done so while interest rates remained steady.
We are seeing smart bankers preemptively approach their better commercial accounts to restructure loan terms. These bankers identify borrowers with floating rate loans (especially those with floors which give the borrower an impression of a fixed rate) and present an alternative structure to ensure that the loan does not pay off and remains an earning asset for the bank with an appropriate NIM. By preemptively approaching these clients the bank enhances its chances of eliminating competition and increasing NIM. In contrast, by waiting for borrowers to witness an increase in their loan interest rate on the next Fed rate hike, bankers take the chance of subjecting their existing loan to competition and additional margin pressure.
2) Fixed Rate Prepayments
In a recent management team meeting the CLO and CFO indicated their coordinated strategy of increasing NIM for the bank by pricing new fixed rate loans to market – as interest rates increase the bank’s new loans will have an increasing yield. This notion was immediately challenged by the CEO who quickly pointed out that most of the bank’s CRE loan portfolio is structured as 20-year amortizing loans, ten year fixed rates, adjusting after the initial five years. The CEO pointed out the following:
- Contractually 20% of the bank’s CRE loan portfolio is repricing annually, while the bank’s entire portfolio of deposits reprices much more rapidly;
- While the bank’s commercial loan prepayment was about 30% per year when interest rates were falling, it has now slowed to about 10% per year and would be expected to slow further as interest rates rise, and
- There is no guaranty that as short-term interest rates rise (and deposit costs increase) that the 5-year index also rises (and loan yields increase). In fact, it is very possible that as short-term rates rise, the yield curve flattens and the five-year index does not increase thereby depressing NIM.
This particular CEO then challenged the CLO to start changing the composition of the loan portfolio to eliminate the above risks. Banks that rely on rising interest rates to lift NIM must be aware of the loan structures on their balance sheet and the possible flattening of the yield curve. Banks that can originate more floating rate assets will have a better chance of increasing NIM as interest rates rise.
3) Contractual Maturity vs. Duration vs. Repricing Events
Some banks are starting to price loans taking into consideration not just the stated contractual maturity, amortization, additional expected principal reduction, and duration, but they are also quantifying and considering repricing events.
Consider a loan with a seven-year contractual term. A seven year fully amortizing car loan has an average life of 3.72 years and modified duration of 3.44, while a seven year CRE loan with a 25-year amortization has an average life of 6.42 years and modified duration of 5.81. The two loans have the same stated maturity but very different expected NIM outcome for the bank. In a rising interest rate environment banks should focus on lending opportunities where they can arbitrage borrowers duration pricing. For example, if borrowers do not distinguish duration but are willing to pay loan rates based on contractually stated maturity, banks can maximize NIM. This can be a big advantage for banks on warehoused 15-year fixed mortgage whose expected life can be as short as three to four years.
Furthermore, banks can go a step further and arbitrage borrowers based on non-stated repricing events. Certain borrowers, industries, and loan structures have a high probability of repricing before the stated maturity. Repricing events could include property sale, change in borrower or guarantor composition, additional loan advances or covenant modifications. All of these events give banks the ability to reprice the loan to market. Banks should identify opportunities where such borrowers are willing to pay a fixed rate of interest for contractual loan term, but such events result in much shorter loan maturities and therefore higher NIM.
As an industry, community banks have extended the duration of their assets (loans and securities). This will likely pose a challenge in maintaining NIM in a rising interest rate environment. We have recently witnessed three interesting and effective strategies that community banks are using to reposition their loan portfolio to increase NIM if interest rates rise.
Submitted by Chris Nichols on April 26, 2017