How Optionality Impacts Your Net Interest Margin

IMPROVING NIM
IMPROVING NIM

For the majority of bankers, maintaining or increasing net interest margin (NIM) is the single most significant focus today. The shape of the yield curve and lower rates have caused NIM compression across the board and have hurt bank equity performance. While we are not big fans of managing bank performance using NIM as it doesn’t take into account risk and cost, it is one of the most common performance metrics used in banking. As such, it pays to understand how optionality impacts NIM, so in this article, we do just that and give some tips on how to increase NIM by controlling optionality. 

As can be seen, by the graph below, the general trend for NIM is down for banks under $5B. Greater competition and a more widespread use of data are the two main drivers of lower NIM. While NIM increased during 1Q of 2019, it has since compressed and is now heading back to the metric’s lows.

Graph of net interest margin (NIM)

 

How Optionality Impacts NIM

Optionality is defined as a state in which choice or discretion is allowed. In finance, optionality is an asset (has value) for the person that can exercise the option, while the person that gave the option has the liability and is short the option.  For example, the option to purchase a barrel of oil at $60 over the next year is valuable even though the price of a barrel of oil (West Texas Intermediate Crude) is currently around $55.  The reason the option to purchase a barrel of oil at $60 is valuable is that there is some chance that the WTI crude price exceeds $60 over the next year, and the option value is exercised giving the owner of the option the gain of the future spot price minus $60.  The person who must sell the oil at $60 is short the option and will take a loss if the price of oil exceeds $60 during the term of the option.

The above example demonstrates a simple commodity option.  Bankers give away options all the time in commercial lending that directly decreases NIM.  By understanding where the option resides and how to avoid giving it away for free, bankers can increase NIM by 50 to 60 basis points on medium-sized commercial loans.

 

Optionality in Commercial Lending

There are two primary ways that commercial lenders extend free options to borrowers and those two options decrease NIM by an average of 50 to 60 basis points on medium-sized commercial loans.

The first optionality that some bankers give borrowers involves quoting loan pricing without indexing to a market-driven interest rate.  Even though most loans take weeks to close from the time a term sheet is issued to loan funding, some bankers quote a loan interest rate and leave it unadjusted through the closing process.  In the weeks that it takes to fund a loan, interest rates can move substantially.  Some bankers will argue that 50% of the time, the bank will gain an advantage and 50% of the time, the borrower will gain the pricing advantage.  However, this is not the reality in a competitive environment.  If rates rise between the term sheet and closing date, the borrower is motivated to take the rate initially promised.  If rates fall during that period, the borrower will ask the lender to reprice to market or threaten to take business elsewhere.  Banks that do not price to an index run the risk of providing the borrower a free option, at the bank’s expense.

The table below shows the possible outcomes of this free option.  Banks that do not price to an index are compressing their NIM.

Loan Optionality Matrix

By pricing to an index (such as Prime, Treasuries, FHLB advances, or swap rate), the bank can maintain its desired profitability if rates move between the quote and the closing dates.  Even if a banker wants to earn a fixed rate that is not expressly quoted as a spread to an index, the fixed-rate must, nonetheless, be internally generated by adding a spread to an index.

The second optionality that some bankers give borrowers is a lack of prepayment protection on loans.  Whether the loan is a fixed rate or floating rate, the borrower retains the right to prepay the loan.  The only time banks can exercise this right is during a credit event.  This prepayment optionality cannot be avoided, but it can be offset with a charge (fee or penalty). 

We ask almost every bank we meet what they typically use for prepayment protection in commercial loans.  The answers run the gamut; however, most banks find it difficult to insist on prepayment protection for their better quality customers because of competitive pressures.  In the last year, we have only met one bank that insisted that they included prepayment protection in 100% of their commercial.  It was only after additional probing that the truth came out that the prepayment provision is invoked if the borrower refinances with another lender, but the provision is not enforced if the loan is repaid from cash flow from the business.  We estimate that on the average commercial loan NIM is reduced by 32 basis points on 5-year loans without substantial prepayment protection, and NIM is reduced by 43 basis points on 10-year loans without prepayment protection.

Without prepayment protection on commercial loans, the results are simple and a terrible consequence to banks’ NIM.  In a falling interest rate environment, borrowers either refinance loans with competitors or threaten to do so – with the same results.  In a rising interest rate environment, borrowers extend the effective life of the loan to as long as contractually possible.  This optionality is a significant drain on commercial banks’ NIM.

 

Conclusion

Bankers need to quote loan rates tied to daily movement in interest rates and, most importantly, find a prepayment provision that they can sell to their best clients.  At CenterState Bank, we find it challenging to include prepayment provision for our better borrowers – except we have found that with some basic education, borrowers will accept symmetrical prepayment provisions associated with a hedged loan.  This prepayment provision eliminates the vast majority of the optionality value for the borrower.