How Your Bank Can Pick Up 40 Basis Points of Margin

Improving Net Interest Margin
IMPROVING MARGIN

Community banks face intense competition from different institutions and various industries.  There is currently a market phenomenon that is creating an unusually challenging environment for community banks that compete for real estate financing. This phenomenon is creating an advantage for some lenders in the amount of seven to 42bps, and community banks must be aware of this aberration if they want to win more quality borrowers.

 

Swap Spreads

 

A swap spread is the difference between the yield on bank financing (without the credit spread) and Treasury yield for the same maturity.  Historically, swap spreads have been positive, and that makes sense because banks fund themselves for at a premium over the cost of financing the government.  However, in the past year, swap spreads have turned negative, and the longer the term, the more negative the swap spread – an unusual situation that creates a funding or a lending advantage for certain banks.

 

Below are graphs for 20 and 30-year swap spreads for the past year.   

 

20 Year Swap Spread

 

30-Year Swap Spread

 

The graphs show that both 20 and 30-year spreads were a positive five basis points a year ago, and the 20-year spread is now negative 20bps, and the 30-year spread is now negative 40bps.  Historically, these spreads have averaged positive 47bps – that is, it was 47bps more expensive for U.S. banks to fund their operations than for the U.S. Government.  Currently, swap spreads are negative across the entire curve – from two years out to 30 years. 

 

Impact on Community Banks

The shape of the yield curve and the negative swap spreads allow banks that use hedging instruments to be up to 40 bps more competitive than competitors that do not use hedging instruments.  That means that a bank pricing a loan with a hedge can recognize 40bps more margin using the same fixed-rate to the borrower, or offer the loan 40bps tighter and maintain the same margin, or some combination of the two.

 

Some argue that only a few banks are large enough or sophisticated enough to make use of hedging instruments, and the impact on community banks is only marginal.  However, there are a couple of flaws in that argument. 

 

  1. There are now 484 banks in the country that are reporting swap volume out of 5,550 regulated depositories (excluding credit unions).We estimate an additional 300 banks are using outsourced hedging solutions that are not reported in regulatory filling. Therefore, approximately 15% of all banks are now taking advantage of the negative swap spreads to price loans more aggressively and generate more margin.
  2. While 15% of banks are utilizing this pricing advantage, that number does not tell the entire story.  Because the banking industry asset and loan distribution are so skewed, we believe that 80% of the real estate term loans booked have an associated hedge or swap spread component offering those lenders a pricing advantage. The graph below shows all of the banks in the country (on the X-axis) and their cumulative loan outstanding as a percentage of total loans.  The ten largest banks in the country hold 40% of all loans in the banking industry.  The 50 largest banks in the country hold 65% of all loans in the banking industry.  Almost all of the largest 200 banks in the country are using a hedging program, and those banks control 82% of all of the loans in the industry.  Therefore, the vast majority of loans financing term real estate (the loan category, which requires long-term fixed-rate structures) are benefiting from the advantage of negative swap spreads.  

 

Number of Banks and Percentage of All Loans

 

Conclusion

 

Community banks need to consider how to compete in a market that is currently giving certain banks up to 40bps pricing advantage by merely using a hedging program.  While the majority of the banks do not hold this pricing advantage, by loan volume, the large majority of real estate loans originated in the country are now utilizing some hedging program that provides a very real competitive pricing advantage.