Many community bankers are experiencing competitive pressures when competing for higher quality credit, relationship-driven accounts. Almost all bankers that we speak to state that competition from banks, credit unions, and alternative lenders is challenging for quality accounts. However, when asked how the bank is differentiating their products and services, two answers are most prevalent: first, bankers say that they try to be more effective salespeople, and, second, bankers try to compete on superior service. Both of these attributes are important, and we have written extensively on both. However, there is a current phenomenon in the market that is staring bankers in the face, and it can help your bank differentiate itself with the goal of winning more quality relationships.
How To Use The Yield Curve Inversion To Your Advantage
An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates. The germane yield curve for banks is the swap interest rate market. At the end of last week, the ten-year benchmark swap rate was almost eight basis points (bps) lower than the one-month index. Historically, these inversions have preceded recessions. However, that is not always the case. Currently, there are no credible signs of an economic recession that would warrant the Federal Reserve to lower interest rates in 2019. The FOMC is on a pause and is predicting no rate movement this year – but predictions may change, in either direction and quickly.
Many bankers see an inverted yield curve as a danger and a challenge. However, that same inverted yield curve creates a substantial opportunity for community banks to differentiate their lending products and secure good quality relationship accounts.
Below is a quote sheet with live interest rates showing pricing on a $1mm commercial loan, 25-year amortization, and structures ranging from floating to 20-year fixed. All of the quotes are equivalent yield to the bank, and each option is almost the same cost to the borrower. With the current shape of the yield curve, the premium of long-term financing has disappeared.
Many bankers may look at this interest rate environment and consider it a threat to profitability. However, at CenterState Bank we believe that this environment creates an excellent opportunity for our bank to differentiate itself from competitors. Any bank that currently offers long-term fixed-rate loans can not only offer rate certainty for the borrower but earn a higher yield than the rate paid by the borrower. A bank can offer a borrower a 10-year fixed rate, for a coupon that is lower than Prime rate, and through a hedge earn a yield that is higher than what the borrower pays.
This is an unusual interest rate environment that is highly attractive for banks that use a loan-hedging platform. Most banks in your market may not be able to offer borrowers a 10, 15 or 20-year fixed rates, but with the inversion of the yield curve, this is precisely how to differentiate your bank.
The ability to offer longer term fixed rates offers the following advantages to the bank:
1) Predictability: Protects the borrower from variability in rate and stabilizes debt service coverage ratio, creating a better credit quality;
2) Increases Lifetime Value: Locks in relationship accounts for a longer period for higher lifetime value, and more cross-sell and upsell opportunities;
3) Sets Your Bank Apart: Differentiates your bank from other lenders to win better quality customers.
The current inverted yield curve has the added advantage of a higher yield to the bank than the fixed rate paid by the borrower - if the loan is hedged.
Some argue that an inverted yield curve creates an incentive for borrowers to choose floating rate loans. But this argument is not convincing theoretically and has empirically not been recognized by borrower behavior. Borrowers would still prefer longer-term fixed rates when the yield curve inverts for the following reasons:
- While the yield curve is a possible predictor of future rates, the current posture by the Federal Reserve is a pause. The next interest rate movement may be up or down, and the FOMC is indicating one rate increase in 2020 on its DOT plot. No one knows where interest rates are heading – including the FOMC.
- Interest rates will go up and down. However, the current rate lock opportunities are unprecedentedly attractive for borrowers. The graph below shows the 10-year fixed rate for borrowers going back to 1988. Borrowers can lock a fixed rate at levels that are approaching the lowest in the last 40 years. If the borrower is looking for an entry point to lock in financing, today’s rates are ultra-attractive.
- There are always prognosticators that will call economic events or forecast business developments that favor one loan structure over another. However, most pundits predicting events and most economists forecasting interest rates have a view that is one to eight quarters out. Most predictions beyond six months are simply guesses. Borrowers that have a committed view on interest rates for the next few months are not natural fixed-rate borrowers. Over 10, 15 or 20 years interest rates will go up and down many times, and self-selected fixed-rate borrowers want to eliminate variability over the long-term and have less concern about the direction of rates for the next few months.
For banks looking to differentiate themselves from competitors, the current inverted yield curve creates an interesting opportunity. By using a hedge platform community banks can offer structures that are novel, win over good quality relationship accounts, and earn a yield that starts at a higher level than the borrower’s payment.
Submitted by Chris Nichols on March 27, 2019