As shown in the graph below, we may be witnessing the end of a multi-decade bull run in bonds. After many decades of decline, interest rates may be on the rise for years to come. This development is creating an opportunity for community banks to book longer-term fixed-rate loans with higher profit margins. However, borrower demand is forcing banks to make loans with 5, 10, and even 20-year fixed-rate maturities. How should banks protect themselves from the rising cost of funding and at the same time improve interest margins? CenterState Bank uses a strategy that enables the pricing of
We have blogged about how low-interest rates, COVID-19 credit strain, and tough competition for quality commercial loans create a challenging environment for community banks.
Between low-interest rates, the concerning rise in COVID-19 cases, and tough competition for quality commercial loans, community banking is a tough business. While there has been a nominal deterioration in credit quality thus far, a deterioration in the business environment related to the pandemic and lack of fiscal stimulus may change that. Net interest margins at community banks are declining, and the trend is likely to continue through 2021.
We believe all banks should have a hedging program to manage interest rate risk while providing a variety of loan structures to satisfy the borrower’s, not the bank’s needs.
Relationships between different variables can be very complex in the real world and banking is a perfect example of this complexity. The human mind, however, is skewed to perceive relationships in a linear fashion and this can lead bankers to make the wrong decisions. With the odd shape of the yield curve, we are seeing smart bankers making very profitable lending decisions because they understand their business model, the shape of the yield curve and the nonlinearity of commercial loan pricing.
For all banks, the flattening yield curve is impacting profitability. The difference between the Two-Year swap and the Ten-Year swap rate is around 12 basis points. For banks over $15B, this flattening moves net interest margin (NIM) lower and then improves past the one year mark. However, for community banks under $15B, the flat curve not only moves net interest margin down, but this lower profitability becomes worse over time.
Everyone agrees that using the correct tool for the job is an important rule for successfully completing a project. Using a sledgehammer on tacks will leave dents, and applying a screwdriver to move boulders will likewise be equally counterproductive. The same rule applies in banking, and most community bankers are well aware of this. Community bankers appreciate that their project is very different than the projects at national and regional banks. Community banks have different business models and different customers compared to the nation
When banks decide to adopt a loan hedging product the initial management strategy is to reserve it as a defensive tool only. Typically bankers decide to adopt a swap program because borrowers demand longer fixed rates, competition is willing to accommodate such structures (often with a swapped solution) and extending loan duration in a rising interest rate cycle does not make sense for prudent ALM purposes.
Compared to larger lenders, community banks have faced significant challenges in generating non-interest income.
In a previous blog, we described what factors community bank managers might want to consider in analyzing a loan hedging program for their specific needs. In that blog, we listed the pros and cons of using a hedge to control risk and increase profitability. We then wrote a follow-on article that analyzed the various instruments and strategies common in the bank hedging market to include swaps and other interest rate derivative instruments. We provided an in-depth