In a competitive lending market, as the case today, banks are looking for an edge to win quality loans. For quality credits, many community lenders are eliminating loan origination fees and prepayment provisions to differentiate from the competition. Since it is easy for an institution to reduce fees and prepayment provisions, that competitive advantage quickly becomes commonplace, and no lender retains an advantage. In this article, we take a quantitative look at the benefits of loan prepayment provisions.
Four Reasons for Prepayment Provisions
While we center on prepayment provisions, we note that inherent switching costs (either friction costs or other barriers to exit) are equally effective in increasing bank profitability.
The first benefit to a bank obtaining a prepayment provision is the opportunity cost of committing to a credit and giving the borrower the unilateral right to prepay when changes in future interest rates or credit spreads make it more beneficial for a borrower to do so. We can measure this cost using simple capital market tools (the option to prepay can be approximated with swaption pricing using the volatility surface of forward rates and credit spreads). This cost to the bank is shown in the graph below.
The graph above shows the economic spread reduction for various loan terms when a meaningful prepayment provision is not present. For a one year loan, the bank forgoes only 3bps in yield for not including a prepayment provision. However, for a five-year loan, the bank’s economic cost of excluding the prepayment provision is 31bps in yield, and for ten years that yield reduction is 41 basis points. Including a prepayment provision in a loan increases the economic value of that asset.
The second benefit to a bank obtaining a prepayment provision is the extension of the expected life of the loan. Prepayment provisions extend the expected life of the loan and increase profitability. Using a sample $500k commercial credit, credit grade four, 75% loan-to-value (LTV), 1.25x debt service coverage (DSC) the relationship between loan term and return on equity (ROE) are shown below.
Because of the very high fixed costs of originating the average-sized loans, loans with expected life below three years show suboptimal ROE. The loan we priced (using standard terms and average efficiency ratio assumptions) has a negative ROE until month 14. Prepayment provisions extend the expected life of a loan and, therefore, increasing profitability. The average expected life of a five-year loan without prepayment provisions is approximately 2.5 years, but with a meaningful prepayment provision, the predicted life rises to 4.5 years, thereby increasing the ROE by 5.5% for our sample $500k loan. One of the easiest ways to increase loan profitability is to recognize (not just book) longer credits.
The third benefit to a bank obtaining a prepayment provision is the forging of a relationship. A banking relationship is defined on three measures: 1) cross-sell and upsell, 2) the percentage of customer wallet, and, 3) lifetime value of the account. All three measures are enhanced because a prepayment provision extends the life of the loan thereby increasing the chances of cross-sells and the percentage of customer’s wallet, and increases lifetime value.
The fourth benefit to a bank obtaining a prepayment provision is preventing negative selection bias in a downturn. We are currently in the longest economic expansion in US history. In this environment, almost all credit quality borrowers have near equal access to capital from multiple lenders. Strong and weak borrowers have ample opportunity to refinance their credit needs. However, in a downturn – which will occur – only the stronger borrowers can secure alternative senior debt financing. In a downturn, the credit quality of a portfolio of loans without prepayment provisions will degrade faster than the same portfolio with prepayment provisions. The lesser quality credits will not see the same financing options available to the higher quality credits.
Some bankers will point out that they will simply not enforce prepayment provisions on poor credit quality loans in a downturn and bankers have that option, but unfortunately, the substandard credits do not pay off because the competition tightens lending standards in the downturn. The greater fool theory breaks down in a recession.
Some bankers will point out that we missed an important benefit of prepayment provisions: the generation of fee income. We did not! Our analysis shows that very few borrowers actually pay prepayment fees because they are not in the loan in the first place, they expire, or the borrower is successful in negotiating them away. In other words, banks recognize the other benefits of the prepayment provision discussed above, but not the fee income. Loans with prepayment provisions tend to stay with the bank longer and do not prepay.
Bankers may be thinking, “I would like to include a prepayment provision, but they are simply off-market where we lend.” We agree that the current prepayment provisions many bankers are requesting are simply not feasible for most structures. However, banks can substantially increase the use of prepayment provisions following a few simple steps and the correct communication with clients. In our future article, we will explain a prepayment provision that has worked on select loans at CenterState Bank which may work for other banks. The key is identifying the right borrowers, properly positioning the loan and explaining the provision to the borrower.
While most banks measure and emphasize net interest margin, and some value the importance of fee income, very few banks today are measuring the significant economic advantages of prepayment provisions. The right prepayment provision may double the ROE of a relationship. While obtaining a meaningful prepayment provision is not simple, with the right structure, explanation and with the right borrower, banks can substantially increase their acceptance.
Submitted by Chris Nichols on May 01, 2019