Data Analysis: Why Are Fixed Rates Climbing as Funding Costs Fall?

For most of 2018, rates rose across the maturity spectrum, driving up banks’ funding costs on fixed rate loans held on balance sheet. Bankers did not fully bake the higher costs into the rates charged to customers, however, leading to an erosion in margins. The narrowing spreads were attributed to several factors, including: 
  • competitive pressures 
  • sticker shock (for both borrowers and RMs)
  • lack of understanding of funds transfer pricing (FTP) and its impact on profitability
  • rate locks implemented in a lower interest-rate environment without match-funding
 
More recently, the tide has turned. Longer-term rates have been contracting for several months, and the treasury yield curve has been flattening, with the gap between the 10-year treasury note and 3-month T-Bill yields slipping into negative territory (Figure 1). Given that commercial bank funding costs generally move in lock step with treasury yields, it is not surprising that funds transfer pricing (FTP) on longer-term fixed rate loans has fallen since the start of the year.
 

Source: Fed H15 Release. Data as of 5/28/2019

 
So fixed rate pricing should be falling, right? Not exactly. PrecisionLender’s commercial loan database indicates that across the market, fixed rates have continued to trend higher in 2019 even as FTP has declined (Figure 2).  
 

Source: PrecisionLender. Dates reflect loan origination date, not portfolio "as of" date.

 

The rising rates large reflect: (1) rate locks put in place before the yield curve flattened without match funding; and (2) some banks’ reluctance to offer lower rates on longer-term credits. The case study below illustrates how some banks have chosen to address the latter point.

 

Case Study: How One Bank Alters Its Funding Curve

This bank found itself facing the same flattened yield curve/cost of funds scenario as previously discussed. (Figure 3)
 
 
The bank elected to use steeper step-ups in term liquidity premiums. (Figure 4)
 

Source: PrecisionLender. Figures represent an individual bank's COF and LP assumptions as reflected in their pricing/profitability platform for fully amortizing term loans with monthly payments. Data as of May 2019.

 
This move ensured that relationship managers were using a more traditional upward-sloped term/return curve as pricing guidance. (Figure 5)
 
 

Fixed Rate Trends vs. Floating Trends

The widening margins on recently-originated fixed rate loans stand in contrast to the results many banks are seeing at the top of the house. At an aggregate portfolio level, Net Interest Margin (NIM) has actually eroded in 2019 for the industry as a whole, according to FDIC call report data. The shrinking portfolio margins coincide with climbing deposit rates, which directly impact profitability on floating rate credits, and may also reflect a funding mismatch between short-term liabilities and longer-term assets. Since the beginning of 2019, even as loan indices have stabilized, deposit rates have edged higher across terms (Figure 6).
 

Source: Federal Reserve Bank of St. Louis (FRED).  Deposit rates reflect accounts over $100K.

Conclusion: A Potential Opportunity?

Even with the rise in deposit rates, deposits are still a far cheaper source of funds for commercial banks than wholesale funds, and deposit gathering therefore remains an important strategy in lowering funding costs and improving NIM on floating rate credits. On longer-dated paper, time will tell whether banks accept the “new normal” – a flat or inverted yield curve – and bake the lower FTP into their fixed rate pricing. If not, banks seeking to capture market share may have a strategic advantage in offering lower fixed rates while still maintaining a healthy margin over cost of funds.
 

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