As the financial crisis unfolded in 2007 and 2008, the Federal Reserve took several unprecedented steps in an attempt to resuscitate the financial system. Among those steps was a cut in the Fed Funds target rate from 5.25% to 0%, and eventually multiple rounds of quantitative easing aimed at adding liquidity to the system and reducing interesting rates further out on the yield curve.
Nearly a decade later, we are still debating the effectiveness of central bank actions. One thing we are not debating, though, is the effect those actions have had on loan yields for commercial banks.
While banks have some control over pricing on new business, there were trillions of dollars in loans tied to indexes, and as those indexes collapsed to record lows, they dragged bank revenue down as well. Bankers everywhere helplessly watched as their loan portfolios priced down to levels they had never seen before, often leaving too little yield to cover overhead.
For obvious reasons, all banks carry these battle scars with them into the current environment. A few banks were either skilled or lucky enough to have floors in many of their variable rate loans, and they significantly outperformed their peers. Those that missed out swore they would never make the same mistake again, and we see the proof of that in our clients’ loan pricing.
Variable-rate deals are more likely than ever to have floors included, and in fact, many are priced with floors that are “in-the-money” right out of the gate. While this behavior is certainly understandable, we see many banks running headlong into the unintended consequences of insisting on floors (including both contractual floors and mandates from management to “never go below x%”). This isn’t to suggest that all floors are bad. They absolutely have real value, and should be included where appropriate. However, banks need to approach them with “eyes wide open” to the potential downside.
We’ll start with the obvious one, which is that insisting on floors is often a competitive disadvantage. Many of the best credits are intrigued by how cheap overnight money is, and they are seeking out lenders who can help them get financing in place at these levels. They are willing to take some interest rate risk, but in return they want their bank to take some as well. For banks that are adamant about including floors, new loan volume will likely slow while prepays on the existing portfolio will speed up.
More concerning, though, is what the use of floors does to relative pricing of a bank’s own offerings. As an example, we recently spoke to a banker who had been given a mandate directly from the board.
“Our margins have slipped too far. From now on, don’t book ANY deals under 4.125%.”
The sentiment is understandable. For too many years now, the exit yields on business that is rolling over have been higher than replacement yields, and we long ago reached the floor on funding costs. There is simply no more blood that can be squeezed from the turnip, so banks are putting a stake in the ground in terms of yield.
The problem comes when you view that pricing decision from your customer’s perspective. For this particular bank, market pricing looks something like this:
Pricing along that curve makes the bank competitive for the types of credits they target, and they had been getting a decent mix of structures and durations. Look what happens when a hard floor of 4.125% is put in place:
The directors have met their objective in that the bank will no longer be booking loans with 3 handles. But, a borrower that would have been happy to borrow floating at Prime now must pay 4.125%. In comparison, they could borrow the same money for 5 years at 4.24%. Which would you choose?
As expected, the bank is seeing a huge shift in demand for longer term fixed rate loans. They have been blaming this on the competition, but in reality, their pricing is forcing their own customers out on the curve. In essence, they have put long term money “on sale” relative to overnight money, and if you looked at their pricing in a vacuum, you would assume that they have a preference for longer deals. That is most definitely not the case.
The real danger is that this risk is largely hidden. You have to dig pretty deep into a bank’s financial data to find the evidence, as on the surface, this banks has managed to stop the bleeding on loan yields. The long, downward trend has stopped, and margins are finally stabilizing. However, on a risk-adjusted basis, the bank has quickly become less profitable. They are earning the same yields for far more interest rate risk, and that risk is growing rapidly.
Since banks are pricing financial instruments, they often get hung up on the math, and forget that they are really just pricing a product in a dynamic and competitive marketplace. Your pricing decisions impact customer demand, often without the bank down the street being involved. Does your loan pricing reflect your appetite for loan types and structures? If not, check out our guidance on setting targets, and make some time for your management team to talk through the implications. Otherwise, your profit saving strategy for today might just be building some ugly risk you have to deal with tomorrow.