The Potential Risks of Rate Floors and Minimums

March 20, 2020 Dallas Wells

As the COVID-19 pandemic has unfolded over the last few weeks, the Federal Reserve has taken several steps to stabilize the financial system. These measures, which have so far included two massive emergency rate cuts and an alphabet soup of funding backstops are unprecedented … with the exception of the financial crisis in 2008 and 2009. 

Just like last time, these moves have contributed to substantial volatility in the global markets, and PrecisionLender is fielding dozens of questions per day from client banks looking for guidance on how to proceed. In this post we will look back to 2009 for an understanding of what actions banks are likely to take, as well as some potential consequences of those actions.

During the financial crisis, the FOMC cut the Fed Funds target rate from 5.25% to 0%, and eventually enacted multiple rounds of quantitative easing aimed at adding liquidity to the system and reducing interesting rates further out on the yield curve.

Over 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.

Banks have some control over pricing on new business, but in 2009 there were trillions of dollars in variable rate loans tied to indices, and as those indices 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 in 2009 were either skilled or lucky enough to have floors on 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 have seen 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 over the last decade have been priced with floors that are “in-the-money,” right out of the gate. While this behavior is certainly understandable, we saw several banks run headlong into the unintended consequences of insisting on floors and nominal rate minimums (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, like all terms in financial instruments, there are tradeoffs, and banks need to approach them with “eyes wide open” to the potential downside. From our experience, there are three significant risks to evaluate.

Risk 1: A Competitive Disadvantage

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.

Risk 2: Added Credit Risk

Related to the first risk, banks that insist on floors risk self-selecting for weaker credits, especially if those floors are even slightly higher than others being offered in the market. Requests in times like this tend to come from two ends of the risk spectrum. On one end are the credits that are weak and are looking for funding to survive. At the other end are the strongest credits, which are being opportunistic and seeking better terms after big market moves.

A bank that is dogmatic about high floors in order to protect their margins runs the risk of being way too appealing to the former and chasing away the latter. Your volume in the coming weeks could be systematically lowering the overall credit health of your balance sheet through this attrition.

Risk 3: Duration Drift

Perhaps just as concerning as the credit risk is the potential to add interest rate risk, and it is always more subtle in landing on your books. Floors will definitely change your risk profile here, and the decision should be made with your overall rate exposure in mind.

In the aftermath of the last crisis, we spoke to many bankers who had strict minimum rate mandates, sometimes directly from the board.

“Our margins have slipped too far. From now on, don’t book ANY deals under 4 and 1/8.”

The sentiment is understandable. For many years, the exit yields on business that was rolling over was higher than replacement yields, with no relief from falling funding costs (which were already near zero). There was simply no more blood to be squeezed from the turnip, so banks were 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 a bank, market pricing might look something like this:

Pricing along that curve makes the bank competitive for the types of credits they target, and they can expect 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, many banks saw a huge shift in demand for longer term fixed rate loans. (It's a trend that appears to be re-occurring in recent weeks). They blamed this on the competition, but in reality, their pricing forced their own customers out on the curve. In essence, they 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 had a preference for longer deals. That is most definitely not the case.

So what happened? For a while, nothing. But, when rates finally started to rise, the industry saw higher net interest margins. These banks lagged behind, as their longer duration loans were repricing higher. They were stuck at the old, lower rates, and in some cases got squeezed as they had to increase their funding costs.

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 bank has managed to stop the bleeding on loan yields. 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.

Conclusion

Since banks are pricing financial instruments, they sometimes get hung up on their internal math, and forget 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, 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.

 

About the Author

Dallas Wells

Dallas is a writer, speaker and former consultant who has held executive roles at two banks with experience in capital planning, liquidity forecasting, investments, budgeting, financial reporting and mergers and acquisitions.

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