The unprecedented drop in short-term interest rates over the past two weeks has raised the specter of a sharp decline in net interest margin (NIM) for commercial banks. As the indices used to price commercial loans – primarily LIBOR and Prime – fall, the gap between lending rates and banks’ funding costs shrinks. In a stable spread environment, this leads to an erosion in NIM.
Indeed, over the past several years, NIM has been highly correlated with one-month LIBOR, the most common index used on middle market and large corporate commercial loans.
Source: FDIC and St. Louis Federal Reserve. NIM figures reflect aggregated call report filings for all U.S. commercial banks, as of December 2019. One-month LIBOR rates reflect quarter-end levels, except for the latest figure, which is as of March 19, 2020.
The recent declines are reminiscent of those which happened at the start of the Great Recession (in 2007-08), though the latest cuts have been implemented far more swiftly, and earlier than most bankers would have expected at the start of the year.
Source: Fed H.15 release and St. Louis Federal Reserve.
Lessons Learned from the Great Recession
While the differences between the 2008 recession and the current pandemic are numerous – not the least of which is the broader scope of the current downturn across all industries and the more rapid onset – the approach banks used to protect NIM 12 years ago may be relevant today. For most banks, it was some combination of wider margins and the implementation of interest rate floors.
At that time, rate floors were not a tough sell. A Prime rate of 8.25% remained in recent memory and no one expected the 3.25% rate to last long. After all, rates had never stayed at the same level for an extended period and Prime had not fallen below 4.5% since the 1950s.
Not surprisingly, when a few banks started to ask for a modest all-in rate floor of 4.5% to 5% across their bilateral portfolios, they encountered limited pushback. The floors continued to be rolled over on most renewals and generated significant incremental spread for several years.
Concurrently, syndicated lenders began implementing LIBOR floors – a floor on the benchmark LIBOR rate rather than the overall interest rate. This was perhaps an even easier sell to issuers, as it was a necessary component to getting the deal syndicated.
The experience for banks who were late to the game and tried to implement floors in 2010 or 2011 was quite different. For those banks, implementing floors meant a net increase in pricing for customers who had become accustomed to low rates. That was a much tougher sell, and few banks who attempted such an endeavor were successful.
That is why banks should now strike while the iron is hot, implement floors which are still lower than the rates customers paid a month ago, but well above the current lending benchmarks.
Already, LIBOR floors have made a comeback in the syndicated loan market, and a growing percentage of the market is seeing floors in the 1% range. Bilateral lenders report somewhat higher LIBOR floors of up to 1.5%, and banks who have implemented all-in rate floors report levels ranging from 4-5%. There are also other banks who only have a 0% floor embedded in their loan documents, to protect against the (hopefully) unlikely scenario where rates turn negative.
Where Are All-In Rate Floors Being Set?
PrecisionLender’s data (through March 19) indicates that, where implemented, all-in rate floors are most commonly set at 3.5%, with nearly two-thirds of the volume carrying a floor between 3.0% and 4.0%.
Source: PrecisionLender. Chart reflects floating rate loans where a rate floor was proposed. Analysis only includes deals priced from 3/1/2020 through 3/19/2020.
How Quickly Are Banks Moving to Implement Floors?
Based on the number of calls PrecisionLender has received on this topic over the past two weeks, it is safe to assume that most banks that had not previously implemented rate floors are considering doing so now.
Already, the trend data suggests that rate floor incidence has been increasing since the middle of last year, as short-term rates headed south (Figure 4). About one-third of all floating rate deals priced on PrecisionLender’s platform in the first quarter of 2020 were modeled with a floor. Rate floor incidence has increased markedly so far in March (through March 19), jumping to 38%. Those figures are likely to accelerate as banks firm up policy around rate floors and work through any logistical issues pertaining to documentation and Loan Ops.
Source: PrecisionLender. Analysis reflects the incidence of floating rate deals priced with a rate floor on the PrecisionLender platform in the indicated period. March 2020 data is as of 3/19/2020
Guidelines for Implementing Floors
1. Make sure rate floors are implemented as bank policy – if floors are not mandated and communication is unclear, success will be limited.
2. Work with legal to get standard language incorporated into loan documents and establish a process for managing exceptions.
3. To the extent that floors will be implemented on the index (e.g. LIBOR floor) rather than the all-in rate, work with Loan Ops to ensure the relevant base rates have been added into the loan system.
4. Arm bankers with the right negotiating tactics, including
- Be transparent but without excessive discussion.
- Where needed, explain the rationale: the narrowing gap between cost of funds and lending rates. Share the rate data with your customer, if appropriate.
- Explain that, in order for the bank to be a strong financial partner who can continue to fund the customer’s business, it is important that it earns a fair margin over its funding costs.
- Put the floor in context – Relative to the rate the customer was paying last month, this deal is cheap financing even with the floor.
In addition, banks should think through the merits of implementing LIBOR floors, which preserve the bank’s risk and size premiums, versus all-in rate floors. If considering all-in rate floors, think about varying the levels by at least a few tiers to minimize the risk of adverse selection. Read more in this blog post, which discusses the pitfalls of rolling out a portfolio-wide minimum rate.
