Financial institutions have battled margin compression during much of the sustained period of low interest rates. According to the Federal Reserve, since 2010, net interest margin for all U.S. banks has fallen from 3.83 percent to 2.95 percent. As loan demand has started to strengthen, many financial institutions are looking at commercial lending as a potential avenue to boost margins and profits. However, competition for loan business in many Southeastern markets is fierce, and institutions holding onto traditional expectations of wider margins on commercial loans may find themselves losing out on the deal.
Whether the Federal Reserve raises interest rates later this year or next, the FOMC has suggested that the pace of any increase will be incremental and slow, unless global economic conditions improve significantly and inflation in the U.S. heats up. Financial institutions are likely to face margin compression in a low-rate environment for some time. Given these conditions, a simple shift in pricing practices can help a lender align itself more closely with local competition and win more business.
When pricing a loan, consider the following two important questions: what is the average life of the loan asset and what is the credit quality of the borrower compared to alternative investment opportunities?
Average Asset Life
The actual life of a loan is usually much shorter than its initial maturity. For example, we can assume that the average life of a 10-year commercial loan is only five years. When pricing such a loan, a lender taking a traditional approach may use the full maturity to determine an interest rate and a desired net interest margin. However, in today’s market, this approach leaves the door open to competitors.
A more reasonable approach in a competitive market may be to compare the commercial loan to alternative investments, such as mortgage-backed securities, at a maturity that matches the loan’s expected average life. Assuming a five-year average life of a 10-year loan, the lender could look at five-year mortgage-backed security yields for comparative purposes. This comparison may be helpful to reset expectations on what defines an acceptable yield for the commercial loan, giving the lender more flexibility to price it competitively in the market.
Comparing Credit Risk
In the debt markets, credit quality determines yield: the higher the credit quality, the lower the yield an investor is willing to accept. Likewise, borrowers with excellent credit profiles generally receive lower interest rates on loans compared to borrowers who pose greater risk to the lender. Taking this concept a step further, comparing a prospective borrower to a similar credit quality investment in the debt market can help inform a pricing decision and enhance a lender’s competitive position.
Consider, for example, a restaurant franchisee that is seeking a commercial loan to open a new location. This operator has been in the business for years, owns multiple other successful franchise locations, and has strong financials. This borrower would likely get a top credit rating from the lender. For pricing purposes, it would be reasonable to compare this loan asset with other highly rated debt investments, such as AAA and AA bonds. What are those assets yielding in the market today? These yields can serve as a basis for the lender’s pricing decision.
Funding to Hedge Risk
The right funding plan can complement a more competitive pricing approach and help institutions hedge the risk of holding longer-term loans on the books.
Two examples of hedging risk using FHLBank Atlanta advances are highlighted below.
Floating Rate Advance with a Cap
FHLBank Atlanta’s Adjustable Rate Credit (ARC) advance with an interest rate cap can create an effective hedge against interest-rate risk associated with longer-term loans. The ARC provides intermediate- to long-term funding tied to one-month or three-month LIBOR. The interest rate resets at periodic intervals, adjusting with market conditions. Adding the interest rate cap protects the shareholder if rates move above a predetermined level at a specific date. Once the advance rate hits the strike rate of the cap, FHLBank Atlanta compensates the shareholder, thus reducing the all-in cost of the advance. The shareholder may pay more initially, but this structure adds flexibility to the shareholder’s liability profile while potentially reducing funding costs.
Fixed Rate Borrowing Blended with Deposits
FHLBank Atlanta’s fixed-rate advance products can also help mitigate the interest-rate risk of holding long-term fixed-rate loans on the books and help an institution gain a competitive pricing advantage. Furthermore, creating a blended funding mix of advances and deposits can help guard against higher rates while minimizing funding costs.
This simple tactic is particularly effective when using a ladder of Fixed Rate Credit (FRC) advances of different maturities. The following example shows a funding mix of 50% advances and 50% deposits. Advances include a one-year FRC at 0.52%, a three-year FRC at 1.16%, and a five-year FRC at 1.70%. Assuming an average deposit rate of 0.65%, the initial blended funding cost is 0.89%. As each advance rolls off, deposits are rebalanced to 50% to mimic principal pay-down on assets.
FHLBank Atlanta offers other products that can help shareholders compete for commercial loans while preserving net interest margins. To learn more about strategies presented in this article and other products, contact your relationship manager at 1.800.536.9650.
John Carney, “Fed Move is No Sure Thing for Bank Profits,” Wall Street Journal, Aug. 16, 2015.
The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial, and accounting advisors before entering into any transaction. Interest and advance rates presented in this article are for illustrative purposes only.