Is your loan pricing strategy protecting the bank and the relationship?
Head of Sales
Financial Institutions | Denver, CO
Client Relationship Management
Financial Institutions | Denver, CO
Two noteworthy loan pricing strategies at community banks have developed in the current rate environment. While well-intentioned, they may not produce the desired outcome of protecting the bank and the relationship.
This piece will expand on the hedging strategies that protect the interests of all parties in the financing transaction. Banks improve their long-term margin and offer borrowers lower-fixed rates with hedging tools.
Observed trend 1: Fixed-rate, on-balance-sheet lending = one-way floaters
Fixed-rate commercial loan pricing is now as high as 8.5% or more. Bankers and investors are eager to take the opportunity to earn attractive yields and fix the rate long-term if they can. While high-fixed rates are attractive, we should ask how fixed these loans are and for how long. Reduced credit availability incentivizes borrowers to accept the offered rate, but how long will they stay when rates fall? History shows that borrowers are likely to demand repricing when rates come down.
This puts bankers in an uncomfortable situation: tell the borrower no and risk the relationship or agree to the waiver and lose the yield.
The best approach for the bank and the relationship is to offer a floating-rate loan with an interest-rate swap. The borrower gets a lower fixed rate: on average, five-year swaps closed in the second quarter of 2023 resulted in borrowers getting a swap rate 1.15% lower than the balance-sheet rate for the same maturity. The borrower is less likely to demand repricing with a lower fixed rate. And if they do require repricing, swaps’ market-based termination costs ensure that both parties are treated fairly.
Observed trend 2: High-strike (throw away) floors
Bankers who bypass the one-way floater quandary and choose instead to offer floating-rate loans have prudently begun to add interest rate floors. Embedding floors in floating rate loans is widespread and, when used appropriately, can be good protection for a bank’s margin.
However, some banks are pursuing high-strike floors, i.e., 100 basis points or less below current Prime or SOFR indices.
Like a one-way floater, borrowers with high-strike floors will likely demand that the bank waive the floor when short-term rates fall. Bankers will be in the same uncomfortable position: tell the borrower no and risk losing the relationship or say yes and lose the protection.
Banks should consider lower-strike floors which are less likely to be thrown away in a falling-rate environment. And as a supplement, banks whose interest income decreases in falling rates should consider buying rate protection in the form of a floor or collar (a purchased floor whose cost is offset by a sold cap). While the idea of paying for rate protection may seem illogical if the financial institution can get the floor at no cost, the value of a purchased floor is that it can’t be thrown away – the dealer bank who sold the floor is required to make payments and can’t renegotiate the agreement.
If your bank is exposed to one-way floaters or throw-away floors, use hedging tools like borrower swaps and balance sheet hedges like floors or collars to protect the bank and provide better solutions to your customers. Banks with these hedging solutions have a decisive competitive advantage and an equally powerful retention tool.
Contact us today to learn how your financial institution can improve your long-term margin and offer borrowers lower-fixed rates with interest rate swaps.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.23-0163
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