Is your loan pricing strategy protecting the bank and the relationship?

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.

Alternative approach:

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.

Alternative approach:

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.

Parting thoughts

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.