It’s probably not news to you that financial institutions find themselves in a unique and challenging rate environment. As writers and advisers, we often exaggerate the difficulty and challenges of any current environment. For example, no matter what anyone said about rates and the economy in 2015, it was still incredibly cheap to borrow money, whether from depositors or wholesale markets. But today’s environment is particularly difficult.

Even before the Fed’s rate cut in July, mortgage rates were starting to fall and have now fallen to their lowest levels in three years. Prime- and LIBOR-based loans are gaining about 50 basis points lower than at the start of this year, and those yields are certain to fall again if the Fed cuts rates again this fall. But the loan, in the form ofcost of fundshasn’t really been cheaper yet.

And unlike 2012, if demand for loans increases due to lower rates for consumers, deposit costs are not expected to decline as much because liquidity, or excess funding available from deposits, has largely dried up. over the past five years. This demand for retail deposits keeps deposit rates higher than they usually remain when wholesale rates begin to decline. In short, the wrong compression is applied to your net interest margin.

Is the stage set for an inevitable drop in yields?

One of the things that makes this difficult is that the active/passive models probably didn’t predict this. When forecasting the future in these models, the common practice is to assume that rate movements occur in parallel. If we model a rate hike of 200 basis points, our models assume that all rates rise by the same absolute values. In practice, this never happens.

For example, the yield curve went from a positive slope in the fall of 2012 to a convex shaped curve in 2019 where today the cost of overnight funding is higher than that of borrowing on 2-3 years. In retail deposit markets, this translates to short-term CD rates almost as high as long-term CD rates. In asset/liability terms, institutions that thought they were asset-sensitive in a rising rate environment were not, as their short-term funding costs rose more than predicted by the models. And now that rates are falling, some institutions’ loan yields could fall more than their cost of funding.

But are these lower returns inevitable? Let’s compare the institutions, because the story may be different.

The following charts show the relative performance of 248 Midwest institutions that we consider high performers and 980 Midwest institutions that we consider poor performers. (In these peer groups, the best performing banks were those with an ROE above 16% and an asset size below $1.5 billion. The worst performing banks were those with an ROE below 9 % and asset size less than $1.5 billion.) loan growth, cost of funding, and the performance of these institutions over the past five years, we have noticed some interesting differences between these two groups.

For example, we often find that high loan growth rates don’t always translate to increased revenue. We also noticed that there is not a big difference in financing costs between the two groups. And in fact, the funding costs of our top performing banks in the Midwest have been higher than those of the underperforming ones over the past year. While there are various reasons why some institutions perform better than their peers, we generally see better loan returns in high performing institutions, and we have noticed this difference with several peer groups.

Factors behind declining loan yields

There are a few basic reasons why one institution will earn less return than another. The first is the composition of the loans. If you are heavily focused on retail mortgages that you keep in your portfolio and aggressively price, you will have a hard time making money due to the market nature of these loans. On the other hand, if you primarily do specialized commercial lending and have particular expertise, you are likely to earn more returns.

A second possible reason: some institutions set aggressive prices with the same products that their competitors offer in order to promote growth. So, as price leaders, they are willing to accept less return for the same loans in order to create volume.

But there is a third possible reason why some institutions winless return on loans, and this reason is often less obvious. You may be earning less on loans because you are not getting paid enough for the risks you take. Lenders earn a margin on loans because they have to cover their operating costs, but also because they bear credit risk, interest rate risk and liquidity risk. You know that lending to people with lower credit ratings means you have to charge more to cover any additional credit losses.

But how much more do you charge? In the majority of the institutions we speak with, the lending function looks to market and competitor rates to make these decisions. And with commodity loans like a conventional 30-year mortgage, institutions need to gauge what the market will bear. Are these market-based rates enough to cover costs, especially compared to other personal lending alternatives available?

Options when NIMs are compressed

So what are financial institutions doing in the face of this pressure they find themselves in today? Do they focus on reducing operating costs? Certain institutions are certainly considering this, as we have already seen the case of a large regional bank announcing layoffs and blaming them on the net interest margin scenario described above. Other institutions might see continued growth as a solution. “If I can take market share from other institutions, I mitigate the net margin loss with higher volume,” is the way the thought goes. There is another choice. Your most valuable asset/liability management tool is your retail price. You derive the majority of your income from the net interest margin; therefore, successful pricing is your best opportunity to maintain that margin.

What’s the best way to successfully price and become a high earning institution? We believe that an essential part of long-term success is using a disciplined team loan pricing process which uses a kind of pricing model to quantify the different risks you take. We strongly believe that high-income institutions are finding ways to be better paid for the risks they take. For example, it is common for institutions to avoid longer-term fixed rate loans due to concerns about the interest rate risk they are assuming.

But financial institutions have long provided fixed rate loans. We have the data and the techniques to assess how much this risk costs to cover. And we know how valuable a fixed rate is to a borrower because they express their preferences for that option through the market. Your job is to assess this value and decide if you want to price enough to satisfy the cost of risk.

Effective loan pricing starts with a framework

Aefficient loan pricingThe process begins with a decision-making framework that assesses all of your opportunities and makes decisions based on facility-level goals. For example, some institutions will set the price in order to achieve a specific loan ROE or ROA, while others will set just enough to earn more than alternative wholesale investments. Once this framework is in place, a model is needed to assess and compare different types of loans and different credit ratings.

In order to capture all risks and costs, loan models should capture all specific cash flows, which include regular amortization payments, prepayments, operating expenses, and a credit loss projection. After that, a model needs to account for interest rate risk and option risk. This is typically accomplished by using funds transfer pricing techniques to calculate the margin needed to eliminate interest rate and option risk. Finally, a competent lending model can also assess the relative value of sets of relationships – calculating the value of bringing deposit accounts with loans, or the discounting potential of loans when multiple types of loans are issued with one borrower.

With a pricing mechanism in place, a regular practice can be established for making pricing decisions. In the case of commodity or rate loans, a pricing committee will periodically review performance (originating volume) andrelative profitabilityagainst goals and decide when and where to make changes to product configuration and pricing.

With commercial lending, a model can be used to assess individual loans or lending and deposit relationships to ensure that the institution’s objectives are being met while meeting the needs of the borrower to the extent possible. possible. For example, one of the best uses of a model in submitting business offers is to learn and know when to walk away from unprofitable relationships.

Lower interest margins are not inevitable

We believe that lower interest margins are not inevitable. If you have loans that are indexed to prime or LIBOR, you are clearly going to lose yield on those loans as market rates go down. But you have ALCO and pricing tools to mitigate those losses as market rates change. Fixed rate loans don’t have to follow the market; many institutions simply assume they have to do this to maintain their original balances.

But without a disciplined process using pricing tools, you allow the market to set rates and therefore your spread. You have other choices. In order to create a high-yield loan portfolio, you need to understand where and why you’re earning yield, and whether you’re being compensated for the risks and costs associated with those opportunities.