4 Mistakes Banks Make When Pricing Fixed Rate Loans

When it comes to fixed rate loan pricing, we see banks doing some crazy stuff. For example, if your bank is pricing a fixed rate spread using a floating rate index like Prime, then go straight to jail, don’t go Go and collect $200, – that’s an asset-liability tragedy. It’s also just as bad to pull a fixed rate out of thin air or base the fixed rate on the competition without knowing what the interest rate risk is. Given recent price volatility, if your bank does this, you might find that you are 20 basis points or more in the hole.

Mistake 1 – Please never make this mistake

The problem with using a floating rate index to price a fixed rate loan is that the floating rate index (Prime, Libor, etc.) excludes interest rate risk. Thus, using this methodology transfers 100% of the interest rate risk to your bank without the appropriate price increase to offset that risk. In a volatile and rising rate environment (made worse when rates start to get low, as they are now), the risk can sometimes be half of the total risk of a loan. Banks that ignore the interest rate begin by undervaluing the loan. Do this enough times and the bank will have eight times their leveraged capital with the odds of success heavily stacked against them.

Mistake 2 – Your current cost of funds is not your future cost of funds

As above, many banks calculate a spread to their current cost of funds. A bank’s current cost of funds also does not take interest rate risk into account. Over time, a bank’s cost of funds will change in very predictable ways, so why not factor that in?

Error 3 – This error is close, but not optimal

Although a bit better, but not ideal, pricing your fixed rate loans against FHLB Advance rates or Treasury bills is problematic. The good news is that both of these methods, if used correctly, take interest rate risk into account. The problem is that when you use FHLB advances, you get FHLB’s cost of capital, cost of funding and credit risk built in. This probably doesn’t apply to your bank, so depending on which FHLB you use, you could be under or overvalued. your risk. Even more concerning is the use of treasury bills or constant maturity treasury bills, as this index is devoid of any credit premium. The use of treasury bills also subjects banks to liquidity risk which generally serves to understate lending risk when banks price the index. For example, if the 10-year (or 5-year) treasury note is “special” or in demand in the repurchase agreement market, then the note may be bid higher, lowering the yield. Pricing issues can also arise during volatile global markets (like today) when central banks and foreign corporations store their cash in the safety of treasury bills. This results in artificially depressed returns relative to interest rate risk, causing banks to undervalue their loans.

Mistake 4 – The most common of all

In addition to the above, another error that occurs a significant percentage of the time is when banks price their loans on an index that matches the maturity of their loan without considering amortization, prepayment structure, credit risk or expected life. A 10-year maturity for a low loan-to-value/high-cash-flow home loan with 10-year amortization with no prepayment protection shouldn’t be off the 10-year index price, but something a lot shorter. The expected life of this loan is around three years with no interest rate movement, and if rates drop in the short term, it could be closer to six months.

Here is a solution

To begin with, banks need to calculate the expected life of their loans taking into account the amortization and expected prepayments. Banks must then match these cash flows to the appropriate index. The best to use is the swap rate which can be found HERE on the Fed’s H15 page. The swap rate is the most liquid index to use for interest rate risk and therefore the most accurate. Additionally, the index has a built-in “AA” credit risk, so although it does not fully capture general market credit risk, it does come fairly close to it. Banks must add their credit risk premium (spread) to this number to arrive at the appropriate fixed rate, taking into account interest, credit and liquidity risks.

To make it easier for financial institutions, we’ve created a fixed rate loan calculator that easily calculates term based on amortization and maturity, plus includes the current market swap rate. This tool is located HERE. There, we can also generate a personalized borrower presentation with your bank’s logo and colors. The video below can be used to teach bankers more about how to best use this free tool and to help better understand how to price fixed rate loans more accurately.

Given the threat of rising rates, this is going to happen more and more at community banks, so having a full working knowledge of how to originate and price fixed rate loans can be the difference between success and average performance.

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CenterState Bank is a $4 billion community bank in Florida that is experimenting its way to becoming a $10 billion top performing institution. CenterState has one of the largest correspondent banking networks in the banking industry and makes its data, policies, vendor analytics, products and insights available to any institution that wishes to journey with us.

About Brandon A. Hood

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