Funding with a Flat Curve
Recently, we have heard a lot about flattening the curve but what do you do with pricing when dealing with a flat loan yield curve? It’s not as if we haven’t faced this before but it has been some time, so we need to dust off our memories and recall what strategy was used. A flattening yield curve may be a result of long-term interest rates falling more than short-term interest rates or short-term rates increasing more than long-term rates. A flat yield curve is typically an indication that investors and traders are worried about the macroeconomic outlook.
Currently, the spread between the overnight advance rate and the 10-year rate is 125 basis points and the Treasuries are even a bit tighter. In order to make a reasonable return of a loan you take the interest income, less operating expenses, less risk provisions giving you net profit. Return on Assets (ROA) is calculated net profit after tax divided by the average asset. Return on Equity (ROE) is calculated ROA/Capital.
Most borrowers want to lock in a fixed rate at these lower interest rate levels. And a financial institution (FI) will be holding on to these lower rate loans for full term most likely. Eventually, when the yield curve steepens, the FI will have a low yielding loan on the books for the duration of that loan. The likelihood of prepaying the loan lessens dramatically when dealing with historical low rates.
Match funding in the traditional sense which includes prepayment penalties would be an option, but borrowers are hesitant to lock into the term with a penalty. Even interest rate swaps from fixed to variable can be pricey and narrow the spreads even further. If the borrower agrees to a floating rate, a floor can help protect the FI and of course the borrower will want a cap/ceiling to protect them from rising interest rates in the future. A compromise may be in offering an adjustable rate product where the interest rate schedule includes a fixed rate and a variable rate.
More importantly, using analytics to truly understand your portfolio mix and how well the FI’s assets match up in terms of duration with its deposits should provide insights what mismatches exist in the portfolio. This could lead to a new product offering on the deposit side of the balance sheet to meet expected demand and subsequently narrow what they offer to strengthen A/L objectives.
Some institutions can decide to quit fixed rate lending in the commercial sector until the spreads widen sufficiently to offset their operating expenses. Generally, lines of credit are floating rate instruments. Consumer loans are traditionally priced off the short-term rates either fixed or not
A flat yield/funding is difficult to address because of the risk/return aspects of lending. The inability to obtain a fair return requires employing differing strategies that fit to your markets and the composition of your balance sheet. Analyzing the portfolio and market expectations and using the tools available will provide insights as to what direction to move when dealing with a flat yield curve.
Posted on Wednesday, May 6, 2020 at 9:15 AM
by John Robertson