The Federal Reserve continues to gradually tighten monetary policy and increase the Fed Funds Rate. At the same time, the long end of the curve, while flattening over the last 12-months, has also risen. This has helped increase loan yields, but not nearly to the same magnitude as market yield curves.
A while back, we wrote an article that made the argument that the single largest profitability driver in loan pricing modelling is the Funds Transfer Pricing (FTP) rate (click to read). This rate is determined by matching the fixed rate term of the loan to the similar point on the funding curve. A simple example would be assigning the 5-year treasury rate to a 5-year fixed rate CRE loan. For amortizing loans, the term is reduced based on the average life of the principal. The difference between the loan rate and the funds transfer pricing rate determines the net interest margin.
Let’s look at a snapshot of the UST curve today versus 1-year ago.
The 3-year UST rate increased 127 basis points, while the 5-year UST rate increased 112 basis points. With all other assumptions like costs, provision expense, and capital allocation remaining the same, 5-year CRE loans originated today should carry yields 112 basis points higher than loans originated 1-year ago. If not, the Return on Equity (ROE) of that segment of the loan portfolio will deteriorate.
So, how are loan yields responding in this rising rate environment? We analyzed community bank data on new loans originated in 2016, 2017, and the first quarter of 2018. The data clearly indicates that the increase in loan yields is lagging the increase in market rates.
The average yield on 5-year CRE loans originated between March 2016 and March 2017 was 4.62%. In the next year, from April 2017 to March 2018, the yield on originated loans increased to 4.93%. This is only an increase of 31 basis points. The margin on these newly originated loans is 81 basis points below similarly structured loans from a year earlier.
There are many factors influencing this relatively modest increase in loan yields, including:
- Continued competitive pressures
- Strategic decisions to grow loan portfolios from existing liquidity
- Little to no increase in institution’s actual funding costs as market rates have increased
If this trend continues, banks that are booking 5-year fixed rate loans will continue to see a decline in their margins, especially as deposit costs increase across the industry. Now more than ever, proper loan pricing discipline is essential and should be an integral part of your commercial loan approval process.