introduction
In the commercial lending world, the prime lending rate has traditionally been reserved for borrowers with the highest credit scores and deemed least likely to default. Borrowers with lower credit scores are typically charged a higher interest rate above the prime rate.
The prime rate is typically 300 basis points (bps) above the federal funds rate target, but many financial institutions set their own bank-specific prime rate.
To combat inflation and stabilise economic activity, the Federal Reserve has raised its target interest rate by 525 basis points over the past two years. The prime rate tracks directly with the federal funds rate, and the rest of the U.S. Treasury (UST) interest rate curve, which represents market interest rates rather than administered rates, has also risen, but to a lesser extent.
Market rates reflect investors' long-term inflation expectations and other market forces and may or may not track changes in managed rates. In the current market cycle, these fundamental rate changes and intense competition among lenders have resulted in many new loan rates being quoted at more than 100 bps below prime rates. In this very challenging environment, two important questions arise:
Prime Minus Lending
Why are we seeing so much “prime minus” lending, and how should lenders respond to these market forces that are putting pressure on margins?
First, let's look at how the UST curve has changed over the past few years.
This table shows the change in the U.S. Treasury yield curve over the past three years. Federal Reserve System. federalreserve.gov.
While the US economy was dealing with the impacts of the COVID-19 pandemic, the US government, the Federal Reserve and the US Treasury were busy providing fiscal stimulus and relief. The CARES Act and the American Rescue Plan, as well as monetary policy measures such as quantitative easing, zero interest rates, the Paycheck Protection Program, student loan forbearance and stimulus checks to individuals, flooded the markets with liquidity. Bank deposit balances soared.
As the pandemic eased and consumers returned to work and resumed normal purchasing patterns, supply chain bottlenecks and increased liquidity from stimulus packages pushed inflation up to levels not seen since 1981. These inflation fears pushed long-term interest rates higher. Between June 2020 and June 2022, the benchmark 5-year Treasury note for commercial loans rose 272 basis points, while short-term rates rose just 125 basis points. In response to the rapid rise in inflation, the Fed began raising its target interest rate. The federal funds rate was raised 11 times in 17 months, for a total of 525 basis points. Initially, the Treasury yield curve maintained a positive slope, but eventually, the longer end of the yield curve was unable to keep up, resulting in its current inverted curve.
The following graph shows how the UST curve has changed over time: Notice that while the short-term portion of the UST curve has historically tracked the Federal Funds rate very closely, the long-term portion has not.
Graph showing change in the U.S. Treasury interest rate curve over the past three years. Federal Reserve System. federalreserve.gov.
So let's look at how this sudden increase in interest rates has affected bank performance. The table below shows median data collected from all commercial and thrift banks with total assets under $10 billion.
Bank performance metrics for the past three years. New volume rates from S&P Global Market Intelligence – LoanPricingPRO®.
From late 2020 through mid-2022, both loan yields and deposit funding costs declined. On the lending side, contractual repayments were replaced with new loans at lower interest rates. Weak demand for commercial loans and competitive pressures pushed interest rates on new loans below 4.00%. Non-interest-bearing and other low-cost deposit balances continued to grow, resulting in debt costs bottoming out in mid-2022.
Starting in the third quarter of 2022, banks began to raise (and receive) interest rates on commercial loans. Long-term interest rates on U.S. Treasury bonds, i.e. 10-year bonds, also rose, driving up interest rates on new mortgages. As banks postponed increases in deposit rates, net interest margins temporarily increased. As can be seen in the graph below, by mid-2023, increases in deposit costs outpaced increases in loan yields, causing margins to decline. This trend is expected to continue as the pace of increases in loan yields slows and deposit costs continue to increase.
Comparison of Loan Yields and Cost of Funds. New Volume Rates from S&P Global Market Intelligence – LoanPricingPRO.
There are many reasons for this increased margin pressure, but one of the main factors is the way commercial loans are priced. Below is a chart comparing current loan yields and, more importantly, new loan rates to prime interest rates.
Through the end of 2021, bankers remained disciplined in achieving spreads above prime rates on new commercial loans. Yield spreads were 40-60 bps above prime rates, even as interest rates were at historic lows and they faced stiff competition.
Since mid-2022, a dramatic shift has occurred: interest rates on new loans, while still rising, have fallen to a negative spread over prime rates. This trend worsened by the third quarter of 2023, when they fell to almost 100 basis points below prime rates.
Loan yields relative to the prime rate. New volume rates from S&P Global Market Intelligence – LoanPricingPRO.
There are likely many reasons for this trend. Competition remains fierce with too much liquidity and too few loans available. Also, yields on alternative investment options are currently significantly below new loan interest rates. To many lenders, a 7.50% loan rate looks attractive when compared to the 4.00% interest rate on a new loan 18 months ago. Finally, some believe that interest rates have peaked and will soon start to fall. These are all common reasons to consider locking in a loan at an interest rate below the prime rate.
However, we must not forget the increasing funding costs of these loans.
Banks with a disciplined pricing model can easily calculate the impact of today's environment on their bottom line. This should include a profitability analysis of the entire customer relationship, not just loan revenue. The decision to offer a commercial loan at a lower than prime rate should be based on proper pricing analysis.
LoanPricingPRO® Scenarios
Two years ago, the average corporate customer had loans with interest rates 40-60 basis points above prime interest rates, as well as significant non-interest bearing deposit balances. Value was given to these deposits through the funds transfer pricing process, allowing loans to be priced very competitively. The example below shows a floating rate loan priced at prime interest rates, with profitability slightly below target. However, when the compensating non-interest bearing deposits are added, the ROE for the entire customer relationship exceeds the bank's minimum target level.
June 2021 – Floating rate loans and large interest-free deposits at Prime.
Fast forward to today. If this loan were renewed or exchanged at a “prime minus” interest rate, the relationship could still be profitable, provided the cost of the same deposits had not risen by more than the change in market interest rates. But if the interest rates paid on these deposits increased significantly, or if they were transferred to high-yield CDs or money market accounts, the value of these deposits would decline and they would no longer be able to support the lower loan rate. In this case, the loan rate would have to go to a much higher “prime plus” rate to compensate for the higher cost of deposits.
Current environment – floating rate loans at prime minus 100 bps and large NIB DDA.
Current environment – Prime plus 100 bps floating rate loans with high cost of deposits.
Conclusion
In today's challenging environment, there is no one-size-fits-all approach to pricing commercial loans. However, a disciplined approach to pricing, coupled with a thorough understanding of relationship profitability, can help banks remain profitable in any interest rate environment. To learn more about Forvis Mazars' strategic loan pricing solutions, visit our LoanPricingPRO® page.