We all know it will happen, the real question is when? As the Federal Reserve monitors unemployment inflation and global markets closely, it is widely expected that the federal-funds rate will be increased in the last quarter of 2015. It has been almost ten years since the Fed raised rates! The Fed dropped rates from 2006 to 2008 and has held them steady ever since. An increase in the federal-funds rate would signal a dramatic change and should cause all financial institutions to consider the impact of a rising rate environment on their portfolio. This will likely cause clients to reassess their products, services, and rates with their existing FI.
Now is the time to:
- Quantify the impact of rising rates on your earnings – thru the use of an Asset Liability Management (ALM) tool or service.
- Devise customer facing strategies to protect profitable clients and provide pricing guidance.
Today I’ll focus on the customer facing strategies.
Background - As rates rise, we will feel pressure to pay higher rates to depositors and seek to gain higher rates from loan clients. Our existing portfolio of fixed rate instruments (fixed rate loans, CDs and variable rate loans with “in the money” floors) will not immediately change. These rising rates will likely cause an FI’s interest expense to rise more quickly than their interest income, thereby causing some margin compression. Since margin has historically represented 60-65% of an FI’s revenue, this margin compression should be of paramount concern. (See below)
In looking at margin trends this return toward more normal loan to deposit spreads shouldn’t be a surprise.
In 2007, our loan to deposit spread was 265bp (7.07% - 4.42%). It then grew dramatically during the financial downturn as deposits moved to FIs and the fed pushed rates lower. The result was a healthy loan to deposit margin of 420 – 480bp from 2009 to 2015. This additional 200bp of spread for the banking industry has been worth over $300 million in additional margin annually, but it is likely to decline as rates rise.
DEPOSIT TO LOAN SPREADS
As we see rising interest rates, the key client facing questions become:
- How do we “protect” our most profitable relationships?
- How do we price transactions competitively and aggressively to win profitable business?
How do we “protect” our most profitable relationships?
To protect these relationships the first thing we must do is understand who these clients are. In most FIs, we see that the profitable relationships are concentrated in the top 20% of clients. As illustrated below, the top 10% of clients deliver an average profit of $4,623! These “protect” clients tend to have larger balances, pay higher fees, and have higher spreads than other clients.
We must identify these clients and build strategies to make sure they never leave. I previously published a blog titled “Key Client Identification and Retention”, which includes several tactics around protecting these clients including:
- Segment these clients into various profit tiers (or ranks)
- Build a series of “benefits” associated with each rank
- Feed these ranks into your core and CRM solutions
- Train your employees on how to extend these benefits to key clients
How do we price transactions competitively and aggressively to win profitable business?
When pricing new business we must focus on the proposed transaction and ensure that we are competitive enough to win the business while also maintaining an adequate return.
Competition is tight but we must avoid “blindly matching our competitors” on every transaction. This would create a “race to the bottom” with the clients benefitting at the FIs cost.
We must establish targeted returns and provide the lenders tools and education to effectively compete. A lender must have a tool that allows them to quickly enter in parameters of the transaction and generate various alternative scenarios with comparable returns.
FIs that offer their clients’ options win more business. Clients like choices: fixed, variable, adjustable, lower rates/high fees, floors, etc. The options put the client in the driver’s seat but also ensure the FIs returns are adequate.
Pricing is very complex with balance, credit risk, terms, floors/ceilings, and compensating balance all playing a factor into how a transaction should be priced.
Conclusion: With rates rising and risk of margin compression squarely in front of us, we must make sure our front-line staff have the tools necessary to identify and protect profitable relationships and effectively price new transactions.