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10/19/2017

Finding the Right Mix of Fixed and Variable Loans in a Rising-Rate Environment

Barry Adcock October 19th, 2017

Most consumers probably understand that when the Federal Reserve increases its benchmark federal funds rate, it’s only a matter of time before the corresponding rise in interest rates hits their wallets. How will mortgage seekers react to the rising-rate environment?

It’s probably a safe prediction that rising interest rates will spur increased interest in fixed-rate mortgages over variable-rate loans. Borrowers seeking new mortgages will likely want to lock in a rate that they can depend on staying stable throughout the life of the loan, rather than take a chance on an initial low rate that could trail escalating interest rates — and leave them paying thousands more when their adjustable-rate mortgages reset after a few years. Anyone currently in an ARM may also feel very inspired to refinance it into a fixed-rate loan.

A rising-rate environment will almost certainly fuel increased consumer interest in fixed-rate mortgages, while whittling away at banks’ portfolios of variable-rate products. Community banks face multiple challenges in maximizing the opportunities presented by greater consumer appetite for fixed-rate loans, including a tactic bigger banks have begun employing — making very low-interest fixed-rate loans for longer and longer terms.

Bigger banks have a broader deposit base, more adroit risk management, and the wherewithal to endure making a little bit less off a longer-term, fixed-rate loan. While larger banks have ample tools they can use to hedge their positions, many smaller banks would find themselves upside down if they tried to employ the same tactics.

What do community banks need to do in order to compete in a rising-rate market where consumers gravitate toward fixed-rate loans?

Understand and account for fixed-rate risks

Risk is an unavoidable reality of banking, but that doesn’t mean community banks should jump into taking perilous risks just to remain competitive with bigger banks. A rising-rate environment is probably not the optimum time for a small bank to begin experimenting with questionably priced loan products that include unsustainable terms and unrealistically low rates.

Rather, community bankers should ensure they understand the real risks in fixed-rate loans and equip themselves with the tools they need to account for those risks in their pricing.

Maintain a good mix

Selling variable-rate loans may be more problematic in a rising-rate environment, but it’s essential community banks continue to maintain a good mix of fixed- and variable-rate loans in their portfolios. Be prepared to continuously model and adjust balance sheet options, including portfolio size or duration, loan and deposit durations, funding mix and transactional terms.

Off-balance sheet options

Community banks that find they require moderate to severe course correction treatments can look at off-balance sheet items. While these options may be more expensive in the long run, their effect is immediate. Such treatments include options, caps, floors, collars, interest rate swaps, liability-sensitive swaps, and asset-sensitive swaps. One caveat — use data and modeling to ensure your board is comfortable with these off-balance sheet items.

Prepare for the next downturn

Given the rising-rate environment and current economic realities, it’s possible the next downturn could occur as early as 2018. The last downturn greatly affected banks that had failed to apply floors to their variable-rate products. Put floors in place now, when they’re less of a concern for borrowers (and your competitors), so that when a downturn occurs your profit margin is protected.

If you are intrigued about being prepared for this volatile time in the market for community banks and credit unions, I have just the resource for you. We teamed up with Orlando Hanselman of Alligators Overhead Strategy and Risk Advisors LLC and Eli Mullis, CFO of WB&T Bankshares to discuss strategies to better position your institution for the next rate cycle. The webinar, entitled “Strategic Responses to the Rising Rates Environment,” discusses key strategies you should be considering to make sure you are ready regardless of what is to come in 2018 and beyond.