Rates are rising! Using rate floors now can protect your NIM in the future

Barry Adcock July 16th, 2018

Federal Reserve System, Federal Open Market CommitteeThe Federal Open Market Committee (FOMC) has been steadily increasing the fed funds target rate since 2015, with the most recent rate hike occurring on June 13, 2018. Despite a historically flat yield curve (28 basis points between the 2-year and 10-year treasury), the communications from the committee leave open the possibility for two additional rate hikes this year with more to come in 2019.

Rates are rising now, but the fact is, they won’t rise forever.

What steps are you taking today to ensure that future falling rates don’t devastate your bank’s performance?

One of the lessons many financial institutions learned the hard way during the 2007-2008 crisis is that sudden and drastic rate cuts by the FOMC are not always predictable beyond a few months and can be devastating to bank earnings. Most institutions had a good portion of their loan portfolio tied to the Prime Rate or other variable indexes. Many of these loans had been funded by fixed-rate time deposits with a contractual term of 12 months or longer. That means decreases in the institutions’ cost of funds (COF) lagged behind the decreases in the yield on the floating rate loan portfolio, creating significant net interest margin (NIM) compression.

As the crisis unfolded, banks scrambled to put rate floors on new loans and loans that renewed at maturity to protect their margins. For some, this was too little too late.

Now the question is, did we learn from this painful lesson, or will banks repeat the same mistakes?

Interest rate floor

The reality is, it is difficult to sell a rate floor to a borrower when rates are falling. Obviously, they want to take advantage of predicted lower rates to help their cash flow situation. Now, while rates are climbing, is the time to make a preemptive strike against the possibility of future falling rate cycles. Almost all market prognosticators are predicting more rate hikes through 2019. Borrowers read and watch the financial news, too. They are much less likely to push back on a reasonable rate floor when the world is expecting rates to rise.

The current economic expansion is very mature and long by historical standards. No expansion lasts forever, so we all know another recession is coming. We just don’t know exactly when it will occur or how severe it will be. Will the FOMC raise rates too high and ultimately suppress economic growth? Will the current administration’s trade policies create a full-out trade war, hurting U.S. producers? Will some geopolitical event occur that disrupts the current expansion? Everyone has their own opinions, but in reality, none of us know what the future holds.

Let us learn from our past mistakes and act now to prepare for what we all know is possible. The profits made through the interest borrowers pay make the world go ’round in banking. Since interest rates fluctuate, it’s in the bank’s best interest to protect itself when those rates start to drop, as they certainly will. Setting a rate floor ensures that any given borrower’s rate cannot fall below that floor, no matter what the interest rate does. Their rate will fluctuate until it reaches the interest rate floor.

This simple step could allow your bank to thrive during the next recession, while others struggle to simply survive.

This content is accurate at the time of publication and may not be updated.