Community bankers are rethinking how low interest rates can get, as they look to keep commercial clients from moving to larger competitors. Lenders at small banks are playing a more aggressive defensive game than first imagined. Many are removing floors on existing loans and offering new floating rates to compete against quotes from bigger banks that are dipping below 2%.

The shift could help bankers hold onto key clients but it also could put those borrowers at risk if the Federal Reserve starts to raise rates. Many past credit issues took place after marginal clients succumbed to rising borrowing costs.

"It was shocking to us," to see rates go so low, says Rusty Cloutier, the president and chief executive of MidSouth Bancorp (MSL) in Lafayette, La. He says one competitor in Dallas is offering prospects a 1.99% floating rate on a two-year commercial loan. "Everyone is cutting rates," he says. "You've got no choice."

Borrowers are the clear beneficiaries, as more banks reduce rates to keep existing relationships intact. In one instance, Cloutier says Midsouth cut a large client's annual borrowing costs by $70,000 just to keep them in the fold.

"We cut our rates pretty good …to keep the business," Cloutier says. "It is cutthroat out here on getting business, it really is." Smaller banks have been consistently undercut by bigger institutions. In mid-February, the average interest rate for a commercial-and-industrial loan at a community bank was 4.73%, according to a recent survey by the Federal Reserve Board.

Large banks had an average rate of 3.34%, the survey found. (The survey used $4.4 billion in assets as its dividing line for small and large banks.) So smaller banks are resorting to floating rate loans to close the gap.

"It is a much more competitive landscape now compared to a year ago, especially for the larger C&I loans," says Curt Myers, the president and chief operating officer at Fulton Bank, a banking unit of Fulton Financial (FULT) in Lancaster, Pa.

"In a lot of cases, a fixed rate may be 2% more than a floating rate and that's a material difference in pay" to the borrower, Myers adds.

Floating rates are usually tied to shorter-term credits such as lines of credit. The Fed's decision to keep interest rates low through next year has led borrowers to push for floating-rate loans of longer duration.

Borrowers "are comfortable with a 2% to 3% floating rate because they know that it's not going up anytime soon," says Michael Brown, a vice chairman and chief operating officer at IberiaBank (IBKC) in Lafayette, La. "Our industry tends to be very accommodating."

Banks of all sizes are struggling to generate C&I volume. The same Fed survey found that volume at large banks fell 7% in mid-February compared to a year earlier. Smaller banks suffered a 9% decline.

Bankers are relying on lower rates to poach clients, though they remain hesitant to drastically alter loan structures after the financial crisis. Bankers say that, in competitive commercial loan markets such as Texas, it is common to see a 2.5% floating rate trump a 3.5% fixed rate.

"We've seen more competition in the first part of this year than we did last year," Brown says. He says competition has picked up as more banks rebound from credit wounds and look to grow.

Investors have also reached a point where they are pressuring banks to expand balance sheets. Investors "don't want to talk about credit, they want to talk about growth," Brown says.

A rise in floating rates concerns bankers like Myers, who wonders about the potential long-term financial risk for those borrowers. "We're worried and we're advising our clients … to make sure they are managing their interest-rate risk," he says. "Rates will go up at some point. If it happens to be a year from now, it could catch a lot of people."

It could also snag a lot of banks. Many bankers agreed that some clients are taking on 10- to 15-year floating-rate loans. Banks could face margin compression if the Fed raises rates and deposits reprice faster than the rates on longer-term floating-rate loans.

Long-term floating-rate loans "can be a bit nutty because you have to be careful that you're matching it with the funding and that's hard to do," says Christopher Marinac, an analyst at FIG Partners. Banks making these loans are "taking a calculated bet that they can get away with this."

Brown says he's seen a bank offer a 15-year owner-occupied loan at an "extraordinarily aggressive" rate of 3.25%. When asked if he would compete with that rate, Brown says it depends.

"We try to look at the individual relationship beyond simply the loan" and "what it means to us on a long-term basis," Brown says. "We're trying to be smart about where it makes sense for us to treat a rate as an exception and not make it a norm."

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