Threat of negative rates has banks setting floors on loans

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Banks have grown so worried about the prospect of a protracted pinch to interest income that they are increasingly turning to a practice more often used in the complicated leveraged loan market: interest rate floors.

The idea is to safeguard against falling rates — and lost future revenue — if the economy takes a step back and the Federal Reserve further reduces borrowing rates to spur growth along. The plans are another sign that more conservative-minded lenders are unwilling to match competitors who are lowering prices or loosening terms to win commercial business.

PNC Financial Services Group in Pittsburgh is among those saying they are concerned about excessive risk-taking. The $406 billion-asset bank company is considering setting floors on interest resets on its floating-rate loans, Chief Investment Officer Gagan Singh said in early November at the BancAnalysts Association of Boston Conference.

“We have been pretty focused on thinking about how we can embed floors in our loans,” Singh said. “It’s not an easy thing to do, [given there are] a lot of documentation and operational issues to deal with. But that really helps when you analyze what happens if rates were to go negative. That provides a pretty important source of duration.”

There are few data sources on interest rate floors, but Leveraged Commentary and Data, an offering of S&P Global Market Intelligence, tracks how often they are used in the institutional speculative-grade leveraged loan market.

These loans are syndicated by banks and sold to investors who often require interest rate floors to guarantee a minimum amount of revenue in case borrowing costs fall too far.

As the Fed was cutting rates to prod the economy out of the Great Recession, virtually all loans in this universe carried an interest rate floor. But as rates increased, banks shed these floors as rate risk waned and competition for these loans increased. A little more than 27% of these loans had an interest rate floor attached as of the end of October, the lowest percentage since LCD began tracking the data during the financial crisis.

But that figure may start climbing again now that the Fed has cut rates three times since the end of July and uncertainty looms over monetary policy and the direction of the U.S. economy.

“Now that the [London interbank offered] rate started declining we see some deals coming back and adding a floor,” S&P Global Market Intelligence Senior Director Marina Lukatsky said in discussing the fallout from the three reductions in the target federal funds rate.

JPMorgan Chase CEO Jamie Dimon said in September that the largest U.S. bank was preparing for the possibility of the Fed taking interest rates to unprecedented lows, though he did not mention interest rate floors directly.

“I don’t think we will have zero rates in the United States, but we are thinking about how to be prepared for it just as a normal course of risk management,” Dimon said. “It seems very hard to me to charge consumers below zero.”

Large regionals and small to midcap banks — where net interest margins have tightened especially rapidly — have spoken openly about the need for floors, analyts at Keefe, Bruyette & Woods said in a Nov. 12 note to clients.

“The topic of loan floors made its way into more conversations this quarter as a means to help mitigate a portion of future negative loan repricing,” KBW analysts said in the report.

Some banks that have put floors in place are already hitting them.

Bank of the Ozarks in Little Rock, Ark., reported during the third quarter that 27% of its current loans are already at their floors, compared with 15% three months earlier. Tim Hicks, chief administrative officer and executive director of investor relations at the $23.4 billion-asset bank, said on a call with analysts in October that the floors “will help eventually alleviate some of the decline in loan yields, which would help alleviate the decline in net interest margin."

About two-thirds of Western Alliance Bank’s variable-rate loans, or a little more than $9 billion, have floors attached, according to its recent financial statement. For every 25 basis points in rate reduction, another $1 billion in loans will have their floors triggered, according to the $26.3 billion-asset bank in Phoenix.

However, other banks, like the $34 billion-asset FNB Corp. in Pittsburgh, are still going without interest rate floors as they compete for new loans.

"We don't have a substantial amount of floors in the portfolio,” FNB Chief Executive Vincent Delie said on an earnings call with analysts in October. “We have found that for higher-quality borrowers, particularly in the commercial space, they don't accept them."

Mike Sumner, director of product management at the consulting firm Deluxe, pitched the idea in meetings with roughly 100 smaller, community banks last year.

Sumner pointed to the fight for deposits as reason some lenders are warming to the idea of interest rate floors. If banks are paying more to attract deposits, he explained, they can only allow floating-rate loans to go so low.

“Many of them had already started thinking about interest rate floors or had already implemented them,” Sumner said. “The others took it to heart.”

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Interest rate risk Net interest margin Commercial lending Risk management LIBOR Regional banks Community banking Federal Reserve PNC Financial Services Group JPMorgan Chase