LENDING RISK

Of all the risks inherent in lending, interest rate risk is the easiest to isolate and quantify. Because of the widespread trading of interest rate products such as swaps and futures, determining the price of rate risk is simple. Take for example a 10-year loan with a 25-year amortization that has a rate to the borrower of 6.2%. By modeling the cash flows and looking at the loan's duration (average life to the next reset can be a proxy), we find that as of this morning, the swaps curve has a fixed rate equivalent of a 4.7%. This is the rate that the market values the interest rate risk on this structure using a 3-month Libor benchmark. In other words, the 6.2% rate on this loan is equal to receiving 3-month Libor + 1.50%. This is a handy calculation because: a) it removes the interest rate risk and isolates the credit premium; and b) it assigns a handy funds transfer pricing cost which the bank can utilize in customer or product profitability models. Some banks have a different view of where interest rates are heading than the market and construct their own "curve" to handle pricing. This is perfectly acceptable for risk management purposes for a bank to take a varying view of forward market rates. The important point here is for banks to analyze, compare and document loans on the same basis (either on a fixed or, preferably, a floating rate basis). By documenting the credit spread, banks better monitor and improve their credit and interest rate management process. Whether our example loan is worth a 1.5% credit spread, only bank management can decide. What is clear is that there is very little argument about how the market values interest rate risk and so any loan debate is where it should be – on the credit risk premium. This concept of measuring interest rate risk also helps in determine how best to fund loan production. Banks that use brokered CDs or FHLB to match fund fixed rate loans could be hurting profitability. If a bank's cost of funds is lower than either of these two alternatives, the bank drives up the cost of earning assets, thereby hurting their competitive advantage. It is usually far better to spend time developing a stable and inexpensive set of core liabilities (which FHLB Advances or brokered CDs may be a part of) or to utilize hedge products to solve interest rate risk, than to sacrifice margins or loan growth. If a bank's cost of funds is currently at 2.25%, then utilizing wholesale fixed rate funding channels would "cost" the bank either 80bp in margin (the difference between 2.25% and current wholesale funding levels) or result in 80bp of higher loan rates. Many independent banks are not cognizant of this calculation and so often under or over factor in the interest rate risk into lending pricing. Next to differences in credit premiums, this is the 2nd largest factor that accounts for divergent loan pricing between banks.