Revisiting Funds Transfer Pricing Post-LIBOR

The end of 2021 also brought with it the planned discontinuation of the London Interbank Offered Rate, or LIBOR, the long-running and globally popular benchmark rate.

Banks in a post-LIBOR world that have been using the LIBOR/interest rate swap curve as the basis for their funds transfer pricing (FTP) will have to replace the benchmark as it is phases out. This also may be a good time for banks using other indices, like FHLB advances and brokered deposits, and evaluate the effectiveness of their methodologies for serving their intended purpose. In both situations, newly available interest rate index curves can contribute to a better option for FTP.

The interest rate curve derived from the LIBOR/swap curve is the interest rate component of FTP at most large banks. It usually is combined with a liquidity transfer price curve to form a composite FTP curve. Mid-sized and smaller banks often use the FHLB advance curve, which is sometimes combined with brokered deposit rates to produce their composite FTP curve. These alternative approaches for calculating FTP do not result in identical curves. As such, having different FTP curves among banks has clear go-to-market implications.

Most large banks are adopting SOFR (secured overnight funding rate) as their replacement benchmark rate for LIBOR to use when indexing floating rate loans and for hedging. SOFR is based on actual borrowing transactions secured by Treasury securities. It is reflective of a risk-free rate and not bank cost of funds, so financial institutions must add a compensating spread to SOFR to align with LIBOR.

Many mid-tier banks are gravitating to Ameribor and the Bloomberg short-term bank yield (BSBY) index, which provide rates based on an aggregation of unsecured bank funding transactions. These indices create a combined interest sensitivity and liquidity interest rate curve; the interest rate and liquidity implications cannot be decomposed for, say, differentiating a 3-month loan from a 5-year loan that reprices every three months.

An effective FTP measure must at least:

  • Accurately reflect the interest rate environment.
  • Appropriately reflect a bank’s market cost of funding in varying economic markets.
  • Be able to separate interest rate and liquidity components for floating rate and indeterminant maturity instruments.

These three principles alone set a high bar for a replacement rate for LIBOR and for how it is applied. They also highlight the challenges of using a single index for both interest rate and liquidity FTP. None of the new indices — SOFR, Ameribor or BSBY — meets these basic FTP principles by themselves; neither can FHLB advances or brokered deposits.

How should a bank proceed? If we take a building block approach to this problem, then we want to consider what the potential building blocks are that can contribute to meeting these principles.

SOFR is intended to accurately reflect the interest rate environment, and using Treasury-secured transactions seems to meet that objective. The addition of a fixed risk-neutral premium to SOFR provides an interest rate index like the LIBOR/swap curve.

Conversely, FHLB advances and brokered deposits are composite curves that represent bank collateralized or insured wholesale funding costs. They capture composite interest sensitivity and liquidity but lack any form of credit risk for term funding. This works fine under some conditions, but may put these banks at a pricing disadvantage for gathering core deposits relative to banks that value liquidity more highly.

Both Ameribor and BSBY are designed to provide a term structure of bank credit sensitive interest rates representative of bank unsecured financing costs. Effectively, these indices provide a composite FTP curve capturing interest sensitivity, liquidity and credit sensitivity. However, because they are composite indices, interest sensitivity and liquidity cannot be decomposed and measured separately. Floating rate and indeterminant-maturity transactions will be difficult to correctly value, since term structure and interest sensitivity are independent.

Using some of these elements as building blocks, a fully-specified FTP curve that separately captures interest sensitivity, liquidity and credit sensitivity can be built which meets the three criteria set above. As shown in the graphic, banks can create a robust FTP curve by combining SOFR, a risk-neutral premium and Ameribor or BSBY. An FTP measure generated from these elements sends appropriate signals on valuation, pricing and performance in all interest rate and economic environments.

The phasing out of LIBOR and the introduction of alternative indices for FTP is forcing banks to review the fundamental components of FTP. As described, banks are not using one approach to calculate FTP; the results of these different approaches have significant go-to-market implications that need to be evaluated at the most senior levels of management.

How Will Rising Interest Rates Impact Your Bank?


interest-rates-10-16-15.pngMost of the news coverage about the potential for rising interest rates has assumed rising rates will help banks. But will it help your bank? It turns out, that’s not an automatic yes. This article will help board members understand how interest rates impact a bank’s profitability, and offers questions that you should be asking your management team.

Many of the biggest banks in the country, which are the subject of so much news and analyst coverage, are deliberately managed to be asset sensitive. That means that they benefit from a rising interest rate environment, because their “assets,” mainly loans, will generate higher income as rates rise. Many big banks have more variable-rate loans on their books, such as commercial and industrial loans, than community banks do, and those loans tend to reprice more quickly up or down when rates rise or fall.

However, community banks can’t make the assumption that they will benefit when rates rise. A careful analysis of their own particular situation is necessary.

“There does seem to be a general perception that rising rates are good for all banks. That’s simply not true,’’ says Matthew D. Pieniazek, president of Darling Consulting Group, in Newburyport, Massachusetts, which advises banks on asset liability management. Many community banks that manage as if they are asset sensitive will actually experience earnings pressures when interest rates rise, he says. (This is known as liability sensitivity, when funding costs increase faster than asset yields.) The biggest risk could come from deposits, but there are also impacts on loans and investment portfolios to consider.

Regulators have made it clear that oversight of interest rate risk, or IRR, rests squarely on the shoulders of the board. The Office of the Comptroller of the Currency issued a joint “advisory on interest rate risk management in 2010” that emphasizes this point:

“Existing interagency and international guidance identifies the board of directors as having the ultimate responsibility for the risks undertaken by an institution, including IRR. As a result, the regulators remind boards of directors that they should understand and be regularly informed about the level and trend of their institutions’ IRR exposure. The board of directors or its delegated committee of board members should oversee the establishment, approval, implementation, and annual review of IRR management strategies, policies, procedures, and limits (or risk tolerances). Institutions should understand the implications of the IRR strategies they pursue, including their potential impact on market, liquidity, credit, and operating risks.”

How do rising interest rates impact deposits?
Since late 2008, the Federal Reserve has kept interest rates near zero, resulting in all kinds of interest bearing deposits and investment products also hitting near zero yields. Alternatives to noninterest bearing deposits such as CDs and other term investments carry premiums that are hardly worth the trouble. There is almost no rate differential between a CD or even a government bond and an FDIC-insured nonmaturity account, such as a savings or checking account at a bank. As a result, the banking industry has experienced a substantial increase in non-maturity deposits. Pieniazek estimates that industry-wide, nonmaturity bank deposits are as much as 20 to 25 percent above normalized levels.

So it’s hard to know as rates rise, how much money will leave the bank. Some customers may do nothing. Others may move money into higher interest-bearing accounts or CDs at the bank. Still, others will put their money in investment accounts or move it to other banks and credit unions that are offering higher rates than your bank.

Pieniazek thinks there is a lot of pent-up demand for higher rates, as baby boomers are getting ready to retire and retirees have been sitting on low-earning deposits for many years. He says that a bank can look historically at its own deposit levels, and take appropriate actions to gauge how much of their non-maturity deposit base might be at risk.

It’s important as a board member to know what your bank’s plan is. “One hundred percent of financial institutions will see deposits leave,’’ Pieniazek says. Deciding how much the bank is willing to lose and the impact of rising rates on its deposit strategy is important for any board.

Questions to ask: When the Fed raises rates the first, second or third time, how are we going to react? Are we going to hold our rates and not chase money? Are we going to let deposits leave us? What are the ramifications and why is that our plan? What could occur that will cause us to change our plan?

Determining to what extent you will lose deposits when rates rise is somewhat of a guessing game, which makes it the hardest part of the balance sheet to assess. Your bank management team can look at particular characteristics of their deposit base to make assumptions about how “sticky” those deposits are, meaning how likely they are to stay with your bank, says Rick Childs, a partner with consulting and accounting firm Crowe Horwath LLP. How long has each customer had a deposit account with the bank? Do they have other accounts or products with the bank, such as loans? Do they direct deposit every month and pay bills out of the account? Or is it a stand-alone money market account where the customer has no other relationship with the bank? Those are the depositors most likely to leave when interest rates rise.

We haven’t seen a lull this long in interest rates so it’s hard to know what will happen, Childs says. If funds leave and you have to replace those funds at higher rates, how will margins be impacted?

Net interest margins are net interest expenses subtracted from net interest income, divided by earning assets, such as loans and investments. So the higher your interest expense, the lower your income. The cost of funds is what it takes to generate the funds your bank needs to operate and lend at the level it desires. While interest expense on deposits is a large part of that, funding costs will also be impacted by borrowings and deposit surrogates such as customer sweep accounts. Bank analysts such as Fig Partners are already looking at the cost of funds for various banks to determine which banks will do better when rates rise. The theory is that the lower the cost of funds, the better the bank will do because it won’t be forced to raise rates on deposits to compete for funds.

Your management team should have well developed assumptions about how deposit rates will be impacted and what the plan is for reacting to rising rates. In general, Childs says the board should be asking management: “Explain to me what those assumptions are and how you derive those.”

What are your bank’s assumptions about what will happen to interest rates and how are those derived? How will your bank react? Your management team should have assumptions about the lag time before your bank raises rates in its different products. For example, if the Federal Reserve raises the federal funds target rate by 100 basis points over time, how much will your NOW accounts (checking accounts that earn interest) go up?

Most banks use vendors to provide interest rate risk modeling tools, and those models will have default assumptions of their own. It’s important to note that the board is responsible for making sure the bank is assessing the appropriateness and reasonableness of those assumptions. It’s not enough to outsource decision-making about interest rate risk and assume you are taking care of your oversight responsibilities.

The good news is that most banks do some kind of stress testing to see what happens to the bank under a variety of interest rate “shock” scenarios. For example, what happens if short-term rates rise 50 basis points? What about 100 basis points? How will that impact earnings? You might read or hear about a phenomenon known as the “flattening of the yield curve.” The yield curve refers to the difference between short and long-term rates or, for example, the fed funds rate versus a 10-year Treasury yield. If short-term rates increase while long-term rates don’t, that lessens the difference between those rates. A more ideal yield curve would have an upward slope, with short-term rates significantly lower than long-term rates. Flatter yield curves are generally bad for banks, because the cost of funds are driven by short-term rates.

How will rising rates impact loans?
Your bank has a particular mix of terms on its loans that will impact what happens to your bank when rates rise.

You probably have a number of floating rate loans that are at a floor, meaning your bank won’t make loans or enable loans to reprice below that level despite prevailing market rates. How much will interest rates need to rise before prevailing rates go above the floor? How long will it take?

Obviously, variable rate loans in a rising rate environment are good for the bank. The bank will see increased interest income as a result. If interest income rises faster than the cost of funds, that means the bank is asset sensitive and earnings will improve in that scenario.

How will rising rates impact our investment portfolio?
There are questions to ask about the bank’s securities portfolio as well. Does the bank own any securities with material extension risk? What is the concentration? Material extension risk is when the life of the security extends in a rising rate environment. Mortgage-backed securities are a good example, and plenty of banks have these. In a rising rate environment, borrowers are less likely to pay off their mortgages. Does the bank have callable bonds? These are bonds where the lender can call the bond early if rates drop, or extend the life of the bond if rates rise, Pieniazek says. Is the bank monitoring opportunities to sell bonds with undue extension risk?

Another factor to consider is what happens if rates don’t rise. Or, they rise much less and more slowly than the Fed portends. For many banks, this could be very harmful, especially if the bank is already experiencing continued declines in net interest margin… For most banks, the sustained low-rate environment is the most problematic issue, Pieniazek says. It’s important to consider this alternative scenario, as well.

In the end, all banks will be impacted by the rate environment. Understanding how your bank is affected by interest rates and the assumptions going into those estimations is a crucial ingredient to providing good oversight both today and in the years ahead.