Revisiting Funds Transfer Pricing Post-LIBOR

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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.

Feeling the Flat Yield Curve Squeeze?

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interest-rate-6-26-18.pngInvestors have always sought better returns for greater risk. Longer investment horizons are associated with a higher amount of risk driven by uncertainty. In the fixed income markets, this translates to higher yields for longer maturities to compensate investors for the risk, thus creating what is called the yield curve. The yield curve has a positive slope in a normal market. The curve can also be flat or even inverted, which typically indicate transitionary periods in the market. That said, interest rate troughs usually do not last more than seven years, and central banks normally do not pump trillions of dollars into global markets as they have over the last several years. With protracted recovery and extreme monetary policy measures, this dreaded flat yield curve seems to be here for a while.

Banks’ primary earning power is largely driven by net interest margin, which is impacted by the shape of the yield curve and the ability to manage interest rate risk. It is prudent to perform non-parallel rate simulations on a regular basis, and regulators require this type of analysis. These simulations should be reviewed with management and saved for future use. Given the protracted flat yield curve environment, banks are feeling margin compression. If you have not done so, it may be time to retrieve these reports, understand if and where risk is impacting your balance sheet and manage your margin accordingly.

There are a number of ways a flat yield curve can negatively impact interest rate margins. Liquidity pressure is often at the top of the list in a rising rate environment. We have seen seven upward moves in the target fed funds rate since the bottom of the recovery, a total of 175 basis points. Depositors are hungrily pursuing newfound interest income. Most banks have had to follow suit and raise deposit rates. On the asset side of the balance sheet, fixed-rate loan yields have remained relatively stagnant. A typical rate on a 20-year amortizing 5-year balloon, owner-occupied commercial real estate loan in the $1-million to $5-million range was priced around 4.75 percent during the bottom of the rate trough.

As deposit rates have risen, banks have had difficulty in pricing the yields on loans of this type much above 5 percent. A third pressure point is the investment portfolio. During a normal yield curve environment, institutions with asset-sensitive balance sheets could earn income by borrowing short-term liabilities and investing at higher yields further out on the curve. Given the tightness of spreads along the curve where typical banks invest, there is minimal advantage to implementing this type of a strategy.

Since the issue of margin compression driven by the flat curve is a top concern for those who manage interest rate risk, the better question is what to do about it. Most bankers know it is present but many avoid the potential ramifications. The non-parallel simulation is an important exercise to understand the implications over the next year or so. The bank may even want to consider running a worst-case scenario simulation around an inverted curve as well. From there some strategic deposit pricing can be implemented.

One strategy may be either maintaining a short duration, and hopefully, inexpensive deposit or locking in funds for longer terms, pending balance sheet needs. Locking in longer term funding will come at a cost to the net interest margin unless the curve inverts. The interest rate risk simulation will help answer those types of questions. It is also a good time to look at a loan pricing model. This would help determine whether to continue to compete on price or pass on deals until margins improve. There is even a level that where banks should turn down business. It is important to understand the price point that becomes dilutive to earnings. Finally, there is a point that one stops taking duration risk in the investment portfolio, stays short and prepares to take advantage of future opportunities while reducing price risk.

Although a flat yield curve is not a new market phenomenon, it is currently impacting bank margins and may continue to for the next year or longer. Our Balance Sheet Strategies Group recommends banks consider the use of a detailed, non-parallel simulation to assess the current market and how to position the balance sheet moving forward. In addition to optimizing the interest rate position going forward, this will also help preserve and potentially enhance the interest margin. Every five basis points saved or earned on a $250-million balance sheet will equate to $125,000 in interest rate margin.