Evaluating BOLI in a High Rate Environment

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With the quick rise in interest rates over the past 18 months, a question many bankers ask is “When will my bank-owned life insurance (BOLI) yields increase?”

BOLI is a long-term investment for banks. Banks purchase BOLI as an asset intended to be bought and held on bank balance sheets, often for 30 years or longer, to optimize the tax and diversification advantages of life insurance. BOLI net yields are typically higher than yields on other taxable bank-eligible investments, especially when death benefits are recognized, according to the COLI Consulting Group’s BOLI Tracker in the first quarter. The account value of BOLI policies accumulates on a tax-deferred basis; the death benefit proceeds are generally income tax free.

Insurance carriers have long-term benefit obligations, including BOLI. To match the duration of their liabilities, they invest in long-term assets, typically resulting in intermediate-term portfolio durations. That means the increasing interest rates over the past 18 months have only recently begun to impact the average investment yields of carriers’ portfolios. If rates remain high, insurers’ portfolio returns will increase over time and crediting rates will increase on a lagging basis.

Banks should focus on the long-term structural characteristics of BOLI that allow it to outperform bank-eligible portfolios of similar credit quality over full market cycles. The ability of insurers to purchase assets unavailable to, and at a scale unachievable by, most banks is a key characteristic of BOLI. The long-term nature of BOLI provides an important hedge to reinvestment risk, which is especially important as many believe rates are nearing a high point in the cycle and reinvestment risk on shorter-term investments is material. Notably, investments in general or hybrid separate account BOLI incur no market value or accumulated other comprehensive income adjustment, or AOCI, unlike most alternate investments. That can be an attractive feature as higher interest rates have caused many banks to sustain significant reductions in equity capital due to AOCI adjustments to their bond portfolios.

Current BOLI Versus Higher-Rate New BOLI
While moving an insurance policy from one carrier to another can be accomplished with a tax-free exchange, provided all applicable state and federal regulations are complied with, policy owners should keep in mind:

  • BOLI is a long-term investment and banks should not be overly swayed by higher new money rates. Sometimes, new money rates will exceed portfolio rates; at other times, portfolio rates will exceed new money rates. Long term, they trend toward equalization.
  • The minimum interest rate guarantee for new BOLI products will likely be lower than the current BOLI policy’s minimum interest rate.
  • Exchange charges, including market value adjustments, could significantly reduce the potential pickup in yield from moving coverage.
  • To qualify as life insurance, the bank must have an insurable interest in each insured on a new policy’s issue date, and this requirement may not be as easy to meet with 1035 exchanged policies.
  • Banks should be encouraged to look at the total return of their BOLI, including expected future death benefits proceeds, rather than solely focusing on cash value growth.
  • Generally, a carrier won’t allow the bank to purchase additional BOLI in the future if the bank moves coverage, limiting the bank’s options for future purchases.

Exceptions where it may be appropriate to consider a 1035 exchange:

  • Credit concerns regarding the current carrier.
  • The carrier has exited the BOLI space and is not meeting customer expectations.
  • Rates have been higher for several years and the carrier has not increased its rates.

With recent increases in interest rates, it’s tempting to expect rapid increases in yields on existing BOLI portfolios. However, BOLI is a long-term investment; crediting rates move up and down gradually, consistent with the duration of carriers’ portfolios. This gradual movement was much appreciated when rates moved down to near 0%, as many BOLI carriers continued to credit interest close to 3%.

Now that rates have increased and the yield curve has inverted, the lag in BOLI crediting rate movement may cause BOLI yields to temporarily be less than yields on some other available investments. But when held to maturity, BOLI typically produces more earnings than other bank-eligible investments. If your bank is considering a 1035 exchange of existing policies, be sure to evaluate the alternatives thoroughly and beware of pressured pitches to chase higher rates.

Insurance services provided through NFP Executive Benefits, LLC. (NFP EB), a subsidiary of NFP Corp. (NFP). Doing business in California as NFP Executive Benefits & Insurance Agency, LLC. (License #OH86767). Securities offered through Kestra Investment Services, LLC, member FINRA/SIPC. Kestra Investment Services, LLC is not affiliated with NFP or NFP EB. Investor Disclosures: https://bit.ly/KF-Disclosures

Life insurance products issued by Massachusetts Mutual Life Insurance Company (MassMutual) and its subsidiaries, C.M. Life Insurance Company (C. M. Life) and MML Bay State Life Insurance Company (MML Bay State), Springfield, MA 01111-0001. C.M. Life and MML Bay State are non-admitted in New York.

MM202608-306528

Treasury Management Steps Into the Spotlight

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At Q2 we typically perform our “State of Commercial Banking” analysis and report on an annual basis. But 2023 has been no typical year for the banking industry. The tumultuous events that began in March prompted us to take stock earlier, with a mid-year analysis. You can download the full report here, but this article will focus on a particularly intriguing finding involving Treasury Management.

Before we dive into the numbers, a quick reminder: the data in this article is pulled primarily from Q2’s proprietary databases and reflects actual commercial relationships with more than 150 banks and credit unions in the United States — ranging from small community banks to top 10 U.S. institutions. We also gleaned insights from relationship manager pricing activity on the Q2 PrecisionLender platform. 

The Shift from NIM to NII
Until the first quarter of 2023, each progressive rate increase had a direct, positive impact on net interest margin. With deposit betas relatively low, the spread between lending rates and funding costs had widened with each Fed increase. But that positive correlation between the Federal Reserve’s fed funds rate and NIM came to an abrupt halt earlier this year, as industry wide NIM compressed despite rising rates.

 

Source: FDIC

Meanwhile, the rising costs associated with commercial lending – interest expense, liquidity premiums and loan loss provisions – have shone a light on cross-sell as banks seek to preserve or even strengthen profitability. After non-interest income had trended lower in the latter stages of 2022, the first quarter of 2023 saw a renewed focus on NII and some impressive gains.

Source: FDIC

Treasury Management Powers Relationship ROE
The data in those FDIC charts highlighted a trend we’d already suspected, confirming what we’d heard anecdotally during our daily conversations with bankers throughout the United States.

It’s hardly a surprise that banks are putting increased emphasis on cross-selling. Irrespective of the rate environment, relationships with ancillary business produce measurably stronger yields than those without. Cross-sell helps preserve long-term operating accounts, granting customers the benefits of earnings credit to offset the cost of the additional services, while also securing low-cost deposits for the bank. Additionally, the non-credit business itself is fee-rich and highly lucrative.

Still, when we delved into the Q2 PrecisionLender Commercial Pricing Database to get a measure of how big that cross-sell impact is, and what’s driving it, we were struck by what we found.

In the first half of 2023, with NIM still relatively high, credit-only relationships gave a solid 13.4% ROE. The ROE rose by nearly 40% (to 18.9%) when relationships also included deposits.

But take a look at what happens when the relationship includes treasury management (TM).

Source: Q2

The ROE on those relationships (both those that include a credit element and those that are only deposits and treasury management) averaged 39.2%!

Moving Forward
The data from the first half of 2023 shows that banks can no longer ride the wave of rate increases to maintain risk-adjusted returns. As lending costs rise, banks are putting increased emphasis on cross-sell. When that cross sell adds treasury management products and services to the relationship, the ROE impact can be powerful.

Managing Interest Rate Risk With Stronger Governance

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Many banks were caught off guard by the rapid pace of interest rate hikes over the past year. Now that the initial shock has hit, bank directors are questioning how to manage interest rate risk better and prepare for disruptions.

While rising rates are part of market cycles, rates rarely increase at their recent velocity. Between March 2022 and June 2023, the federal funds rate rose from 0.25% to 5.25%, a 500-basis point increase in less than 15 months.

A High Velocity Rise Caught Bank Leaders Off Guard
Not since the 1970s have rates increased at this pace in such a short time frame. Even in the cycle preceding the 2008 financial crisis, rates rose from 1% in 2004 to 5.25% in 2006 over 24 months. The latest interest rate hikes are steeper — and come at a time when banks were already awash in cash and liquidity. With excess cash, less loan demand and no place to park their money in recent years, many banks purchased securities, which historically have been a safe bet in such times.

But few boards were prepared for rates to increase so quickly. Since March 2022, continual increases in the federal funds rate have reduced the value of banks’ fixed-rate assets and shortened the maturity of their deposits. Two bank collapses in March 2023 demonstrated how quickly interest rate risk can grow into a liquidity risk and reputation risk.

Bank Directors Can Focus on Strong Governance, Risk Mitigation
Now that they have experienced an unprecedented event, bank directors are questioning what they can do to prepare for future interest rate shocks. But banks don’t necessarily need new risk management strategies. What they should do now is use the risk-mitigating levers available to them and act with strong governance.

Most banks already have asset-liability management committees that meet quarterly to stress test the balance sheet with instantaneous shocks, ramps and nonparallel yield curves. While going through the motions every quarter might appease regulators, it won’t prepare banks for black swan events. Banks need to hold these stress-testing meetings more frequently and make them more than compliance exercises.

In addition, bank directors should review assumptions used in their asset-liability management report packages. Some directors take these assumptions at face value without questioning how they were calculated or if they reflect reality. Yet the output of a model is only as good as the integrity of its underlying conventions or specifications.

Additional Strategies Require a Focus on Execution
Repricing products, changing product mix or employing derivatives can be other effective tools for managing risk. But again, the key is in execution. Some banks fear alienating customers or the community by repricing or changing products that are safer for the bank but might not be preferred by the customer. For example, some institutions prefer to book fixed-rate loans to meet customer demand, even though floating-rate loans might help the bank better manage risk.

While derivatives can add risk if not properly understood and managed, they can be a highly effective tool to manage interest rate risk if used early in the cycle. Once rate changes are underway, a derivative might no longer be helpful or might be cost-prohibitive.

Even as the Federal Reserve contemplates its next move, bank directors can look at the recent past as a learning experience and an opportunity to better prepare for the future.

Finding Opportunities in a Rising Interest Rate Environment

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Over the course of a year or so, the Federal Reserve has raised short-term interest rates more than 475 basis points.

Bankers with a portion of their balance sheet assets invested in fixed income securities are all too aware of the “Finance 101” lesson of the inverse relationship between interest rates and the market value of fixed income securities. While the recent Fed actions certainly have negative implications for parts of the bank’s balance sheet, they also have some positive ones.

For instance, banks with available liquidity have some great buying opportunities currently in the market. In addition to obviously investing in government securities with durations on the short end of the yield curve, the cash value yields on certain types of bank owned life insurance, or BOLI, are currently the highest they have been in at least 15 years.

Regulators allow banks to use BOLI to offset the cost of providing new or existing employee benefits. Part of the way BOLI offsets these employee benefit costs is by providing compelling cash value rates of return, which are generally provided by life insurance carriers that carry high credit quality. Another benefit of BOLI is that most types have cash values vests on a daily basis — the cash value doesn’t reduce in a rising interest rate environment. This eliminates the mark-to-market risk associated with other assets on the bank’s balance sheet, such as fixed income securities or loans.

Other higher yielding, high credit quality opportunities are also currently available in the market. Many of the same high credit quality life insurance carriers that offer BOLI have begun offering, or are creating, a guaranteed investment certificate or GIC. GICs are sometimes referred to as a financial agreement or FA. The GIC works much like a certificate of deposit, where the purchaser deposits money with the offering entity — in this case, the life insurance carrier — and earns interest on the deposited money. Much like a CD, the money must be deposited for a fixed length of time and interest rates vary according to the duration. GICs are nothing new; insurance companies themselves have been investing in them for decades.

Another interesting development over the last few months is the ability for banks to invest in a collateralized loan obligation, or CLO. A CLO is a single security that is backed by a pool of debt. As a floating-rate security, it offers income protection in varying market conditions while also minimizing duration. Additionally, CLOs typically offer higher yields than similarly rated corporate bonds and other structured products. We have also seen CLO portfolios added as investment options of private placement variable universal life BOLI designs to provide a bank with additional benefits. This structure has the advantage of giving bank owners the ability to enhance the yield of assets that are designated as offsetting employee benefit expenses. The advantages of this type of structure are obvious in the current inflationary environment.

So while the actions of the Fed have certainly added challenges to the typical banks’ balance sheet, for those institutions who are well positioned, it has also created numerous opportunities.

Hedging in the Spotlight After Banks Failed to Mitigate Interest Rate Risk

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Even as progressively higher interest rates throughout 2022 caused increasingly large unrealized losses on banks’ books, they rarely hedged that risk.

In fact, banks with fragile funding, like high concentrations of uninsured deposits, sold or reduced their hedges in 2022 as interest rates climbed, according to a new paper from university researchers. Rising interest rates have caused long-term assets, such as bonds and loans that pay a fixed rate, to decline in value. One way for banks to mitigate that risk is to use interest rate swaps, contracts that banks can purchase to turn fixed rate assets into floating rate assets. That eliminates the potential for unrealized losses to increase if rates continue to increase.

Banks are weighed down by the declining value of their assets. Ninety-seven percent of 435 major exchange listed U.S. banks reported that the fair value of their loans was below their carried value at the end of 2022, according to The Wall Street Journal citing data provided by S&P Global Market Intelligence. The difference was a $242 billion loss, reversing a paper gain of $96 billion at year-end 2021. The unrealized loss equated to 14% of those banks’ total equity and 21% of their tangible common equity.

“In some ways, the cake is baked. If I own a bunch of fixed rate bonds or I’ve made a bunch of fixed rate loans that are below market [interest rates] … there’s not a lot you can do,” says Ben Lewis, managing director and global head of sales for financial institutions at Chatham Financial. “But one of the things that’s super interesting about the current environment is that you can actually get paid to hedge.”

Only about 6% of aggregate assets at U.S. banks are hedged by swaps, according to the April research paper “Limited Hedging and Gambling for Resurrection by U.S. Banks During the 2022 Monetary Tightening?” Researchers calculated the swap coverage using call report data from the first quarter of 2022, and quarterly and annual filings.

Companies that offer a way to hedge against interest rate risk say swaps are even more attractive for banks right now given the inverted yield curve: long-term bonds have a lower yield than short-term bonds. That tends to indicate a recession is more likely.

“Regardless of when banks hedge, they’re eliminating future rate risk,” says Isaac Wheeler, head of balance sheet strategy at Derivative Path. “But if a bank didn’t do it a month ago and it hedged today instead, it now gets 100 basis point higher spread on a floating rate basis, which is a lot better.”

Interest rate risk is a concern because banks face rising funding costs, resulting in net interest margin compression. Both Derivative Path and Chatham Financial help banks with hedges and report a pickup in activity since the March banking crisis. Wheeler says concerns about NIM compression are driving banks to focus on hedging loans; hedging activity at his firm is now split equally between loans and securities.

Lewis says the community banks he’s working with are using hedging to avoid the impact of worst-case rate scenarios on their long-term assets. “They’re willing to give up some income today or potentially future income tomorrow to manage that risk,” he says.

But one reason why banks may hesitate to add swaps now is because the swap locks in whatever unrealized loss the bank already has on the asset. While the asset’s market value won’t further erode, the swap means there’s no ability to reverse the unrealized loss if rates fall. A bank that believes rates will begin falling in 2023 may decide to wait for the unrealized loss on the asset to reverse.

In either case, it’s a good idea for bank boards to be skeptical about interest rate predictions. Directors should ask management about contingency plans if rates move in a way they didn’t model and should explore how different rate environments impact their margin and earnings. They may decide to hedge a portion of their longer-term assets to reduce pressure on their NIM without locking in too many of their unrealized losses.

“Banks get to choose what risks they can take, and I think now more than ever, the idea of taking interest rate risk isn’t appealing,” Wheeler says. “A lot of banks eventually realize that they don’t want to be in the business of taking rate risk, or that’s not how they want to generate earnings. They want to lean into the other things that they’re better at, while trying to reduce rate risk.”

Hazy Outlook for Bank M&A in 2023

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The bank M&A landscape in 2023 will likely be affected by several factors, including concerns about credit quality and turmoil in the stock market, says Rick Childs, partner at Crowe LLP. While sellers will naturally want to get the best price possible, rising interest rates and weak bank stock valuations will impact what buyers are willing to pay. Bankers that do engage in dealmaking will need to exercise careful due diligence to understand a seller’s core deposits and credit risk. Concern about the national economy could prompt bankers to look more closely at in-market M&A, when possible. 

Topics include: 

  • Credit Quality 
  • Customer Communication 
  • Staff Retention
  • Impact of Stock Valuations 

The 2023 Bank M&A Survey examines current growth strategies, including expectations for acquirers and what might drive a bank to sell, and provides an outlook on economic and regulatory matters. The survey results are also explored in the 1st quarter 2023 issue of Bank Director magazine.

2023 Bank M&A Survey Results: Can Buyers and Sellers Come to Terms?

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Year after year, Bank Director’s annual M&A surveys find a wide disparity between the executives and board members who want to acquire a bank and those willing to sell one. That divide appears to have widened in 2022, with the number of announced deals dropping to 130 as of Oct. 12, according to S&P Global Market Intelligence. That contrasts sharply with 206 transactions announced in 2021 and an average of roughly 258 annually in the five years before the onset of the pandemic in 2020.

Prospective buyers, it seems, are having a tough time making the M&A math work these days. And prospective sellers express a preference for continued independence if they can’t garner the price they feel their owners deserve in a deal.

Bank Director’s 2023 Bank M&A Survey, sponsored by Crowe LLP, finds that acquisitions are still part of the long-term strategy for most institutions, with responding directors and senior executives continuing to point to scale and geographic expansion as the primary drivers for M&A. Of these prospective buyers, 39% believe their bank is likely to acquire another financial institution by the end of 2023, down from 48% in last year’s survey who believed they could make a deal by the end of 2022.

“Our stock valuation makes us a very competitive buyer; however, you can only buy what is for sale,” writes the independent chair of a publicly-traded, Northeastern bank. “With the current regulatory environment and risks related to rising interest rates and recession, we believe more banks without scale will decide to sell but the old adage still applies: ‘banks are sold, not bought.’”

Less than half of respondents to the survey, which was conducted in September, say their board and management team would be open to selling the bank over the next five years. Many point to being closely held, or think that their shareholders and communities would be better served if the bank continues as an independent entity. “We obviously would exercise our fiduciary responsibilities to our shareholders, but we feel strongly about remaining a locally owned and managed community bank,” writes the CEO of a small private bank below $500 million in assets.

And there’s a significant mismatch on price that prohibits deals from getting done. Forty-three percent of prospective buyers indicate they’d pay 1.5 times tangible book value for a target meeting their acquisition strategy; 22% would pay more. Of respondents indicating they’d be open to selling their institution, 70% would seek a price above that number.

Losses in bank security portfolios during the second and third quarters have affected that divide, as sellers don’t want to take a lower price for a temporary loss. But the fact remains that buyers paid a median 1.55 times tangible book in 2022, based on S&P data through Oct. 12, and a median 1.53 times book in 2021.

Key Findings

Focus On Deposits
Reflecting the rising rate environment, 58% of prospective acquirers point to an attractive deposit base as a top target attribute, up significantly from 36% last year. Acquirers also value a complementary culture (57%), locations in growing markets (51%), efficiency gains (51%), talented lenders and lending teams (46%), and demonstrated loan growth (44%). Suitable targets appear tough to find for prospective acquirers: Just one-third indicate that there are a sufficient number of targets to drive their growth strategy.

Why Sell?
Of respondents open to selling their institution, 42% point to an inability to provide a competitive return to shareholders as a factor that could drive a sale in the next five years. Thirty-eight percent cite CEO and senior management succession.

Retaining Talent
When asked about integrating an acquisition, respondents point to concerns about people. Eighty-one percent worry about effectively integrating two cultures, and 68% express concerns about retaining key staff. Technology integration is also a key concern for prospective buyers. Worries about talent become even more apparent when respondents are asked about acquiring staff as a result of in-market consolidation: 47% say their bank actively recruits talent from merged organizations, and another 39% are open to acquiring dissatisfied employees in the wake of a deal.

Economic Anxiety
Two-thirds believe the U.S. is in a recession, but just 30% believe their local markets are experiencing a downturn. Looking ahead to 2023, bankers overall have a pessimistic outlook for the country’s prospects, with 59% expecting a recessionary environment.

Technology Deals
Interest in investing in or acquiring fintechs remains low compared to past surveys. Just 15% say their bank indirectly invested in these companies through one or more venture capital funds in 2021-22. Fewer (1%) acquired a technology company during that time, while 16% believe they could acquire a technology firm by the end of 2023. Eighty-one percent of those banks investing in tech say they want to gain a better understanding of the space; less than half point to financial returns, specific technology improvements or the addition of new revenue streams. Just one-third of these investors believe their investment has achieved its overall goals; 47% are unsure.

Capital To Fuel Growth
Most prospective buyers (85%) feel confident that their bank has adequate access to capital to drive its growth. However, one-third of potential public acquirers believe the valuation of their stock would not be attractive enough to acquire another institution.

To view the high-level findings, click here.

Bank Services members can access a deeper exploration of the survey results. Members can click here to view the complete results, broken out by asset category and other relevant attributes. If you want to find out how your bank can gain access to this exclusive report, contact [email protected].

Strengthening Financial Performance in a Rising Rate Environment

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Interest rate volatility has been a dominant theme this year and inflation worries have begun morphing into recession fears.

For banks, rising rates are generally a positive trend; they tend to result in higher deposit franchise values and higher net interest margins. While unrealized losses in the available for sale bond portfolio also typically increase during rising rate environments, adhering to a disciplined investment framework can help bank leaders avoid knee-jerk reactions and put unrealized losses into the right context (discussed previously here).

As rates continue to rise, it’s time to check the pulse on your institution’s pricing model. In addition to pricing assets accurately, a successful bank also focuses on funding cheaply, using a number of models to identify relative value and hedging interest rate risk when necessary. Here, we’ll dive deeper into three principles that can help institutions strengthen their financial performance.

Principle 1: Disciplined Asset Pricing
Capital requirements mean that a bank has a finite capacity to add assets to its balance sheet. Each asset going on the balance sheet must be critically evaluated to ensure it meets your institution’s specific performance goals and risk mandates.

Using a risk-adjusted return on capital (RAROC) framework for asset pricing and relative value assessment helps establish a consistent, sustainable decision-making framework for capital allocation. Clearly, different assets have different risks and returns. An effective financial manager ensures that the bank is meeting its hurdle rates, or return on capital, and that the model and assumptions are as accurate as possible.

A mispriced asset isn’t just a risk to margin. It also represents liquidation risk, as assets priced incorrectly to market perceptions of risk have a higher likelihood of poor sale performance, such as losses on sale or failure to sell. The value of the institution can also be impacted if the bank consistently — even marginally — misprices assets. Overall, if an asset is not appropriately priced for the risks and costs associated with it, then a bank should critically evaluate its role on the balance sheet.

Principle 2: The Value of Deposit Funding
Banks benefit from low-cost, sticky funding. Core deposits typically comprise the largest and cheapest funding source, followed by term and wholesale funding and all other, generally short-term, funding sources.

Understanding your funding’s beta is a key first step to unlocking better financial performance.

In this application, beta is a measurement of the relationship between a funding source’s interest rate and an observable market rate; it is the sensitivity of funding cost relative to a change in interest rates.

As rates rise, low beta funding results in greater growth in franchise value compared to high beta funding. As assets reprice to the higher rate environment, balance sheets with low beta funding will see margins steadily widen. Banks with high beta funding tend to exhibit margin compression and declining valuations. Conversely, low beta funding results in more stable valuation as rates rise.

Principle 3: Risk Management in an ALM and RAROC Framework
Borrowers and depositors maximize their own utility, which often presents a dilemma for the financial institutions that serve them. When interest rates are low, borrowers typically want long-term, fixed-rate loans and depositors keep their deposits shorter term.  When interest rates are higher, we typically see the opposite behavior: depositors begin to consider term deposits and borrowers demand more floating rate loans. This dynamic can cause mismatches in asset and liability duration, resulting in interest rate risk exposure. Banks must regularly measure and monitor their risk exposure, especially when rates are on the move.

Significant divergence from neutral rate risk — a closely aligned repricing profile of a bank’s assets and liabilities — exposes a bank’s return on equity and valuation to potential volatility and underperformance when rates move. That’s where hedging comes in. Hedging can assist a bank by reducing asset-liability mismatches, enhancing its competitiveness by locking in spread through disciplined asset pricing and stabilizing financial performance. After all, banks are in the business of lending and safekeeping funds, but must take on risk to generate return. Hedging can reduce discomfort with a bank’s existing or projected balance sheet risks and improve balance sheet strategy agility to better meet customers’ needs.

There are opportunities for banks all along the yield curve. But institutions that don’t hedge compete for assets in the crowded short duration space — often with significant opportunity costs.

Rising rates generally result in stronger margins and valuations for well-funded depositories; disciplined asset pricing in a risk-adjusted framework is critical for financial performance. As a financial professional, it’s important that the board has a firm understanding of what drives deposit franchise value. Take the time to ensure that the entire leadership team understands potential risk in your bank’s ALM composition and be prepared to hedge, if needed.

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.