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Floating Rate Loans: Do Banks and Their Customers Really Need Them?

Moscow, November 06, 2016 — Business Systems Consult. Many analysts and market participants complain that floating rate loans are not so widely distributed as some people would like. Especially this problem is discussed at the emerging markets, as recent conference “Russian Derivative Market: Are Derivatives Able to Insure Russian Economy” of Russian National Financial Association showed.

But we believe, it is worth to discuss a more general issue: should banks develop this product?

Enthusiasts of floating rate lending provide the following arguments FOR this product.

First of all, they say, banks are hedging against adverse interest rate movements. If market interest rates grow, cost of funds also grows. Interest rates for the new loans are also becoming higher. But loan portfolio usually has lower turnover than deposit portfolio. Therefore, interest rate margin falls quickly but restores slowly.

The second argument stems from client relationships. If loan interest rate is linked to some objective and index, if it is beyond control of parties of the loan agreement, it is simpler to increase the loan rate if market interest rates have grown. The prepayment risk (it may be very painful!) also disappears.

Third, from a client’s point of view, floating rate credit line is a stable source of funding that does not require additional agreements regardless the market interest rates. Unlike fixed rate credit lines, there is no need for additional interest rate reconciliation before taking the loan. There is no incentives for the client to address the bank if market level of interest rates decreased.

What seems in these arguments wrong? Why floating rate loans are not widely distributed in emerging markets?

One of the most important functions of banking sector is protection of productive sector from market shocks (in particular, shocks in cost of funds). The reward for this function is about one quarter of total net interest income. A delicious review of banking can be found here.

Productive sector is more interested in fixed interest rates that can be took as a base point for financial planning in project finance and production cost projections. The attempts to overplay market professionals in financial markets end usually badly.

The importance of protection against market shock can be hardly overestimated. In the beginning of 2015 MosPrime interest rate index for Rouble funds reached 24—28% p. a. while productive sector borrowed funds at 15—18% p. a. The interest rate loss in banking sector was compensated later, but at the peak of crisis some of productive enterprises were protected.

The expansion of floating rate lending means for banking sector abstaining from this function. Therefore, the threat to macroeconomic stability emerges. Moreover, abandonment from this function makes strategic positions of traditional banking weaker. Actually, we observe the rise of alternative finance and banking sector under the pressure in the developed markets.

Hedging is considered as a remedy for risk. However, it is only half-truth. More precisely, one tenth of truth. Actually, hedging is a replacement of one bundle of risks for the other one. For example, floating rate lending increases legal risks because the concrete amounts under agreement are not specified. Therefore, these loan agreements do not have all the attributes of true contract. In this context, a client which is not a market professional can always try to repeal the loan contract (in fact, there is a lot of precedents all over derivative markets).

Some observers suppose that the significant share of floating rate loans prevents FED from key rate increase which is promised for the last year. The matter is that the interest rate level affects the credit risk profile of the economy, and sometimes the economy can not afford to carry higher risks. Thus, the absence of interest rate risks converts to a huge and hardly manageable credit risk.

Forced conversion of loan portfolio from fixed rate loans to floating rate ones actually leads to losses if interest rates decrease. The revenue from floating rate loans falls instantly but the cost of funds only gradually as old deposits are replaced with the new ones. Therefore, introduction of floating rate products should be careful. A set of limits, controlling and analytical procedures should be established around this product. Comprehensive analysis of asset and liability structure should be conducted. The methodologies for this analysis are not straightforward and should be thoroughly developed.

A basis for hedge is understanding of risk as a result of random change in risk factors. But are interest rates random? Many central banks all over the world conduct inflation targeting policies (actually, these policies are considered as a best practice in monetary policy). For example, all Central Banks introduce this policy to fight inflation. This leads to lowering interest rates. Should banks make easier for their clients lowering the loan interest rates under these conditions, sharing the profit with them?

Client relationship problems disappear only at first glance. Change in interest rates by 0.5—1% p. a. is not significant to break the client relations and claim to reconsider the contracts. But if interest rates change crucially, all pricing models break. For example, in December, 2014 key monetary policy rate in Russia grew by 6.5% p. a. At that time cost of funds for banks spiked by 20% p. a. All interest rate indices do not cover the change in interest rate spreads.

The lack of good interest rate indices is a separate problem and... a different story.

Concluding, floating rate lending carries not only benefits but also costs. It requires deep knowledge of strategic drivers of banking business, educated feeling of asset and liability behaviour, and weighted consideration of all the risks. Implementation of this product is a complicated project in the bank. This project deals with complex issues. Participation of qualified team in this project is a must.

Read more:

Russian Version of this Article at Bankir.ru

How to Manage Loan Portfolio in Big Banks: Technology and Applications

Methodologies for Loan Portfolio Modelling

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Опубликовано 06 Nov 2016 Author Magister ludi

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