The Federal Reserve is now well into its latest rate-hike campaign that started with a quarter-point boost in the Federal Funds rate in late 2015. This was the first of nine rate increases that have brought interest rates up from zero to a target range of 2.25-2.50 percent.
While the Fed has hinted recently that it may slow the pace of rate hikes this year, there’s no question that interest rates remain low from a historical perspective. The 65-year average interest rate of the 10-year U.S. Treasury bond is 5.85 percent. If rates eventually revert to the historical mean, it could mean an increase of more than 300 basis points from current levels.
What Can Borrowers Do Now?
Rising interest rates could have a significant impact on many of your borrowers and, by extension, your bank. For example, borrowers may no longer be able to service debt if their loans adjust or mature in a rising rate environment. Higher rates will also lower the value of collateral (especially real estate) pledged to support business loans.
Therefore, it’s critical to assess your borrowers’ current interest rate positions and take steps to insulate the bank from the negative consequences of higher rates. It starts with talking to borrowers about how vulnerable they could be to rising rates and what they can do now to mitigate the potential impact.
For starters, borrowers should determine whether they can raise prices, cut costs, or live with lower profit margins if rates continue to rise. They should also look for ways to improve operational efficiency in order to boost financial performance.
This includes improving receivables collections and inventory management to boost cash flow. Can fixed assets be liquidated and excess inventory sold off and the proceeds used to pay down debt and reduce interest expense?
How Can You Help Borrowers?
Next, examine how your bank can help borrowers who are especially vulnerable to rising interest rates. In some situations, you may want to talk to borrowers about restructuring debt by converting variable-rate loans to fixed-rate loans. This could result in borrowers paying a higher rate now, but they won’t have to worry about rates rising even more in the future.
Another idea is to offer borrowers interest rate risk management products like caps, swaps, futures, and options. Large banks have been using these aggressively to offer borrowers long-term fixed rate loans, but many community banks don’t offer them.
One solution is to contract for these products with an outside partner or service provider, such as an investment bank or the Federal Home Loan Bank (FHLB). The SBA can also help you convert borrowers’ variable debt to long-term fixed-rate debt. Not only do these solutions allow you to help your borrowers, but they also generate additional fee income for the bank.
The Need for Stress Testing
Given the current rising rate environment, you should stress test both individual loans and your entire portfolio for the impact of rising interest rates. The sooner you can quantify the impact of higher rates on borrowers’ cash flow and their ability to service debt, the more proactive you can be in helping borrowers prepare.
Note that the regulators require loan-by-loan stress testing if your portfolio has significant exposure to commercial real estate. At the individual loan level, add 300 to 400 basis points (or more) to variable rate borrowers’ debt loads to determine the potential impact of rising rates on their debt service capacity.
This will reveal their incremental interest expense and give you a good idea of their ability to generate sufficient cash flow to service debt. In particular, you want to determine at what point debt service coverage falls below 1.0 and at what point the collateral value exceeds your internal loan-to-value guidelines.
Also make assumptions about the impact of gross potential rent, vacancy rates, operating expenses and capitalization rates to determine the potential impact of rising interest rates on your borrowers’ debt service capacity.
Of course, nobody knows exactly how much, or how fast, interest rates will go up. But it’s a good bet that rates will continue to rise for the foreseeable future. This makes now a good time to be proactive and start planning for how rising rates could impact your borrowers and your bank.
Please contact us if you’d like to discuss interest rate risk management strategies in more detail.