Some community banks are seeing broad challenges in trying to book and maintain quality loans. These challenges include borrower demand for long-term fixed rates, general lack of qualified borrowers, and intense competition from multiple lenders (including banks, credit unions, insurance companies and alternative financial institutions). We would like to share a specific loan origination and portfolio tactic that has worked for banks of various sizes and has been successfully deployed by community banks across the country. The tactic is to utilize a barbell approach to loan origination which is easy to adopt and requires only that a bank accept modern tools and analysis.
The tactic calls for banks to divide their marketing and structuring approach to appeal to two distinct set of borrowers. In bucket A are smaller loans sizes, acceptable but not stellar credits, and borrowers that are not targeted by national or larger regional banks. Bucket A will contain borrowers who will accept prepayment penalties and will generally accept a 3, 4 or 5-year fixed rate commitment. Bucket B contains larger loans, better credit quality borrowers, who are actively courted by national or regional bank, and are seeking a fixed rate terms of longer than 5 years.
For bucket A customers, the bank offers a fixed rate structure and attempts to gain the highest fixed rate for the shortest fixed term possible. The bank takes on interest rate risk for this bucket but attempts to manage that risk through pricing. For bucket B customers, the bank offers the longest fixed-rate structure but offsets that interest rate risk with a hedge such as our ARC Program, FHLB advance or balance sheet derivative. Instead of competing in the 5 or 7 year term, bucket B borrowers are offered 10, 15 or even 20-year terms. Bucket B customers have a lower credit risk, no interest rate risk (this is eliminated through the hedge) and much longer term. The intent of going further out on the curve for bucket B customers is to eliminate some competition and offset interest rate risk at the same time. The strategy for bucket B customers makes particular sense if that customer would otherwise be lost to a national bank competitor that will offer a 10-year fixed rate. Therefore, the community bank is obtaining a customer that it otherwise would not retain.
Bucket B Marketing
Part of the advantage of bucket B loans is that it can be used with laser focus to go after certain segments. Medical professionals, manufacturing companies looking to purchase their facility or schools looking to expand their campus have all been excellent targets that CenterState and other banks have been successful with. By targeting particular customer sets, a bank differentiates themselves by showing a certain level of expertise to an industry which should further enhance pricing and closing success.
Banks deploying this tactic end up with a bucket A portfolio of smaller-sized loans with wider margins, higher credit risk and a more relationship oriented customer. The bank is also able to tailor a solution to the bucket B credit customers who have larger loan needs, are more sophisticated and courted by a number of banks that may be willing to offer 10 to 20 year fixed rates. Rather than competing with many institutions for the standard bucket B structure, the bank will attempt to eliminate smaller bank competition by going much further out on the curve. The bucket B credit customer is a little more sophisticated, has a larger loan size, and is in jeopardy of being lost to a large bank.
The bank deploying the barbell loan origination tactic is able to diversify its portfolio by size, credit quality, term and interest rate risk. When rates rise, bucket A loans will decrease the bank’s net interest margin (NIM), while bucket B loans will increase the bank’s NIM. Prepayment speeds typically decrease when rates rise, however, for bucket A loans the bank can forgive the prepayment penalty to attempt to increase prepayment rates in this loan category. Bucket B loans will enhance the bank’s loan credit profile – these loans are better credit, refinance risk has been eliminated and low fixed payment coupon all lead to better long-term NPAs for the bank.
While bucket A loans help the bank’s current earnings, when rates rise bucket B loans will help the bank with margin. The additional advantage to the bank is that bucket B loans are better protected from competitors (a long-term fixed rate loan with the right prepayment structure is difficult for a competitor to poach). For banks that are struggling with loan volumes, bucket B loans will comprise a small but important portion of the total loan portfolio. These bucket B loans will be larger size and enhance the bank’s loan-to-deposit ratio.
The barbell approach has historically worked for the fixed income portfolio and can be very effective for the loan portfolio as well. The advantage of incorporating the barbell approach to a loan portfolio is that it can create better credit and interest rate diversification, increase loan volumes, eliminate some competition (and hopefully increase returns for the bank) and allow a more focused and effective loan marketing campaign.
Submitted by Chris Nichols on November 03, 2015