The Perils of Fixed Rate Lending

Offering fixed-rate loans to commercial customers in today’s rate environment might seem like a win-win scenario: customer gets a product they are familiar with, and the bank is protected when rates decline. However, the unclear market outlook and political uncertainty add considerable risk to such an approach. Instead, banks should consider interest rate derivative solutions, which can offer more predictability and flexibility.

When projecting future funding costs for the bank, the factors influencing short-term funding (Fed policy, inflation, and labor data, US economic growth) have been remarkably unpredictable, a dynamic not expected to change in the coming months. 

Market projections for short-term rates at the end of 2025 have climbed ~50 basis points since early September. Recent data has shown strong labor markets and persistently elevated inflation, while central bankers have made it clear that the Federal Open Market Committee (FOMC) will cautiously approach any potential future rate changes.

Let us look at two hypothetical market scenarios:

Higher Rates

• Fiscal policy has stimulated the economy, tightened labor markets, and fears of excessive inflation materialize. The Fed ceases cutting short-term rates and is forced to consider further hikes in the coming years.

• Banks that offered fixed-rate loans based on over-estimates of rate declines will miss out on higher floating yields and may face margin compression as deposit costs climb.

Lower Rates

• The US economy enters an unforeseen recession, the Fed cuts rates by 200bps and is expected to leave them there for an extended period of time, driving the long end of the curve lower. 

• Prepayments of higher-yielding fixed-rate loans accelerate, precisely when banks would prefer to keep them on their balance sheet. Prepayment penalties are often negotiated by borrowers, thus limiting their reliability as a way to offset the earnings impact of prepayments or influence borrower behavior.

Derivative solutions can more effectively help banks protect margins:

Launch (or continue utilizing) a customer swap program.

• Banks offer borrowers a pay-fixed interest rate swap coupled with a floating-rate loan.
• Borrowers pay a fixed rate, while banks book a floating-rate asset that secures a credit-quality appropriate margin .
• Customer swaps also present a significant non-interest fee income opportunity for the bank.

Hedge individual or a pool of loans on a one-off basis.

• Banks can extend a conventional fixed-rate loan to borrowers, then synthetically convert it to a floating-rate asset by executing a pay-fixed swap.
• Borrowers obtain a familiar loan structure while banks earn a variable rate and benefit if rates remain high.
• This approach is especially useful when borrowers fall outside the typical profile for a customer swap.  

With either of the above approaches, it is prudent to have the proper sales, accounting, technology, and operations expertise – whether that comes via in-house personnel or partnering with an experienced advisor/fintech firm.

Contact us at [email protected] or 212-651-9050 to discuss the appropriate solution for your financial institution.