by
Dallas Wells
There is a common saying in banking that you are only as smart as your dumbest competitor. Some of you probably hear that and cringe, but unfortunately it seems all too true today, especially in the market for loans. As a follow up to
yesterday's post, why is it that so many bankers are so willing to give in to borrowers right now?
In short, it comes down to the fact that the loan market a a whole is not growing fast enough:
Banks are facing rapidly declining asset yields, and have no more room to reduce funding costs. Margin compression is a reality for all banks, and the only solution is to outgrow the dropping asset yield. It is a simple rate vs volume trade off. The problem is that most banks in any given market are pursuing this same strategy, and the puny overall loan growth can't provide for everyone. Banks are trying to grow by stealing business from each other, which has created a nasty
Nash Equilibrium.
This particular Nash Equilibrium is causing the "right" decision for each bank to be to match low rates. How so?
Consider a small market that has two banks (Red Bank and Blue Bank) that are competing for the same $2 million worth of loans ($1 million at each bank). The loans are currently at 5%, but the borrowers want to refinance and feel that it should be a 3% loan in the current environment. This table summarizes the choices for each bank:
Each bank has the choice to either offer 5% or 3%. If both banks offer 5%, they can expect to retain their loans. However, if one offers 3% and the other holds at 5%, the bank with the lower rate ends up with both loans. Here is the revenue impact of the decision matrix above:
With this table, we can look at the expected outcome. Red Bank can offer 5%, and they will either earn $50k or they will earn $0. With a 50/50 probability from Blue Bank, their expected revenue is $50k + $0k = $50k, times the 50% probability = $25k. In other words, if they offer 5%, they can expect to on average earn $25k.
But, if Red bank offers 3%, they will either earn $60k, or they will earn $30k. Using the same process, $60k + $30k = $90k, times the 50% probability = $45k. If they offer 3%, they expect on average to earn $45k.
This is a Nash Equilibrium because both banks face the same decision, and can know how the other will optimally behave. If both banks were willing to stay at 5%, they would each earn $50k. Instead, using the basic thought process above, they will actually earn $30k. Both banks reduce their income out of fear.
So what is the answer? Unfortunately, there is no easy answer, which is why we are all still facing this conundrum on a daily basis. The banks that are avoiding this, though, generally fit somewhere on this list:
- They are a niche lender with expertise in a specific market. This expertise either provides added value for the borrower or limits the competition.
- They have long term borrowers that have been with the bank through multiple rate and economic cycles. The bank has built trust, and their borrowers know they will treat them fairly. There is no need to shop every new and old borrowing need.
- They are proactive with their balance sheet structure, and find ways (such as with swaps) to offer terms that other banks will not bid as aggressively. Every bank in town will chase a short or variable rate loan with a strong credit profile. Not as many will chase a 10, 15, or 20 year fixed rate.
If you feel like you are stuck in this Nash Equilibrium with no end in sight, where can you fit on this list to end the cycle?
Let us know if we can help.