Preparing for Rising Interest Rates: Key Steps for Financial Institutions

With the potential for rising interest rates, financial institutions must proactively manage their loan portfolios. Many loans set to reprice or mature within the next 6 to 12 months will likely face higher interest rates, posing significant risks to individual borrowers and the overall portfolio. Here’s how institutions can prepare and mitigate potential issues.

Preparing for Rising Interest Rates: Key Steps for Financial Institutions

Identify Loans Repricing or Maturing in the Next 6–12 Months

One of the most critical steps financial institutions can take is identifying loans that will reprice or mature soon. These loans will likely be subject to higher interest rates, which could impact borrowers’ ability to meet repayment obligations. Assessing the dollar amount of loans set to reprice and reviewing collateral values can help institutions anticipate potential risk rating changes. This early analysis allows banks to identify vulnerable borrowers and the possible impact on the loan portfolio. Institutions can take preemptive action by tracking loans approaching maturity or repricing, such as restructuring terms or increasing communication with borrowers, to mitigate potential risks.

Strengthen Stress Testing & Scenario Analysis

Robust stress testing and scenario analysis are vital for understanding credit risks, especially in a rising rate environment. These tests allow institutions to simulate various financial scenarios and assess how borrowers and loan portfolios respond to different economic conditions. When conducting stress tests, institutions should focus on:

• Cash flow: Understanding how rising rates may impact borrowers’ cash flow is crucial to determining their ability to meet loan obligations.
• Interest rates: Examining how higher rates affect existing and new loans.
• Occupancy rates: For real estate-backed loans, stress testing the impact of changing occupancy levels can help assess property income streams.
• Cap rates: Analysing how changing cap rates affect property values and, subsequently, loan collateral.

These stress tests can uncover potential cash flow concerns, allowing financial institutions to address risk rating changes proactively.

Compare Actual vs. Projected NOI

Another essential step is comparing actual net operating income (NOI) against borrower projections and appraisal NOIs. This comparison allows institutions to gauge whether the property’s performance aligns with expectations. If the actual NOI falls short of forecasts or the property’s value has declined since the appraisal, the financial institution can take corrective measures, such as adjusting loan terms or risk ratings. Regularly comparing these NOI helps identify underperforming projects requiring more immediate attention.

Evaluate Construction Loans with Permanent Financing Conversions

Construction loans with upcoming permanent financing conversions are another concern in a rising rate environment. The permanent financing rates are likely higher than those assumed during the original underwriting process. Financial institutions must carefully analyze the projected cash flows under current interest rates to determine whether borrowers can still repay their loans with the new, higher rates. If the existing projections don’t support repayment under the new rates, institutions should adjust expectations and possibly renegotiate loan terms to safeguard both the borrower and the institution.

Act Early to Prevent Credit Losses

Early identification of potential problem loans is crucial to avoiding credit losses. By analyzing loans approaching repricing or maturity, conducting thorough stress tests, and reassessing borrower financials, institutions can develop timely strategies to address risks. Proactive measures, such as renegotiating loan terms, providing borrower support, or adjusting risk ratings, can significantly reduce the chances of loan defaults. Financial institutions well-prepared for a rising interest rate environment will be better positioned to protect their portfolios and maintain robust economic health.