Archived Information

Reauthorization of the Higher Education Act


Impact of the Administration Student Loan Interest Rate Proposal On Small Banks

Some lenders under the Federal Family Education Loan Program (FFELP) initially claimed that the scheduled change in interest rates would destroy their profitability by mismatching a long-term student rate with their own short-term funding vehicles. The Administration has addressed this concern by proposing a return to 91-day Treasury bills or some more efficient short-term rate for student interest payments, while ensuring that students still receive the benefit of the scheduled reduction in rates. Some lenders now say that small banks will desert FFELP en masse if that reduction is made, but there is no factual basis for such a statement. Most small banks participating in FFELP essentially act as brokers for the secondary market so a student rate that maintains a sufficient level of profitability for the secondary markets will enable small banks to continue to participate in the program -- unless the secondary markets decide for other reasons to eliminate them.

Most small banks still participating in FFELP essentially act as brokers for secondary markets. The 25 largest bank originators account for about 55 percent of new loan volume. The 50 top loan originators account for almost 75 percent of total volume. Well over the bottom half of the current bank lenders account for only one-half of one percent of total volume, and they sell their loans as fast as they originate them. They act primarily as sources of product for the secondary markets. In this capacity the originating banks often (1) receive from the secondary markets the capital and servicing capacity to maintain the loans as record owners for short periods of time after originating them, (2) are guaranteed a net interest spread while the loans are in their names and (3) then transfer the loans to the secondary markets, usually at a premium guaranteed in advance. Such banks are in the business to earn fees for their services, not to earn a rate of return on capital. Their profitability is determined by their overall arrangements with the secondary markets, not just by the interest rates on the loans.

Small banks have been leaving FFELP for many years. Since the middle 1980s, the number of FFELP lenders has declined from over 11,000 to under 5,000. The vast majority of the lenders leaving the program have been the small ones, including most small banks that actually held loans through repayment. The decline in their number has been the result of a variety of causes: particularly, general consolidation in the financial services industry, transfer of one-third of loan volume to Direct Loans and the very small size of most banks' participation in FFELP. In 1996, for example, the average total loan originations of the smallest 10 percent of bank lenders was only $59,000.

The Administration's proposal will not significantly accelerate the departure of small banks. The role of small banks as marketing arms for secondary markets is dependent on the continued profitability of the secondary markets. Since secondary markets have competitive advantages over banks, such as the some $15 billion in tax-exempt funding for those other than Sallie Mae, there is no reason that an interest rate sufficient for large banks would not be sufficient for them also. Indeed, Sallie Mae has traditionally had the highest rate of return among lenders.

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