Evaluating how your bank’s loans are priced relative to risks and costs
By Tom Farin
Competition for quality loans is becoming intense. It’s happening on the retail side with auto loan pricing, especially for indirect loans. It’s also happening on the commercial side, particularly for 5/15 and 5/20 balloon commercial real estate loans. Community banks generally fall into two camps—those that price by the seat of their pants based on competitor rates, and those that use loan-pricing models.
The seat-of-the-pants advocates claim that the market sets rates, not some loan-pricing model. But many of these banks have been confounded by how to compete at current extremely low market rates. Without a loan-pricing model, a bank has nothing to use as a benchmark to evaluate whether its low-rate loans are well priced relative to its risks and costs.
This raises an important point: In most circumstances, loan-pricing models are not used simply to price loans (as the name implies). Rather, they are best used to separate the well-priced from poorly priced loans based on rates being offered in a market.
Using loan pricing models
Merely having a loan-pricing model doesn’t necessarily solve the problems encountered by the seat-of-the-pants crowd. Such models need good data, need to consider all the risks and costs associated with loans, and need to focus on the right decision tool for making decisions.
Let’s address three requirements for using loan-pricing models effectively.
– Have good data. When a bank prices a loan, it is pricing cash flows, not maturities. So it needs to know how a loan gives off its cash flows and whether the interest flows are fixed or variable. In addition, the bank needs to have data relative to fees, origination and servicing costs.
– Consider all risks. Loan-pricing models should review interest rate risk, credit risk, option risk and capital risk. A common problem in pricing models is that they fail to consider some risks and miscalculate adjustments for others. A good example is interest rate risk. Many models use the institution’s cost of funds as a funding expense. In doing so they sometimes overlook that it takes more expensive funding to fund a 30-year, fixed-rate mortgage than a variable-rate home equity line.
– Use the right decision tool. Most loan-pricing models focus on risk-adjusted return on capital (RAROC, or return of equity.) A RAROC tool is appropriate when funding is tight and capital is scarce. Booked loans should maximize return on the scarcest resources (capital and funding).
However, RAROC is the wrong tool for many banks today. If a bank is very liquid, I could argue that its cost of funds is a sunk cost. It is already paying for the funding. The real question is, should the bank make the loan or park it in its investment portfolio?
If a bank rejects a loan because its return of equity is 8 percent, well below the bank’s hurdle rate of 15 percent, the money that would fund the loan is going to end up in the bank’s investment portfolio. Have any of you checked the return of equity of your bank’s institutional investments lately?
On the other hand, what if a bank’s loan-pricing model allows it to compare the yield on a loan to a comparable bundle of investments, after adjusting for its risks and costs associated with the loan? If the loan offers a meaningful spread over the investment alternative, wouldn’t the bank be better off making the loan, even if it doesn’t meet its return-on-equity (RAROC) hurdle?
Stepping Outside the Box
It is hard to duck fundamental rules of microeconomics when dealing with loan pricing. Here’s why: Say a large number of institutions are attempting to sell 5/20 commercial real estate loans (the supply) to a relatively small number of quality, A-credit borrowers (the demand). When supply exceeds demand, price gets bid lower. (In banking, price is measured by rates, fees and economic value of the loan being originated.) That is what is happening now for most commercial real estate and consumer auto loans—a supply/demand imbalance that favors borrowers.
On the other hand, say only a few institutions are willing to make fixed-rate, fully amortizing 15- and 20-year commercial real estate loans (supply). Customers for those loans (demand) would love to lock in rates at the bottom of the rate cycle. To the extent demand exceeds supply, prices get bid up—rates, fees, economic value.
If institutions hope to make more loans, then why is the supply of products like fully amortizing commercial real estate loans so limited? Often institutions are unwilling to assume the interest rate risk in these products.
But what if a loan is priced in a way that its rate more than covers its additional interest rate risk? Wouldn’t it make sense to make the loan, turn the additional rate-risk premium over to the CFO and say, “Here’s the additional revenue needed to hedge the interest rate risk in this loan. You decide whether to spend the money.” Properly setting up a loan-pricing model can identify situations where the supply/demand imbalance favors the bank.
Many community banks are asset-sensitive. Their yields will go up faster than their cost of funds in a rising interest rate environment. Adding a fixed-rate loan to an asset-sensitive balance sheet reduces interest rate sensitivity.
A CFO in an asset-sensitive situation may choose the additional premium, rather than pay to hedge the loan’s risk. The hedge is already in place on the bank’s balance sheet to offset the interest rate risk in a fixed-rate loan. In that situation, the loan becomes even more profitable.
Availability of quality loans is tight. But with an effective loan-pricing model and an effective asset-liability model, your community bank may be able to locate profitable loans that fit nicely within its portfolio by stepping outside the box.
So what are you waiting for?
Tom Farin is president and CEO of Farin & Associates Inc., a financial services consulting firm in Fitchburg, Wis.