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Are you pricing loans for risk?

6 ways to look at the risks every lender takes

“There’s really not much that indicates we’ve learned anything new over the last several cycles,” says veteran lender and CEO Ed O’Leary. Each week in his blog he strives to fix that. “There’s really not much that indicates we’ve learned anything new over the last several cycles,” says veteran lender and CEO Ed O’Leary. Each week in his blog he strives to fix that.

I have a friend of long standing who has had a successful career as a bank consultant and extensive experience in teaching fundamentals of lending to client banks. He’s also a regular presenter at banking schools and conferences, so a great many lenders have heard his ideas and comments firsthand. He typically introduces the topic of risk by saying that lenders can: avoid it; mitigate it; transfer it; insure against it; limit it (risk caps) …

… or just plain take it. (More about that later.)

That’s a pretty good laundry list of alternatives typically available to lenders. And I suspect that all of us have done all of these things at one time or another.

Yet there’s soft underside to this range of risk management activities. I bet that we’re not paying enough attention to it. And we should be, because the current credit cycle appears to be moving into a more mature phase.

Warning bells from OCC

Several weeks ago the Comptroller of the Currency released his semi-annual risk assessment summary for national banks. The formal report and the Comptroller’s accompanying public statement suggests a rising level of concern at certain practices the examiners are seeing nationally.

Two items on the list that caught my eye are an easing of loan terms and an anxiety for income.

Easing of terms frequently manifests itself in an increasing number of exceptions to long-standing provisions of a bank’s loan policy for alleged competitive necessity. Anxiety for income often results in a lengthening of the duration of investment portfolios and a tendency to generate incremental loan volume primarily on the basis of loan pricing.

Probably the fundamental risk-reward relationship for banks (if not for all enterprise) is the Return on Equity ratio. This is the return on the investment of the owners and its calculation is simply net income divided by average owners’ equity. This ratio expresses the idea that reward is usually commensurate with risk.

In other words, greater returns are usually accompanied by greater risk to the enterprise.

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So, a fundamental question to me is whether banks explicitly link risk management activities in the way they price for their services. Simply put: Are we pricing for risk?

There are some who will say that the only way to literally price for risk is to charge a rate of interest of 100%. So much for the strictest application of that principle, as it will not generate much loan business.

Examining 5 ways of handling risks

Let’s look at my consultant friend’s list of risk management activities and ask, what are the explicit costs associated with adopting each strategy?

1. Avoid the risk means declining the risk. Don’t do the deal.

2. Mitigate the risk can mean a variety of things. But often it means a higher level of scrutiny of the borrower’s activities.

To accomplish this we must spread statements, administer and control our collateral, make frequent and regular inspections, and require periodic reports and certifications from the borrower. If this doesn’t occupy much time by the lender, then someone in Credit Administration is performing the tasks.

And one way or another, this activity has to be paid for.

3. Transfer the risk can also imply a variety of activities, but it will often require some specific action, such as hedging.

4. Insuring against the risk is an explicit cost to the borrower or the bank.

5. Putting limits on the risk may mean hedging at an explicit cost to the bank or a transaction that is less satisfactory to the borrower because of what the limits may be and how they will be managed, overseen and enforced.

6. Take the risk. We often do that—and—willingly, because we believe that we have prudently underwritten the credit and fully understand the risk to the bank by our experience with the borrower and our assessment of external conditions.

Hopefully, we’re not cutting corners here.

But are we thinking of the explicit but always obvious costs associated with about everything we might do other than simply accept the risk? 

Are you offering cut-rate credit?

I suspect not. We often ignore the administrative costs that on a deal-by-deal basis may not be burdensome but in the aggregate can significantly impact bank profitability over time. In the normal press of business, we often don’t stop to consider what the embedded costs of increased scrutiny and administration ultimately mean.

Instead, we drive the resulting loan rate calculation by an assessment of what’s the skinniest rate that will be acceptable to the borrower and that we can “get by with” in the loan approval process.

Lending money usually means for a bank’s loan officer negotiating on two fronts—with the borrower and with the loan committee.

Which part is easier for the lender? I can imagine the smiles that this question might provoke, as some bank environments are very tough on the principle of appropriate pricing.

Competition is and always will be the “balance wheel” of what the market will demand (or permit). But we too seldom ask the issue of what the alternative risk management or abatement strategies will require in terms of explicit cost.

From my years as a regional bank’s credit administrator, I can tell you that the costs are substantial and seldom receive top of mind or consistent attention in the loan underwriting process.

The recent rate increase by the Federal Reserve has not helped the industry’s net interest margin problem and probably won’t in the immediate future. Relief will require continued emphasis on loan pricing. The Comptroller’s comments recently reaffirm the tendency to underprice our principal product.

Unfortunately we continue to be locked into a long-term problem that the market will not solve for us very soon. Instead, we’ve got to focus on pricing for the sake of our margins and administrative overhead.

Is your bank appropriately pricing for risk? Tell me about it in the comment section below.

Ed O’Leary

Banking Exchange Contributing Editor Ed O'Leary, a veteran lender and workout expert, spent nearly 50 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. His last job before retiring was as the CEO of a regional bank headquartered in Alburquerque, N.M. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending. O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools. Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses. You can e-mail him at etoleary@att.net. O'Leary's website can be found at www.etoleary.com.

In mid-2016 O'Leary's "Talking Credit" blog received a bronze excellence award for the Northeastern Region from the American Society of Business Publication Editors.

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