Commercial loan pricing’s safety and soundness implications

This is the third in a series of articles Harland Financial’s Mitch Lucas that explores the impact of safety and soundness considerations on pricing strategies. In this article, he’ll focus on the concept of relationship pricing in setting rates and terms on commercial loans. You can find links to part 1 and part 2 at the end of this installment.

The concept of relationship pricing is nothing new to the commercial loan officer. However, a good relationship pricing strategy will balance the management of interest rate and credit risk against customer profitability, thus optimizing the rate of return on equity and contributing to the safety and soundness of the institution.

Relationship pricing

In simplest terms, relationship pricing provides flexibility in setting the terms of a loan based on the perceived risk and profitability associated with a particular customer. Practically, this means that the loan officer can offer a custom package to the borrower in order to move a deal forward.

In order to make the deal appealing to both the borrower and the financial institution, the lender may look for ways to bring more of a particularly attractive borrower’s business into the bank in the form of compensating balances or other deposit requirements.

On the other hand, when assessing a potentially high-risk borrowing request, the lender may look for opportunities for cross-collateralization or other methods of risk mitigation.

In order to control such flexibility and make it effective and compliant, it is imperative for the bank to have appropriate models in place to assess pricing of the particular credit at hand, along with the overall customer relationship.

It would be counter-productive to offer incentives in terms of discounted rates to a customer who may ultimately present the institution with an unprofitable relationship. This is true even of high-volume or high-profit customers--in the end, it will not benefit the institution (or for that matter increase the institution’s safety and soundness) to make concessions that reduce the profitability of the new account.

So, the models making up a relationship pricing strategy should consider both pricing and how it broadly benefits the institution, as well as the specific profitability of a given relationship.

The institution must be able to classify customers into one of the following categories, ideally booking many more profitable and potentially profitable accounts than unprofitable and potentially unprofitable accounts: profitable; potentially profitable; potentially unprofitable; and unprofitable.

But how can an accurate assessment of the overall relationship be accomplished?

By following the thought process outlined below.

Overhead costs

Before the institution can fit a customer neatly into a profitability category, the institution must understand the overhead costs associated with loan origination, funding, and servicing, along with the cost of funds. This involves estimates based on the size and type of loans making up the institution’s portfolio.

Overhead costs are not simply a percentage of the loan amount, but rather vary based on the complexity and overall risk associated with each loan. The larger and more complex the loan--a high-dollar commercial construction loan relative to a small commercial installment loan, for example--the greater the overhead to originate and service.

That said, in a competitive pricing environment, high overhead, or excess capital, can break a deal aimed at a profitable or potentially profitable customer.  Competitive influences also should be factored into the calculation of the financial institution’s internal costs, so that internal overhead costs are not overstated. 

Yield curves

After overhead costs are reasonably estimated, a good starting point for estimating the cost of funds and setting interest rates will consider a third-party index or yield curve, such as the FHLB curve, Treasury curve, or LIBOR swap curve.

These indices reflect the relationship between short and long-term rates, and can be used to predict market rates into the future.  Disciplined use of yield curves to set interest rates will contribute to consistency in pricing and add credibility to historical analyses. 

Ultimately, margins based on credit risk can be best defended and avoid fair lending or other challenges if the lender begins with a solid rate methodology. That means transparency in setting rates in light of transaction-specific factors.

Risk-rating

Pricing models should also account for the risk of a loan or customer.

For this to be effective, of course, an institution must have a strong risk-rating methodology that has sufficient risk categories to meaningfully differentiate between them. This contributes to pricing decisions that are profitable for the institution.

Robust risk ratings schemas should consider borrower industry, industry economic cycle, mitigating economic cycle factors, age of business, borrower customer concentration, collateral depreciation versus repayment amortization, and similar influences.

Assuming the risk-rating is based on objective factors, it provides further insulation against claims of unfair lending.

Deposits and other business

When pricing a particular transaction, the loan officer must also assess the borrower’s total relationship with the institution. While this is a somewhat subjective analysis, consideration of the borrower’s compensating balances or other relationships with the institution may result in an adjustment to the interest rate.

Done skillfully, recognition of factors that generate income or reduce the institution’s cost of funds will boost the institution’s profitability in the long run and allow the institution to book more profitable and potentially profitable relationships than the converse.

Note that consideration should be given to Regulation Y’s anti-tying restrictions in this context, but there is a broad exemption for “traditional bank products” that allows for discounts or other consideration to given in exchange for a specified combined minimum balance as long as certain requirements are met.

Loan pricing software

There are a variety of products on the market that can simplify the relationship pricing model. They offer the advantage of providing a variety of options and quickly assessing alternative assumptions to return consistent results.

However, they do not replace thoughtful capital and portfolio management.

As was quoted in the first of this series of articles and is worth repeating here: 

“Effective risk management has always been central to safe and sound banking activities and has become more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking.” (FDIC Risk Management Manual of Examination Policies)

Safety and soundness

The goal of price optimization can be achieved through a consistently applied relationship pricing methodology that considers both pricing and its benefit to the institution and the profitability of the relationship.

This, in turn, will provide reliable documentation regarding pricing criteria reflecting compliance with fair lending laws. Consistency in pricing decisions will help institutions avoid claims of discrimination and disparate impact. Furthermore, an effective pricing strategy that takes into consideration the total customer relationship will build higher quality, more profitable portfolios.

Getting the best return with minimum risk is every banker’s goal. In our next article, we’ll explore consumer and portfolio pricing strategies.

About Mitchell Lucas

Mitchell V. Lucas is vice-president, product management and legal compliance, Harland Financial Solutions

Part 1: Making innovative pricing work

Part 2: Deposit pricing’s safety and soundness implications