Most banks feel comfortable making smaller-sized loans. But should that comfort level be so automatic?
The obvious reasoning is that a smaller loan will present less of a loss should it go into default. And it follows that less of a loss means less risk, and, therefore, higher return.
That reasoning could be faulty and could end up getting your bank into trouble. Often it is the larger loan that presents less risk.
Why bigger may be better
There are three reasons I make this statement.
1. Acquisition cost. The investment to book a larger loan is just slightly more from a dollar value perspective (and lower on a percentage basis) than that of a small loan.
2. Workout cost. Should the loan go bad, the workout cost is almost identical for a wide swath of loan sizes.
You still need a new appraisal, you still need a lawyer and you still need to manage the workout process. As a result, the loss given default on a percentage basis is much larger for the smaller loan than the larger loan.
3. Borrower strength. Larger loans tend to be made to larger borrowers. Typically these credits enjoy more financial support and are in larger markets with more liquidity.
As a result, the loss given default from the liquidation sale alone is often smaller on a larger loan than it is on a smaller loan.
A practical example
To illustrate this, let's compare a $600,000 loan with a $4 million loan. Let’s hold everything constant, including the probability of default, loss given default, and even workout costs.
For both loans, historical direct and indirect workout expense is approximately the same at $159,00. For the $600,000 loan, assuming a loan made at 75% loan-to-value, that workout expense is 19.8% of the collateral value. This compares to only 2.98% for the $4 million loan. Acquisition cost, if we add it in, further exacerbates this.
If you assume a 2.10% probability of default on both loans and a 25% loss given default net of workout expenses, because of the economics of the above, you would lose $156,000 on the $600,000 loan, but only $139,000 on the $4 million loan. If you adjust for liquidity, that loss difference is even greater.
The other way to look at this is you would need a smaller loan-to-value ratio on the $600,000 or a lower probability of default to equate to the same risk-adjusted return.
For example, if the probability of default was 3.35% for the $4 million sized loan, you would need a 2.10% probability of default on the $600,00 loan to equate to the same return.
Implications for lender prospecting
The economics of loan size is important to take into account when evaluating the overall risk of a loan.
Often this is a strategic decision of targeting a certain size or type of small business or a certain geographic area. Other times, this is a tactical byproduct of having the bank focus on non-risk-adjusted margin.
When non-risk-adjusted margin is an objective, the bank has a higher probability of getting adversely selected so that new origination is composed of a higher-than-average number of higher risk loans.
These loans often have higher credit processing costs, as there is usually a “story” to them so underwriting is more complex. Such loans are often in higher-risk areas, such as construction or in tertiary markets.
In practical terms, lending risk should be viewed on an expected loss basis and not just a function of loan size. Banks that target smaller loans may find that they are getting a false sense of security and potentially sacrificing credit and earnings risk.
To create a more profitable bank, take a look at your portfolio and understand how loan size can decrease the loss given default.