Thinking through risk-adjusted loan pricing

My last blog, “Loan portfolio management begins with forestry,” discussed how to get started in loan portfolio management, an important strategic component of managing your bank.

I discussed the need to focus on understanding the “forest” better by looking at its contours and characteristics, while not inspecting individual trees. In this blog I’ll discuss how to get started in adding loan profitability to your portfolio management reporting.

Loan profitability is a complex subject that can create dissent within an organization. The program I’ll describe can minimize controversy while providing useful management tools to understand loan portfolio performance.

Loan profitability analysis helps bank management understand which lending activities add to the bank’s economic value of the bank, and which do not. They enable management to put resources where they most belong and to track profitability trends and goals.

It’s my strong view, as stated in the last blog, that loan portfolio management has great value even without profitability information. Please don’t wait to implement portfolio management until profitability reporting is in place!

How profitability and risk management mesh

If you are a chief credit officer or a chief risk officer reading this blog, you may wonder if pricing comes within your purview. In the case of the expectations for the role of the CCO in any given organization, it may not be appropriate. Consistent with my view of ERM, however, I believe pricing lies directly within a CRO’s set of responsibilities. Pricing represent a consistent, long-term driver of shareholder value.

As opposed to many other risk-oriented portfolio reports, loan portfolio profitability focuses on the overwhelming majority of loans in your portfolio—the good (profitable) ones! 

We all know the bad ones lose money, even if (eventually) repaid in full. The discussion here will therefore focus on the good loans in the portfolio and how to understand their contribution to value. As for other portfolio management initiatives, though, a prerequisite is to have in place a risk rating system consistently applied for your pass-graded loans.

What drives your portfolio’s profitability?

The key question you want to answer regarding loan portfolio profitability is: What loan types and of what quality drive the economic value of the loan portfolio at your bank?

Economic value is an important phrase here. This differs from accounting profitability in important ways. A key duty for the CRO is to focus on an approach that fully risk-adjusts your loan portfolio—a clear shortcoming of accounting profitability.

Economic value focuses on the expected long-term performance of a class of assets, whereas accounting primarily looks at today’s results, even after taking into account changes in ALLL standards.

Factors to consider in thinking about economic value include how loans are funded and how they will perform over at least one full economic cycle, among a variety of other items. (I’m deferring discussion of deposits and costs for a later column.)

Loan funding should always be thought of as being done at the margin—because that’s what actually happens. Averages should be avoided, as should unrelated deposits. Because this approach is meant to evaluate risk-adjusted loan profitability, loans should be funded on a matched basis.

Let ALCO manage the degree of mismatches in the funding book; loans should stand on their own.

So you will want to develop a reasonable, consistent approach to how you fund loans of given maturity, repricing, and amortization characteristics. Treasury, of course, will drive those calculations.

Looking at credit costs and capital

The next factor to consider is the expected credit costs (losses) that will be incurred. Since none of us has a crystal ball, long-term average losses should be used to arrive at “expected losses” (EL). EL result from the calculation that looks at the probability of default (PD), exposure at default (EAD), and loss given default (LGD). Although portfolio-level data is available from a variety of sources, you will need to understand losses by risk rating and loan type. Data gathering and estimates must be started.

The next factor is capital, which is just as important as funding and expected credit losses. The role of capital is what the CRO needs to advocate for to enable the bank to establish fully risk-adjusted loan portfolio profitability measures. A bank, like any other business enterprise, adds economic value when its returns exceed its cost of capital. So to determine if an activity adds to economic value, the amount of capital needed and its costs must be determined.

Capital is necessary to keep a business in existence during bad times so it can enjoy the good times when they come. That means that the duration and extent of the bad times affect the amount of capital necessary to sustain a company or support an activity within a company. This concept might be captured in the phrase “volatility of losses.” 

Decades of studies in the banking industry demonstrate that the poorer-rated a credit, the more volatile its performance. This is only common sense. During good times, leverage and expansion are rewarded. Companies earn quick returns and may well have pricing power to sustain or increase margins.

When the business cycle trends down, all that is reversed. The companies that prospered during good times typically, and quickly, fall victim to the economy. Operating leverage vanishes, margins shrink along with pricing power, fixed costs can’t be met, and collateral values fall. Hence, quick and severe losses accrue to the company’s creditors. This sudden and severe change in performance is only partially captured in the EL calculation.

Aligning capital and portfolio risk

A bank with a portfolio of volatile credits needs more capital to absorb losses when they arise. Attributing capital based on risk rating and type of loan is therefore essential to fully risk-adjusting loan portfolio profitability measures.

Even during good times, capital is expensive. The amount of capital required to support a loan portfolio in general is the subject of much expert analysis. One approach that appeals at the community bank level is to bring the average capital in line with the average risk-weighted regulatory capital requirements. In the case of commercial loans, that is 8%.

In deciding how much capital to allocate in a bank that has three risk rating categories, then, 5% can be used for the best pass credits, 8% for the next best level, and 12% for the third level in the pass category. The cost of the capital should then be added to the cost of funding the loan and the expected credit losses to subtract from the note yield, which results in a risk–adjusted gross profit on a loan.

Integrate all this into your portfolio reporting and you will be able to manage your portfolio to add value as well as income.