As loan pricing becomes more competitive, the opportunity to book high quality credits at thin margins presents itself more and more. A 2% margined loan represents about a 9% risk-adjusted return on equity (depending on your cost structure), which is below most bank’s cost of capital. As such, there is every reason to pass on the credit and let another bank book the loan. However, before you do, consider the following points:
EPS is increased
Booking a 9% loan may hurt your ROE and ROA, but it will help your earnings per share. This is a clear case of being clear what your goals are. Is it a dividend? Capital efficiency? Or, is your goal another metric? EPS is likely what your shareholders are really concerned about. While we are big fans of capital productivity, we would argue that under-deployed efficient capital is not as good as fully deployed non-efficient capital. If you have under-leveraged deposits and capital, then that 9% ROE loan should be considered.
A bank is not the sum of its loans
A bunch of 9% ROE loans can produce a 20% ROE bank. If constructed the right way, a well-engineered balance sheet produces greater excess return than the sum of its parts. Build a diversified portfolio and the sum of your risk is decreased thereby increasing the ROE on all loans. In fact, proper construction can add approximately 20% more return making that group of 9% loans closer to an 11% return. Further, interest income is just one part of the equation. That loan also represents fee income, referrals, deposits and other future business that you may or may not be capturing. Additional income may not only come from future cross-sell, but from future growth in the relationship, as those $50k of balances turn into $150k in two years. Add these streams in and your bank can easily take those 9% loans and turn them into a 20% relationship. In fact, while a bank is not the sum if its loans, the sum of its relationship profitability would yield something closer to aggregate ROE.
You are measuring risk wrong
Almost every bank measures risk at its highest point – at inception. The reality is that risk changes over time. Businesses grow, property appreciates and loan balances get paid down. All things being equal, the risk of a loan peaks somewhere between years two and five of a life of a loan and then trails down. Of course risk can increase at any time, but the odds are with you that the risks decrease if you pick the right management team. Few risk systems capture the profile of credit exposure over time and so approximate the probability of default at the time of booking. As seasoning occurs, spreads tightened giving that loan more value and increasing the return substantially above that 9%. It is also important to realize that most likely you are counting your loan reserve as an expense when it is capital. You might include a 2% reserve now resulting in 9% return, but the reality is you will likely reduce your loan loss reserve in the future, particularly as credit quality improves.
You are ignoring operating leverage and the time value of money
You might be allocating your capital, funding cost and direct loan maintenance expenses to the loan, but that says nothing of the fixed investment you have in your infrastructure. Even if you are one of those sophisticated banks that have a state-of-the-art funds transfer methodology, it is doubtful that you take into account the opportunity cost of resource slack. You may want to hold out for that 20% ROE loan, but while you do you have excess capacity and under-deployed resources that could be producing income. Better to use your loan system, branch, risk management system and other fixed resources with excess capacity to drive dollars to the bottom line today. A dollar today, means much more than a dollar tomorrow.
You face a declining cost curve
Processes and technology is increasingly driving down the future cost of operating a bank. Just as remote deposit capture reduces the need for a courier or a branch; new loan processing systems, credit stress test models, channel delivery, management systems and hundreds of other items will make the bank more efficient in the future. Banks not only base their profitability decisions on loans using the highest expected credit risk, but they also underwrite loans based on their current cost structure. Wells Fargo, for example, is underwriting loans not on where their cost structure is today, but where it is in the future. If you don’t have initiatives to reduce operating cost in the future, you should and planning for it will ensure it will happen and thus should be considered when booking loans today.
You face an inclining fee income curve
The opposite of the above, to survive, your bank will also have to add other products such as international services, insurance, treasury management, payroll and other products to produce fee income. Adding these future services will increase the overall lifetime value of a large portion of your customers, thus resulting in higher future ROE for many of your customers. If you don’t have the quality businesses that you need, you may never have enough scale to make these fee income lines worth the risk.
You have already invested your acquisition cost
Most likely you have already spent half your acquisition cost in putting the bank in a position to issue a term sheet on the loan. While not our best argument, making that loan at 9% recoups that investment in obtaining that relationship and enhances the banks overall ROE compared to letting that loan go to a competitor.
Speaking of the loans you want to go to a competitor, it is the higher margined, riskier loans that contain a large credit component that you really want to see go to a competitor. These loans may produce a high ROE now, but if you are going to error, we recommended erring on the side of being able to extract future value from a quality relationship than having to bet on future credit fundamentals.
Before you turn down that quality loan at a thin margin consider there is very little correlation between earnings and net interest margin. A bank is faced with a series of investment decisions at any given time and it has to be sure that before you pass up that 9% ROE loan a better loan must come by and come by quickly. If you give up that 9% this year, because of the time value of money, that means you need to book loan with a larger ROE next year and a still larger ROE the year after. If you are already leveraged up, then passing on a low earning loan may be your best move. However, if you have under-deployed capital, funding and infrastructure, making that 2% margined loan may be your best tactical move.
Submitted by Chris Nichols on May 07, 2014