Commercial loan competition is intense and we recently witnessed a long-term customer of a community bank refinance with a competitor bank for just a 15bps lower loan rate, zero closing costs and no loan fees. This is an extreme example, but the point is germane – competition is intense and community banks need to be creative to manage profitability. We would like to share one particular tactic that we use at CenterState Bank to increase commercial loan profitability. We are certain that your bank can benefit from this same approach and possibly experience an immediate increase in earnings.
Regardless of your geographic market, your bank’s size or management expertise, if you have an existing loan portfolio and your lenders are also tasked with booking new loans, then the tactic we promote at CenterState Bank will also work for your bank.
It costs the average community bank approximately $14k to book a new commercial loan, but only about $2k to modify or amend an existing commercial loan. The difference between a new credit and an existing credit (all else equal) is 5.1% in ROE. Stated another way, if you retain one existing loan, and concurrently book another identical loan with a new client, the existing loan has a 5.1% higher return on equity than the new loan. That is enough to move your from an average performing bank to an above average performing bank.
The economics of loan origination versus loan retention are intuitive and the results make sense. The cost of garnering new commercial loans is very high as it takes time and effort. Booking a new client involves enormous costs in marketing, sales time, underwriting and documentation. Unfortunately, the prepayment speeds on commercial loans at community banks is unnecessarily high and is running at over 30% per annum at many urban community banks. Banks that can simply decrease commercial loan prepayment speeds at the bank by 50% can increase the bank’s loan portfolio ROE by about 80bps. There is no other way to achieve such a large incremental return on a loan portfolio without changing the infrastructure, location or product set of a bank.
At CenterState, we strive to avoid high prepayment speeds by simply taking the time to identify profitable existing loans and spending approximately 25% of our marketing efforts in defending existing relationships and lowering prepayments.
We identify profitable relationships and then identify any of the following variables that increase the likelihood of that customer being poached by competitors:
- Any expression of dissatisfaction with the bank, banker, terms or pricing of the existing loan
- Loans maturing within the next 2-3 years
- Borrowers that are paying above-market fixed rates or credit spread
- Borrowers with no, or weak, prepayment penalties
- Term loans with variable rate structures
- Borrowers with low switching costs (no treasury management, wealth management or investment management services)
- Customers with high probability of defection triggered by low product usage, lack of primary relationship, etc.
- Customer is not in a loan structure that best matches their asset-liability position
Any of our profitable customers that demonstrate any of the above parameters are emphasized for cross-sell and loan modification. Our advantage as the existing lender is that we know the borrower’s business and credit well, we have the customer’s financial information and any amendment or add-on business can benefit from a quick closing.
Loan Modification Strategy
One specific element of our strategy is to approach existing commercial relationships and offer them loan modification that reflect current prevailing interest rates, extend fixed rate terms or simply reflect the client’s current business needs.
Our modification strategy involves a simplified process of creating a change in terms or loan modification agreement. The entire set of documents may be as short as four to six pages. We also provide this service with or without fees depending on circumstances and market competition. We forgive prepayment penalties and we can roll in costs of any yield maintenance provision into new loan terms. New appraisals may, or may not, be required depending on the nature of modification, underlying collateral, and advances of any new funds. We use our hedge program to offer fixed rate terms out to 20 years.
Defending existing relationships and driving down prepayment speeds on commercial loans is perhaps the single most efficient and productive way for community banks to enhance ROE. The specific strategy of modifying existing loans to retain clients can enhance the loan’s return on equity by approximately 5%. There is scarcely any other way to drive such an increase in loan profitability.
We observe that the vast majority of community bank energy is devoted to marketing, sourcing, and booking new business, but much less emphasis is placed on maximizing profitability on the existing loan portfolio. Banks that can devote resources to modifying existing loans which may be at jeopardy of prepayment can gain significant profitability.
Submitted by Chris Nichols on January 24, 2017