In two previous articles on the utilization of scale when it comes to lending, we analyzed certain variables on all commercial mortgages originated in 2017 by all bank lenders. We looked at (HERE) the relationship between the size of a commercial loan and the loan’s profitability. We also considered (HERE) the relationship between average loan size, the number of employees and salary with regard to the impact on general bank performance. We provided specific recommendations that community banks can immediately deploy to increase performance in 2018.
Our conclusions from the two previous articles are as follows:
- While national banks are originating larger CRE loans, the average loan size at these large banks is $3.7mm (well within the lending limit of many community banks). Community banks (banks below $10B) originate much smaller average CRE loans (for many community banks, the average commercial loan size is $300k).
- Larger loans are more profitable for commercial banks. CRE loans in the $1mm to $2mm range can substantially improve community banks’ return on assets (ROA).
- Evidence shows that the market does not allow sufficiently wider loan pricing for smaller loans. Smaller loans are less profitable because of the disproportionately higher origination and maintenance costs. Based on our analysis, community banks can increase ROA by an average of 39 bps by increasing average commercial loan size from $300k to $1mm.
- Larger banks have substantially more loans per employee, and there is a substantial positive correlation between loans per employee and a bank’s ROA. Community banks that can increase loans per FTE can increase performance substantially.
- Decreasing loan run-off is another important factor in increasing bank performance, and banks should target loans that have longer expected average lives. This often means targeting more relationship driven customers but usually always means utilizing prepayment provisions in the loan.
- There is a positive correlation between salary-per-full-time-equivalent-employee (FTE) and a bank’s ROA. While not immediately intuitive, it does make sense that better employees command higher compensation and these employees generate higher ROA.
In this article, we would like to explore strategies that community banks can deploy to increase loans per lender to enhance ROA.
The Commercial Banker Loan Portfolio
The average top performing commercial lender that is focused on relationship banking and not just being transactional can maintain 15 to 35 active accounts. At an average commercial loan size of $300k, and an average of two loans per account, that translates to a $9mm to $21mm commercial loan portfolio per lender. This is generally not sufficient revenue to produce a positive ROA when factoring cost of funds, cost of credit and other required support staff.
We spoke with more than 20 self-reported “relationship-driven” banks with a return on equity performance for 2017 (3 quarters) above 13%, including our own, to collect data on what a commercial loan portfolio looks like with regard to FTE leverage. We compared that performance to average bank data. For “Lending FTE” we included all commercial lenders and portfolio managers. Also, for clarification, we point out that this article is by no means implying that you can be a top performing bank if you focus on relationship management. In fact, as we pointed out in previous research (HERE), or data indicates otherwise. This is admittedly a small sample size and we positively selected relationship banks that were “top performers” based on ROE. Despite those survey limitations, the data does point to some interesting insights.
From the table below, you can see that if you are going to focus on relationships, it pays to focus on the relationship and use your valuable time to go after fewer, but larger loans not to mention relationships with more deposit balances.
The following are variables that directly affect a lender’s ability to manage a loan portfolio:
- Lenders that perform underwriting and maintenance functions will be able to carry fewer accounts in their portfolio. Therefore, each loan must be larger to justify the lender’s cost. Lenders that perform sales and relationship management roles can carry a larger portfolio.
- Loan portfolios reflect the 80/20 rule. That is, 20% of any lender’s accounts generate 80% of the revenue and profitability. Community banks must have a defined strategy to grade each account and develop a plan for maintaining the most profitable customers while attempting to migrate or shed the suboptimal relationships. Many banks use a 1 through 4 scoring system. Customers rated “1” are most profitable for the bank, customers rated “2” have a potential to be a “1” with more resources and time. Customers rated “3” are marginal, but worth maintaining. Customers rated “4” are on profitability watch and may be a drain on the bank’s ROA.
- The vast majority of lenders cannot make more than 200 calls per year, and most lenders are maxed at 100 calls per year. Customers rated “1” would be touched ten times per year. Customers rated “2” would be touched six times per year. Customers rated “3” and “4” would be touched four times and once per year, respectively.
- New business acquisition is important for any bank because customers are inadvertently lost, and some customers should be actively shed. Therefore, average relationship lenders will allocate somewhere between 30% and 50% of their calling efforts on new business acquisition. That means out of 100 calls per year, 30 to 50 will be on prospects because it takes about 50 qualified and researched calls per year to garner 4 to 5 new accounts.
- Lenders that work at banks that do not have business development officers, inside sales and lead generation or marketing support will need to do all of this work in addition to their lending function.
Let us analyze all of the above information into a diagrammatic format assuming that a lender can make 150 calls per year:
Any lender making 150 calls per year, and staying involved in some underwriting duties is keeping very busy. But that lender is handling only 25 customers. Each customer may have an average of two loans (customers rated “1” have more loans and customers rated “4” will have fewer loans). If the average loan size in this portfolio is $300k, the total loan portfolio is only $15mm. At an average loan yield of 4.5%, the portfolio revenue is $675k which is insufficient to cover salary, cost of funding, cost of capital and overhead for support staff.
A few important comments emanate from our analysis:
- Focusing on net interest margin can hurt you. You may achieve your net interest margin goal for the year, but you can’t spend net interest margin. Don’t be pennywise and pound foolish here – You would rather have a larger relationship at a smaller margin than a smaller relationship at a wider margin. Focus on risk-adjusted return and net profit then watch the difference in your performance.
- Seasoned lenders should strive to maintain an average loan size of $1mm for customers rated 1 through 3.
- Community banks must ensure low prepayment speeds for loans in the 1 through 3 rated bucket. This means being mindful of your customer segment, your loan structure, and your pricing.
- Community banks would be well served to allocate resources to inside sales, lead generation, and marketing support to help lenders maximize their prospecting efforts. Lenders often don’t know what they don’t know and need training on how to work with an inside sales marketing person that can assist.
- Community banks must use a Customer Relationship Management (CRM) system. A CRM system increases lenders’ efficiency, and it also institutionalizes accounts so that when lenders leave, the bank has a database of calling efforts and a record of the prospecting funnel. You can’t grow, say you are all about “service” and purport to be a relationship-driven bank without a CRM system. Stop handicapping yourself.
One way that community banks can increase commercial loan profitability is to analyze their lending team and loan portfolio composition and distribution. Most lenders cannot make more than 150 calls per year and 30% to 50% of those calls will be on prospects. With no more than 100 calls per year available to service existing accounts, and assuming that top customers are called ten times per year, a lender becomes stretched for time very quickly. A seasoned lender should maintain an average customer lending balance of $2mm with an average of 2 loans per customer or about $1mm per commercial loan average. Mathematically, loans below a $1mm, unless they are gateway business, are rarely profitable for community banks.
Submitted by Chris Nichols on January 22, 2018