Part of the problem with banking education is that it is incomplete. Banking schools like Stonier and Pacific Coast Banking School are good but they just teach part of the picture. They can talk about how to underwrite a loan or understand risk, but they leave a chasm in understanding about the true risk of underwriting. Outside of banking schools, most loan officers these days are self-taught practitioners in the art of lending and have learned their knowledge through a series of trials by fire. These loan officers have vast amount of understanding of recourse, perfecting title, character, collateral value and cash flow all focused on trying to divine if a borrower will repay the loan on a timely basis.
Unfortunately, the return of principal, while important, is only part of the battle. Many lending officers, while well-educated and experienced, surrender their main advantage to the borrower during negotiations, loan structuring and portfolio management. At the bank, most of the analysis is done on finding an acceptable borrower and loan, and then hoping for the best structure and price. This is to say that loan underwriting is only a fraction of the knowledge that is needed to successfully build a top performing bank.
What Really Matters: Underwriting Prices, Not Borrowers
The missing part of many loan officers’ education is yield management. In banking, we tend to ask the wrong question as this is how we have been conditioned to think. The question is not whether a particular loan will return principal or if a particular loan will return a positive risk-adjusted return after taking into account risk, cost of origination and capital. The real question is this – How can your bank most efficiently acquire a customer relationship that returns an above average risk-adjusted spread and how can the bank further increase that relationship’s profitability over time?
The Education of A Banker
Of course, all bankers know this, but few follow through. To really live this lending philosophy you have to get quantitative and move from art to science. When you do, lenders begin to understand that they are underwriting loan spreads and total relationship profitability, not borrowers. High quality borrowers that have lots of other business to bring to the bank start to make sense at Libor + 150bp pricing. Conversely, construction, hotel loans, gas stations and even subprime residential all makes sense if priced right.
If you can’t get the price you need to make the relationship profitable, you walk away, or find a way to raise the price or lower the risk. Often times the question is not how you can raise a loan’s price, but how can you reduce the risk. Getting rid of the balloon structure, requiring more of a reserve fund, adding or subtracting optionality, adding covenants that adjust pricing, or requiring monthly operating data are all ways to tilt the odds in your favor given a certain price to make the loan profitable. This means that loan officers have to become more relationship officers and need to learn other products as it is all part of the equation. Often its beneficial to bring in specialists in merchant card, cash management, wealth management or other product lines in order to fully value the relationship. If banks are really in the relationship business, shouldn't we be pricing the relationship and not the loan? Unfortunately, we don’t see these tactics enough and we have yet to find a banking school that teaches this philosophy.
Further, the goal isn’t to price a relationship on where it is today, but where you think it is going to be tomorrow. It is rare that we see an analysis of how interest rate risk will impact credit in the future. If rates are expected to triple over the next ten years isn’t this going to matter?
It is rarer still that when it comes to commercial real estate, we see a loan write up look at current permitting trends and parcel sales in order to extrapolate future competition and effective rents. This process obviously takes more work and it involves running multiple scenarios of the cash flows to find out what is ahead for the company, the property or the asset. However, understanding cash flow sensitivity is step one in trying to find out if the pricing provides an adequate return.
Finally, it is the rarest of rare that we ever see a cross-sell program put in place for a customer at the time of loan origination so that a sales execution plan is generated, the expected profitability of which is taken into account. Lending is just part of the equation. Oftentimes, it is the smallest part of the equation.
It is Time To Improve Our Education
If your bank has restrictions on certain lending types without taking into consideration structure or price, if your bank tends to price all loans the same way or rate credits in primarily one or two buckets, or if your bank isn’t aware of how to increase yield and reduce risk through loan structuring and relationship management, maybe it is time to take another look at banking practices. Banking is getting more quantitative and you don’t want to be the one without the proper information or process in place.
Success in banking is going to revolve around being able to collect a group of customers that offer above average lifetime value and then work on growing both their business and your business. It is not so much as picking what loans will payoff, but what relationships present the greatest risk/reward profile.
Banking has fundamentally changed in the last five years and it is for the better. Isn’t it time we start teaching it?
Submitted by Chris Nichols on November 21, 2013