How Loan Size Impacts Loan Performance In 2017

Commercial Loan Performance

We recently reviewed and analyzed the commercial mortgage market for 2017 to identify patterns or developments that community banks may utilize to enhance performance. We analyzed the available data for 2017 for commercial mortgage origination and found a few specific ways that community banks can improve their loan portfolio performance in 2018.  While some strategies require substantial time to implement, broad employee buy-in or a substantial investment in infrastructure, in this article we identify a few strategies that are simple to implement, available for most banks, require little to no new investment and can be immediately effective in increasing ROA in 2018.


The Data


We reviewed the latest 2017 mortgage fillings data as reported by S&P Market Intelligence.  This company tracks loan originations and provides some interesting commercial mortgage analytics.  We analyzed the data for geography, loan category, loan size and originating lender.  We excluded residential loans and second mortgages. The total annualized commercial mortgage origination for 2017 is approximately $1.44T.  The top five bank lenders are listed below.  It struck us that while these large banks originated a large portion of all loans in the country as a percentage of total market share, these top five banks actually originated fewer commercial mortgage loans then their market share would dictate. In other words, these banks demonstrate lower loan bookings and fewer loan runoffs. 


Commercial Loan Origination By Bank


The majority of commercial loan mortgage activity is geographically concentrated with just six states comprising 50% of all originations.  The top five states are listed below. 


Commercial Loan Origination By State


The most striking and unexpected part of the data was the average commercial loan size that the larger banks generated.  While we expected larger banks to generate larger loans, the disparity was not proportional to the lenders’ balance sheet.  The average loan size for all banks in 2017 was $1.40mm. However, the average loan size for the five larger banks is listed below.  It is obvious that larger banks can originate larger loans. However, the average size of the loans for these larger banks is much smaller proportionately than their balance sheets would dictate.


Average Loan Size


We next ran our analysis on the relationship between loan size and profitability (ROE) using the average community bank’s overhead structure.  We kept the loan quality and pricing the same, varying only the loan size.  We assumed the standard origination and maintenance costs for the average community bank across the country.  Our output appears below.


ROE v Loan Size


Obviously, the same loan, same credit quality, and pricing generate a different ROE with different loan sizes.  However, the size effect tends to disappear between $1 and $2mm.  That means that generating loans larger than $2m no longer leads to higher profitability – assuming no other changes to the loan credit quality, cross-sell opportunities or any other loan variable.


This is a very interesting phenomenon since most community bank average commercial loan size is well below $1mm (closer to $300k) and most community banks do see ample opportunities to originate loans in the $1-2mm range.  At $300k loan size, the ROA for the average loan is suboptimal.  By increasing loan size to $1mm, the average community bank can increase ROA by approximately 39bps. 


Putting This Into Action


Larger banks do originate larger loans. However, the average size of the loans they originate is much smaller than their balance sheet size would dictate. Given the average cost for banks to originate and maintain commercial loans, it appears that the size effect of commercial credits breaks at the $1-2mm range. That means that banks can optimize loan profitability by increasing their average loan size to that sweet spot. While some community banks may not be able to increase their average loan size because of their geographic location, loan niche, or competition, many banks have ample opportunity to optimize loan return by targeting larger credits.


The easiest way to increase average loan size is to incorporate a commercial loan pricing model for all pricing decisions. Using a loan pricing model immediately provides management with the feedback that compels wider margins on smaller loans to maintain their hurdle ROE. Conversely, banks need to take into account both credit and origination cost when originating a loan. Community banks that refuse to go below a 3.0% net interest margin for a larger loan may be doing themselves a material disservice as they give up a loan with a higher ROE compared to a $300k loan at a 3.50% margin. Banks that do not have a loan pricing model must be more diligent to maintain wider spreads for smaller credits and tighter margins for larger credits to drive higher returns.  For banks that do not rely on a loan pricing model, maintaining a target loan size mix is crucial to success.