Mispricing of small balance loans is the major problem facing our industry and is a drag on many banks. It is difficult to make a $50,000 loan profitable. Let’s consider a typical small business commercial loan example: a five-year loan for equipment with a 1% origination fee. To make a 15% risk-adjusted return on equity, a banker must price this loan at a minimum of a 7.75% spread using direct costs and assuming average credit. That is a thick spread and not only could make your bank less competitive but also potentially increases the risk. In this article, we walk through one overlooked aspect of small balance loan pricing and show an alternative paradigm to achieve higher profitability with less risk.
Making A Small Balance Loan Profitable
Using our data, a majority, some 78%, of small balance relationships are unprofitable for community banks. High acquisition costs, steep processing costs, short maturity and limited revenue all hinder profitability. One clear solution that we have discussed before is to digitize the channel to allow for automatic decisioning and processing (HERE). This lowers acquisition and processing costs to allow smaller loans to be profitable. We will put that path aside for this article and just focus on pricing.
To price at a typical five-year $50,000 loan, pricing around Libor + 7.75% with a 1% fee is required. This allows us a 15% return (below), or a return above our cost of capital.
The problem is that the large spread and high price, exacerbates future credit risk by causing stress on the debt service coverage should the business run into trouble, and/or the economy goes into a downturn. Also, the above market spread adversely selects only lesser credit customers. Further, in an improving economy, competition for this customer’s relationship may intensify causing this loan to be quickly refinanced. While you may not care if the credit goes away, the issue is that you did not have enough time to earn back your acquisition and processing cost often turning a small balance loan into an outright loss.
The Better Way
Instead of charging a 1% fee and 7.75%, it is better to charge a flat $3,200 fee for the loan and reduce the net interest cost to Libor + 5.75% (as shown below). This achieves the same 15% risk-adjusted return but has the advantage of shifting some of the cost upfront where credit risk is often the lowest. This increases debt service coverage in later years reducing the probability of default to a more manageable level. Further, the lower credit spread makes this loan less likely to be refinanced away as a competing bank will have to not only tighten their credit spread below the 5.75%, but they will have to talk the customer into repaying the upfront fee. The likely result is that this loan will stay on your books longer than the one priced at L + 7.75% giving your bank more probability to earn your 15% return.
Finally, requiring an upfront cash payment to make a small dollar loan also tends to have a slight positive selection effect. Those customers that have greater confidence in their future tend to be more likely to pay the upfront fee as opposed to wanting to finance the amount over time. The customers that want a higher rate and a lower upfront fee are those that are trying to stretch their cash and loan proceeds to the maximum and tend to be more speculative in nature.
The other underappreciated aspect of small business lending is the quality of the collateral. By requiring a higher quality of collateral, credit risk can be reduced in the form of a lower loss given default. While this doesn’t impact the probability of default, it does impact the expected loss which is analogous to your credit risk. Below, we start with L + 7.75% loan and a pledge on the general assets that comes out with a 78 basis points expected loss rate. However, by moving to the upfront fee structure, reducing the spread to 5.75%, and requiring marketable securities as collateral, credit risk can be dramatically reduced by more than 4.5 times. If this was the case, we could further reduce both the upfront fee and the net interest spread.
While some banks may not be able to gain cash, CDs, marketing securities, real estate or other quality collateral to start, building provisions into the loan to allow collateral substitution in exchange for reduced pricing is a solid way to incentivize the reduction of credit risk over time.
The Best Way
The underpricing of small balance business loans is one of the most chronic issues we have in this industry when it comes to profitability. The best way to handle small-dollar loans is to employ a series of tactics from choosing customers wisely based on future profitability, digitizing the process, requiring larger upfront fees, requiring other business products such as deposits/fee income lines, incentivizing collateral upgrades and electronically nurturing these customers to proactively expand the business relationship over time. In this manner, value can be diversified, credit risk can be decreased and profitability of 18% or greater can be achieved.
Submitted by Chris Nichols on February 27, 2018