Many community bankers have expressed an interest in adopting debt-yield ratio for underwriting purposes. In our previous blogs, we outlined how debt service coverage (DSC) and loan-to-value (LTV) ratios can trick bankers into making suboptimal credit decisions especially because of atypical cap rates, interest rates, or amortization periods. We spoke to some bankers about how best to incorporate debt-yield standards for their institution, and in this article, we would like to highlight one specific area to help bankers avoid an unsuspected danger.
Management is asking for trouble by imposing in isolation an absolute threshold for any credit measure. When bankers incorporate debt-yield as a credit measure, best practice requires that credit is measured against yields. Otherwise, banks become negatively selected by borrowers and lenders.
In the table below we use a commercial loan pricing model to price two loans, one with an 8% debt-yield and the same loan adjusted to meet a 10% debt-yield. Loan A is a loan with an 8% debt-yield and is a marginal credit, but more importantly, the commercial loan pricing model shows that the return on Loan A is below the bank’s cost of capital and erodes shareholder value. On the other hand, Loan B demonstrates a 10% debt-yield loan has an acceptable credit quality and, further, is expected to yield a return that is above the bank’s cost of capital. If one assumes that if a bank sets a minimum debt-yield at 9%, the bank will get more loans like the 10% debt-yield loan versus the 8% debt-yield loan. However, one would be wrong to make that assumption.
All bankers are familiar with a risk-return tradeoff. This concept states that potential return (yield) rises with an increase in risk. This concept applies solidly to banking. However, many community bankers do an excellent job in measuring risk but spend very little time quantifying return other than loan yield. Loan yield is not the same as a return, which measures the entire customer revenue across multiple products and over the lifetime of the relationship. Consider the graph below showing return on the Y-axis and risk on the X-axis. The risk is measured by debt-yield. Assume that the bank sets credit policy at 9% minimum debt-yield for a specific property type.
With no other tools or policy in place, the bank inadvertently will create the following issues:
- Most lenders will now bring loans right at the 9% debt-yield. There will be little motivation to find borrowers that have 10% or 11% debt-yield if any loan above 9% is deemed acceptable. If management cannot differentiate the risk-return tradeoff and incent behavior accordingly, then lenders take the route of least resistance and source the barely acceptable credits.
- Not all loans with debt-yield above 9% are equally profitable to the bank. In the above graph, we identify two semicircles (Group A and Group B). Group A are loans priced slightly better for a given level of risk than the average risk-return prevailing in the credit market. In contrast, Group B are loans priced slightly lower for a given level of risk than the average risk-return in the market. Both Group A and Group B loans qualify for the minimum debt-yield standard; however, Group A loans provide the bank with superior returns. In fact, while the credit market is semi-efficient and the risk-return line holds for many credits, there are sufficient opportunities in the credit market to be substantially fooled in making Group B loans and there are also sufficient opportunities to make outsized returns in Group A loans. Community banks must strive to make Group A loans to the extent possible. If banks cannot measure the difference between Group A and Group B loans, again lenders will take the route of least resistance and source Group B loans (they are easier to sell to borrowers).
- Most lenders will not bring in loans below the bank’s stated minimum credit policy. However, this is not the desired result either. While policy should be met in 85% to 95% of all instances, there may be some loans that are slightly below the bank’s minimum debt-yield that present such a high return that the loan is still profitable and is expected to yield a return that is above the bank’s cost of capital. These opportunities may be rare, but highly profitable for the bank, and lenders should not be discouraged from making such opportunities available to the bank.
Setting a risk tolerance (whether it is debt-yield or some other measure) without also measuring return is a recipe to underperform the market. The market (in a broader sense) is composed of thousands of lenders, and the top 80% to 90% of those market participants are larger institutions that do rely extensively on a rigorous measure of return. These same institutions are looking for opportunities to maximize origination of loans that fall at or above the risk-return line. Community banks must also measure the return to be able to compete and retain profitability.
By far the most frequent question we hear from banks is “where should I price this loan”? This is the greatest source of anxiety for bankers who are trying to do the following: a) avoid underpricing to competition, b) obtain a return commensurate with risk, and c) attempt to price relationships that involve credit, fees, treasury management services, and deposits. Banks must be able to effectively quantify not just risk but also return based on various services and total relationship value.
Submitted by Chris Nichols on February 25, 2019