Based on our observations, we estimate that somewhere between 20% and 25% of community banks have adopted a policy requiring minimum yield or credit spreads for their newly originated commercial loans. The strategy requiring minimum commercial credit spreads may be well-intentioned, but the results for banks may be less than optimal. We understand and are proponents of pricing discipline and optimizing return for credit-intensive products, but a policy or pricing methodology requiring minimum credit spreads is arguable the most potentially profitability-reducing and hurtful strategy deployed by banks.
Objectives of Loan Pricing
Banks use loan pricing strategies to achieve dozens of different goals, but the most common are as follow:
- Increase the granularity of credit pricing,
Accurately allocate capital,
- Maintain market discipline,
- Educate management and lenders,
- Become more attuned to prevailing market conditions,
- Standardize pricing across divisions, product lines and relationships,
- Increase profitability,
- Decrease risk,
- Enhance reporting, control, and governance.
Minimum Credit Spreads
In low-interest rate environments and when credit might either be deteriorating or facing tremendous uncertainty, as is the case today, bankers scramble to enhance profitability – this is an understandable reaction to market pressures. It would appear that the easiest way for bankers to increase profit margin or return on equity (ROE) is to increase loan yield – it is straightforward to implement this strategy on paper, but the results are not favorable.
Requiring minimum credit spreads for commercial loans have the following unintended consequences:
Decrease of Average Spread: Despite management's best efforts, lenders interpret the minimum spread as the only spread available to their customers. Even as management underscores that the minimum spread is for the best, most profitable bank relationship, most lenders believe that each of their customers has the highest credit quality, is most loyal to the bank, and demonstrates the greatest cross-sell relationship opportunities for the bank. The starting point that is meant to be a floor (the minimum credit spread) inadvertently becomes the pricing ceiling or cap. In the longer term, this strategy decreases the average credit spread for the bank instead of enhancing it.
Compression Due to Competition: There are three ways that managers can price their loans (or any product or service for that matter):
- Price to the competition. Banks determine where competitors are charging for similar loans in the marketplace and price accordingly.
- Cost-plus pricing. Here banks calculate their cost of capital, funding costs, all direct and indirect costs, and add a margin to determine the price.
- Perceived value to the customer. While more subjective, the bank determines the maximum a borrower will pay for the perceived value of the banker's expertise and the problem that the bank is solving. This is the optimal way for banks to price their loans to increase ROE.
But when banks institute a minimum credit spread strategy, typically that minimum spread is based on what the competition is pricing. Managers look at the average spreads in the market and set their minimum spread relative to that industry average. However, pricing to the competition is the worst pricing choice for banks. Pricing to the competition is an abdication of management's duties. Minimum credit spread effectively transfers an important corporate power to the competition. While bankers should be aware of the prevailing pricing in their market, that information is properly used to make a buy-or-sell decision (make a loan or buy a security), not to match or follow the competition. The above is true in most industries, but in banking, pricing to the competition is even more derelict because the decision is not just about revenue; it is also the extension of credit. The better way for banks to price loans is based on perceived value to the customer, and minimum credit spreads force bankers away from that pricing principle.
Survivorship Bias: To optimize loan portfolio profitability, community banks must recognize how to migrate through the credit spectrum (see an example of the concept in the graph below). During long periods of expansion, banks misprice credit risk more severely. In a recession, better credit quality loans have a higher risk-adjusted ROE. When the economy slows as it has, many banks want to capture the better credit quality loans (reactively migrating credit quality), but by that time, the forward-thinking banks have already started rotating their credit quality in the anticipation of the change in the business cycle, thereby crowding out the reactive banks. By selecting the correct credit quality in anticipation of the change in the economy, banks can avoid negative selection bias. For example, if a bank is not anticipating changing economic conditions and generates credit quality across the spectrum, in a downturn, the competition will scramble to steal high credit quality loans and avoid the lower credit quality loans, naturally decreasing the average credit quality of the portfolio. A minimum credit spread strategy is inherently set up to capture lower credit quality credits because management typically sets the minimum spread to capture more yield, not to funnel high-credit quality at a lower yield.
The minimum credit spread strategy magnifies survivorship bias in banking. Survivorship bias is the logical error of concentrating on outcomes that made it past some selection process and overlooking outcomes that do not make the selection process. The issue for many banks is this: the performance of all loans is measured over a number of years, but is done quarterly on financial statements looking backward. But the profitability of an individual loan going into the portfolio is not measured at inception because minimum credit spreads are not a measure of profitability and minimum credit spread has no actual causal relationship to profitability.
Survivorship bias occurs at banks using minimum credit spread because the more profitable loans (paradoxically some of the ones with the lower credit spread) are heavily underrepresented in that bank's portfolio. Managers are then challenged to increase the bank's ROE and choose loans with an even higher yield, but, unfortunately, lower collective ROE. The profitable loans may not just be not booked; they are not even vetted by management because lenders are following the minimum credit spread guidelines.
Adopting minimum credit spreads misdirect bankers' attention from what should matter in loan pricing: credit quality, loan size, relationship cross-selling, and lifetime value of the customer. Managers are better advised to measure upfront the criteria of a commercial loan that is used to gauge success – which is generally not credit spread.
Submitted by Chris Nichols on September 28, 2020