One thing that is underappreciated in our industry is the difference between loan structure risk versus credit risk. While these are intertwined, the two risks are different as we will explore.
Tag: Loan Pricing
At this juncture of the credit cycle, community banks must be judicious in the way they source, structure and book commercial loans. Competition is stiff, and every banker is trying to outsmart and out-compete multiple lenders vying for the same customer. Unfortunately, negotiating terms and pricing on a commercial loan feels a little like entering a bazaar wher
Net interest margin (NIM) is one of the most over-utilized metrics in banking. As we have pointed out in the past, if you include all the failed banks over the last ten years, the statistic is about 20% predictive of underperformance. Thus, if you manage your bank trying to get the largest NIM possible, you are likely to produce less profit, not more. Of course, all things being equal you want wider NIM loans than not, but all things are rarely equal.
Funds transfer pricing (FTP) has been an important tool for financial institutions for several decades. The methodology was introduced to banks in the early 1980s to help allocate corporate costs among business lines. Since then, the mechanism has been central to also helping allocate risk among business units. For instance, if your bank has interest rate sensitivity, what portion of the risk is driven by fee lines (f.e. mortgages), loans and deposits. In this article, we look at the concepts of FTP and detail how banks can use the methodology to better manage risk.
Last month, right after lunch, the borrower came into the bank to close his company’s owner-occupied commercial loan for $5mm – it happened to be March 21st. The borrower closed the loan, locked in a 4.50% rate for 10-years, shook hands, smiled and walked out the door. The Chief Lender and the CFO walked over to the business development officer and congratulated him on a job well done. High-fives ensued, and everyone was happy. Should they be? The Bank just lost $238k in one day, and the worst part is, no one knew the difference except the borrower.
Loan pricing is both an art and a science. While there are three primary ways to price bank products, one methodology is consistently used by top performing banks. Since we talk and see the pricing at hundreds of banks each month about loan pricing and we monitor credit risk, cost and non-bank competition in every state, we have a unique vantage point to see what works and what doesn’t when it comes to banking profitable commercial customers.
Loan spreads for C&I and CRE loans decreased slightly in February of this year from a month earlier, and they contracted further in March. We expect that spreads will continue to contract throughout the remainder of the year. The primary driver of declining loan spreads is the tax changes that passed into law at the end of last year. The vast majority of lending institutions have benefited from an approximately 30% reduction in their tax rate (or a reduction in the tax rate of the pass-through entity). The interesting question is this:
In our previous blog (HERE), we discussed the three primary criteria that banks should consider in choosing an appropriate index to price commercial loans. We concluded that, for the time being, LIBOR (surprisingly) was a superior index for community banks to use because of its high correlation to community banks’ cost of funding (better than Prime or US Treasury). We also discussed why LIBOR is a more flexible loan index for community banks becau
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.
Profitability is the degree to which an activity yields profit or financial gain. While this concept is simple to understand, in reviewing a bank’s financial statements where profitability can be easily measured for past performance, bankers often don’t measure the profitability of a loan at inception and certainly not with the same level of certainty.