Last week, we broke down how a quantitative bank may look at credit in order to get more accurate on their credit grades. Most banks do this to make sure they have their loan loss reserve levels correct. However, the better reason to invest in your credit model is to win more loans from the competition, while not being adversely selected. Today, we look at one of those two strategies that a bank might employ to drive out their competition from the marketplace or at least protect themselves from being driven out of business.
Target Higher Quality Relationships
This tactic works because many financial institutions effectively use a limited number of internal credit grades and price accordingly. That is to say that these banks have credit grades that cover a wide spectrum of credit and that whole spectrum is priced identically. When faced with competition that lacks granularity in their credit model, the optimal tactic is to segment the risk grade further in order to offer more competition pricing to the higher quality end of the credit spectrum. It is at the ends of the spectrum, particularly with Grade 2 and Grade 5 loans where banks can see the biggest differences and have the largest competitive advantage. Of those two, we discuss Grade 2 loans today since these are the higher quality loans and present less downside risk to banks employing this tactic.
Putting The Tactic In Motion
Banks that can discern between higher quality relationships can target these low risk-clients through a variety of channels including fee lines of business and deposits. However, the easiest to understand is through lending. Compare 2 banks. Bank 1 is a bank that has a granular and accurate credit grading system. Bank 2 not only has limited and less accurate credit grades, but prices each loan within a grade the same regardless of risk.
Bank 1 then markets and offers risk-based pricing to the higher credit quality end of the spectrum. This significantly undercuts Bank 2 and what happens is that Bank 1 ends up winning a majority of the loans that have lower probabilities of default (PDs). This is the yellow section in the diagram below.
Bank 2 allocates a standard 1% reserve to all Grade 2 credits. This is above the actual risk in this grade so it is over allocating reserves and hurting its competitive positioning. Bank 1, on the other hand, has more credit grades and more accurately matches risk with reserves within a credit grade. In the 10 loan example above, Bank 1 allocates a full 3 points less in reserves, or an average of 98% less. Instead of 1%, the average allocation is 30 basis points. This allows Bank 1 to price these loans substantially less.
How much less in pricing depends on the structure and credit, but for the Grade 2 portion of the spectrum, the difference is about 50 basis points for a 10-year fully amortizing loan. In other words, if a bank was targeting a 14% risk-adjusted return on equity, instead of Libor + 2.90%, by better allocating risk, it could price at Libor + 2.40% to achieve the same ROE.
To combat this tactic, banks need to add more credit grades or utilize a risk-adjusted loan pricing model such as Smart Loan Express. This will better match risk with pricing. If you do have a multi-dimensional credit grading system that takes into account probabilities of default and loss given default or you have at least 20 risk grades (and price accordingly) then you are well positioned to execute this tactic against less knowledgeable banks.
Submitted by Chris Nichols on November 19, 2015