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. This is especially true when the loan profitability is measured ex-ante – meaning taking into account the forecasted versus actual results of a specific loan. We have written extensively on loan profitability and various ways to measure loan profits. In this post, we wanted to discuss the concept of lifetime value of net profit as an important tool for bankers to measure loan performance.
Lifetime Value of Net Profit
The lifetime value of net profit (LVNP) for a loan is simply the present value of revenue earned minus all expenses for the life of the loan. Expenses include the cost of funds, credit costs, acquisition and maintenance costs. This measure of profitability is very important because bankers do not pay employees or shareholders with net interest margin (NIM) or measures like return on equity (ROE) / return on assets (ROA). Everyone is paid with dollars and LVNP measures exactly that – the currency we universally use to compensate for the effort is best measured by LVNP.
Averages can hide a lot of information, and we recall the adage about a man who drowned crossing a stream with an average depth of six inches. The same thing happens in loan portfolios. What we see is that a bank’s loan portfolio performs at one level, but individual loans within the portfolio perform vastly different from one another. In fact, the variance of loan performance within a portfolio takes either the classical 80/20 split where 80% of the profitability of the portfolio is driven by 20% of the loans, or a 120/10 split where 120% of the profitability of the portfolio is derived from 10% of the loans and the remaining 90% of the loans have negative profitability. We believe that this phenomenon is present because some bank does not measure the LVNP for each loan and assume that loans are largely homogenous. In fact, loan profitability in an average community bank demonstrates very wide dispersion that can range from an ROE of negative four digits (as in -1,000% ROE) all the way to positive three digits. An important activity in lending is to measure individual loan LNPV to compose the highest performing loan portfolio.
Our research continues to show that NIM is negatively correlated with bank profitability. As banks chase higher NIM, loan size, credit quality, relationship value all decrease resulting in lower profitability. Look no further than the recent changes from tax reform, and you can appreciate that a large percentage of banks are missing out on taking the enhanced return into account when setting pricing, structure and portfolio-level metrics.
Using ROE/ROA as a measure of profitability can counteract this NIM trap, but using ROE/ROA as a benchmark of profitability has its issues. A $100k and a $1mm loan may both have a 15% ROE, but any bank would prefer a $1mm loan at the same ROE because of the much higher dollar in profits generated by higher balances. This is where LVNP is such an important measure. We researched numerous scenarios using current market pricing and structures. Some of our analysis follows.
For all of the graphs that follow we used a standard investor CRE loan, new origination, 25-year amortization due in five years, Prime-based pricing, with credit risk rating 4, and standard acquisition and maintenance costs. The graph below shows three margins (Prime - 1%, Prime flat and Prime + 1%) for various loan sizes. One important observation is that ROE hurdles are difficult to meet at any pricing levels for commercial loans below $500k. This is important to consider because the average community bank loan size is below $500k (about $300k). On an ROE basis, commercial loans become profitable either with the benefit of loan size or above average market spreads. The latter is not a tenable long-term strategy for any bank.
We then took the same loans, spreads and ran our LVNP measures. Using the same loan parameters, the graph below suggests that average community bank loan size earns negative LVNP except at the widest pricing (Prime + 1%). This is another important consideration – small loans do not allow banks to generate positive LVNP because of the overhead (inelastic) costs of acquisition and maintenance. It appears that $500k is an important threshold for loan size to generate positive LVNP assuming that banks that have either limited pricing power or standard underwriting processes. Banks that can price well above market or those banks that can streamline underwriting, documentation, and onboarding may be able to generate LVNP for smaller loans.
Finally, and most importantly, we wanted to establish a pricing breakeven point between a community bank’s average loan size ($300k) and, in our opinion, the more optimal loan size for a community bank of $1mm. The graph below shows LVNP for two loans ($300k and $1mm) for various Prime margins. The graph demonstrates that to obtain equal LVNP on a $300k and on a $1mm loan, the smaller loan must be priced at Prime + 2.25%, while the larger loan can be priced at Prime minus 1.0%. Stated another way, a lender needs to convince a borrower to pay Prime plus 2.25% on a $300k loan, but only Prime minus 1.0% for a $1mm loan to generate the same number of dollars in profit. If there is no constraint on some loans a lender can source, originate, document, book and maintain, then the lender could book 3.3 times as many $300k loans as $1mm loans and be ahead on LVNP. However, that is not reality, and each bank employee can only handle a finite amount of work.
Banks cannot spend NIM or ROE/ROA. We spend net profit. Banks would be well served to use net profit and lifetime profit measures for loan profitability to align loan performance with bank results. LVNP is a better measure of loan profitability and can mitigate the 80/20 rule for loan portfolios and increase bank performance. Using LVNP as a measure of profitability, our research shows a strong relationship between loan size and profitability. It is extremely rare to find a bank whose average commercial loan size is below $500k making above its cost of capital. If your bank wants to make an instant change in profitability, aligning pricing, risk and loan size together is the fastest way to affect performance.
Submitted by Chris Nichols on January 31, 2018