Most banks feel comfortable making smaller sized loans. The obvious reasoning is that a smaller loan will present less of a loss should it go into default - less of a loss means less risk, and, therefore, higher return. That reasoning could be faulty and could end up getting your bank into trouble as often times it is the larger loan that presents less risk. There are three reasons for this. First, the acquisition cost of a larger loan is just slightly more from a dollar value perspective (and lower on a percentage basis) than that of a small loan. Second, should the loan go bad, the workout cost is almost identical for a wide swath of loan sizes. You still need a new appraisal, you still need a lawyer and you still need to manage the workout process. As a result, the loss given default on a percentage basis is much larger for the smaller loan than the larger loan. Finally, larger loans tend to be made to larger borrowers with more financial support and in larger markets with more liquidity. As a result, the loss given default from the liquidation sale alone is often smaller on a larger loan than it is on a smaller loan.
To illustrate this, let's compare a $600k loan with a $4 million loan. Let’s hold everything constant including the probability of default, loss given default and even workout costs. For both loans, historical direct and indirect workout expense is approximately the same at $159k. For the $600k loan, assuming a loan made at 75% loan-to-value, that workout expense is 19.8% of the collateral value. This compares to only 2.98% for the $4 million loan. Acquisition cost, if we added it in, further exacerbates this.
If you assume a 2.10% probability of default on both loans and a 25% loss given default net of workout expenses, because of the economics of the above, you would lose $156k on the $600k loan, but only $139k on the $4 million loan. If you adjust for liquidity, that loss difference is even greater.
The other way to look at this is you would need a smaller loan-to-value ratio on the $600k or a lower probability of default to equate to the same risk-adjusted return. For example, if the probability of default was 3.35% for the $4 million sized loan, you would need a 2.10% probability of default on the $600k loan to equate to the same return.
The economics of loan size is important to take into account when evaluating the overall risk of a loan. Often this is a strategic decision of targeting a certain size or type of small business or a certain geographic area. Other times, this is a tactical byproduct of having the bank focus on non-risk adjusted margin. When non-risk adjusted margin is an objective, the bank has a higher probability of getting adversely selected so that new origination is composed of a higher than average number of higher risk loans. These loans often have higher credit processing costs (as there is usually a story to them so underwriting is more complex), in higher risk areas (construction, etc.), in tertiary markets or are smaller in size.
Risk in lending should be viewed on an expected loss basis and not just a function of loan size. Banks that target smaller loans may find that they are getting a false sense of security and potentially sacrifice credit and earnings risk. To create a more profitable bank, take a look at your portfolio and understand how loan size can decrease the loss given default.
Submitted by Chris Nichols on November 13, 2014