We are at the ICBA 2017 Live convention in San Antonio, and there is nothing like a heated banking discussion over dinner with good bankers. We were comparing battle stories and the ever-important concept of loan pricing came up. Our banker friend lamented on the tight pricing in his territory and that his competition was pricing commercial loans 25 to 50bps below Prime. We work with banks across the country, and we see the competition that is currently driving loan spreads tighter. However, we had to point out that Prime minus 50 to Prime minus 75bps is standard in most markets and still represents a decent return on equity. Our community bank friend disagreed and indicated that most community banks cannot show a positive ROE below Prime flat pricing. We went to our modeling, analysis and some client questioning to understand his reasoning.
Where Size Matters
We understood our client’s pricing and profitability conclusions when we took a closer look at his loan portfolio - the bank’s average commercial loan is a little under $210k in size. It is very hard to make commercial lending profitable for such small loans. Below is a graph showing the relationship between ROA and loan size for all commercial loans at a community bank that is just over $1B in total assets. This particular bank has approximately 4,200 commercial loans, and when we priced each loan (through a loan pricing model), the vast majority of loans below $250k in principal balance show negative ROA. There is a very strong relationship between loan size and profitability.
We then went to our loan pricing model and priced up a new CRE loan, 25-year amortization, four year expected life, risk-rated 4 (75% LTV and 1.35 DSCR), and we priced the loan at Prime minus 75bps. We priced the same loan but varied the principal amount from $10k to $5mm. The loan size vs. ROE graph appears below.
What is interesting to note is that this “aggressively” priced, but credit worthy, loan is profitable at larger sizes. At $2.4mm size, this loan has a ROE of 15%. However, that same structure and pricing shows a negative ROE when the loan size drops to $240k. The only change, in this case, driving the ROE is the loan size.
After looking at the model’s cash flows in greater detail, we were able to understand why the ROE drops so precipitously for small credits. Banking is a high-leverage operational business. It costs most banks about the same amount to source, underwrite, document, book, and service a $100k commercial loan as a $1mm commercial loan. Obviously, the $1mm credit has ten times the revenue (but only slightly higher overhead costs). If we remove any credit component of the loan, the cash flows demonstrate that on the loan structure discussed above, the loan with a $100k starting principal balance earns the bank only $672 in revenue over four years (this is before any credit provisions). The math is very telling – most banks cannot earn an acceptable rate of return on capital earning $168 per year on $100k credits (not even factoring any credit losses).
However, for the same loan with a $1mm starting principal balance, the bank will earn $85k in revenue over a four-year period (and a 13% ROE after credit provisioning). There is a reason why larger credits are more competitively priced than smaller credits.
But I Only See Smaller Loans
Of course, many banks will argue that generating larger loans is near impossible since most of their customer base is demanding smaller loans. For any bank that thinks this way, we submit that it is a chicken-and-egg-type problem. Larger banks are pricing the larger loans at tighter spreads and are winning that business. Thus, without accurate pricing, some community banks get adversely selected and do only get customers that cannot find a home at larger banks due to pricing.
Worst yet, this syndrome gets ingrained in a community bank’s DNA as success with smaller loans gets reinforced in the line and credit staff, so everyone gets condition to think they are the bank of the very small business. It is the old adage that when you only have a hammer, everything looks like a nail. If all you have is one loan price, everything looks like a small loan.
Change strategy, pricing and marketing and any bank can gather larger sized credits.
It is difficult to assess the average loan size across various banks or asset bands because banks do not report total loans on the balance sheet. However, select national banks do report their new loan originations and number of loans booked in a period. Below is a table showing average loan sizes for CRE originations through 12 months ending in October 2016.
Obviously bigger banks with higher capital levels have the capacity to book larger loans. But many community banks have the capacity to book credits above $1mm, and yet the average commercial loan size at community banks is much smaller than their legal lending limits.
Some argue that community banks must maintain smaller loan size to create a diversified loan portfolio. However, research shows that a bank with more than 100 loans has a fully diversified portfolio of credits. While this depends on loan type and borrower type, usually anything above 100 loans does little to reduce credit risk through diversification.
Adversely Selecting The Next Bank
We believe that one major driver of the discrepancy in average loan sizes between banks is the empirical evidence that larger loans are more profitable at lower margins. Banks that do not carefully measure the importance of loan size in relation to their operational leverage inadvertently underprice small loans and overprice larger loans, driving down their average loan size, and decreasing their ROA and ROE. Community banks can still make smaller loans profitable but at wider spreads. That same $250k loan must be priced at Prime + 4.00% to reach a reasonable ROE of 13% (not the Prime minus 75bps pricing that we ran through our model).
If your lenders read this and say – “I would never win any business at Prime + 4.00%” then this goes back to our point above. If true, then those loans will be originated by banks that are not reading this, that do not have a pricing model and have no pricing strategy. The result will be that your competition will make less money while you will forgo a loan that would have cost you more money. Whamo – your bank becomes more profitable both on a relative and absolute basis.
Your lending and credit staff can take that free time that they gained by not producing unprofitable loans and go after larger clients that want credit larger than $400k. They gain operational efficiencies, and instead of booking five loans at $210k, they book one loan at $1mm. They lower their incremental cost and still have time to market and go after larger loans. Whamo – your bank is now in the upward spiral of profitability.
We recommend that all community banks use a risk-adjusted return on capital (RAROC) loan pricing model. We have one that is available at our cost for $80 per person per month with no contract and no upfront expense (more information HERE). There is no excuse for not having a model – it is easy to use, cheap and without commitment. If not ours, then there are many other loan pricing models available. If you don’t have a risk and cost adjusted pricing model then you are just guessing. Guessing, we remind you while you are eight to ten times leveraged and your competition has the facts. That is a bad competitive position to be in.
Whatever model you choose, banks can calibrate the assumptions to the bank’s specific operational leverage to allow bankers to properly assess return on assets. With the correct calibration, a model will help bankers support a strategy of pricing loans to size and distinguishing the important impact of operational leverage.
Submitted by Chris Nichols on March 15, 2017