Before You Waive Prepayment Protection On A Loan, Consider This

Structuring Loan Value

Top performing banks use prepayment protection (PP) on commercial loans to deliver superior value and gain a competitive advantage against their competition. The connection between PP and bank value is not always apparent, but we can measure this relationship and quantify when it makes sense to remove or insist on PP.  Some banks mistakenly avoid including PP in commercial loans as a competitive strategy.  We feel that eliminating PP on commercial loans materially detracts from profitability, degrades credit quality and attracts the wrong commercial customers.

 

Prepayment Protection

 

Prepayment protection (PP) can take various forms.  PP can be a prepayment provision in loan documents; it can also be the inherent switching costs, such as the friction costs of loan origination fees, appraisal costs, or legal fees.  PP can also be obtained through high switching costs generated with certain cross-sold products such as treasury management and merchant services.

 

There are at least three ways to quantify the value of prepayment protection.  First, is the opportunity cost of committing to a loan and giving the borrower the unilateral right to prepay the loan when changes in future interest rates or credit spreads make it more beneficial for a borrower to do so.  We can measure the capital market costs to a lender of giving the borrower this free option to prepay the loan, and the results are shown in the graph below.

The Value of Prepayment Protection

 

The graph above shows the effective spread reduction for various loan terms when PP is not present.  The data indicates that for a five-year commercial loan, the lender’s economic cost of excluding PP is 31bps in loan spread (or 1.55% upfront fee).  In other words, to make up for the value reduced by not including PP the bank must obtain an additional 31bps in net interest margin (NIM) for every year of that loan.  For a ten-year commercial loan, the lender’s economic cost of not including PP is 41 bps in loan spread (or 4.1% upfront fee).  This data shows just one cost to banks for not protecting their earning assets with PP.

 

The second way to quantify the value is to look at the impact of PP on the expected life of the loan.  PP extends the expected life of the loan and increases profitability.  We ran this analysis on a specific average commercial credit (75% loan-to-value, 1.25 debt service coverage ratio) at $500k principal amount.  The results of the relationship between loan term and ROE are shown below.

Expected Loan Term vs. ROE

 

Because of the very high fixed costs of originating the average-sized loan, and the high efficiency at the average community bank, loans with expected life under three years show suboptimal ROE.  PP extends the expected life of a loan and, therefore, increases profitability.  The average expected life of a five-year loan without PP is approximately 2.5 years, but with commercially standard PP the expected life rises to 4.7 years, increasing the ROE by 3.2% for our sample $500k loan. 

 

The third and most important way to consider the value of PP is to analyze the bank’s strategy and differentiation goals.  What are the benefits to a bank of not including PP and does the strategy help the bank differentiate itself from the competition?  The existential purpose of a bank is to serve customer needs profitably.  While some borrowers may want to avoid PP, why would a bank agree if the economics are unfavorable?  We note that the value lost to a bank in eliminating PP is much greater than borrowers are willing to pay the bank in margin or fees. 

 

While banks generally erode profitability when PP is not present, there is more to this argument.  By including PP, banks are selecting more profitable customers.

PP allows banks to advance their strategy and differentiate their brand in the following way:

 

  1. PP extends the expected life of a loan, thereby creating relationship rather than transactional customers.  A customer that is not interested in establishing a relationship with the bank is typically not the right customer for a community bank.
  2. PP appeals to lower risk credits.  Borrowers that do not have stable cash flows or well-defined business models may need different financing in the future and try to avoid PP.  Some borrowers that want the ability to substitute financing in the future and resist PP are shopping for a better financing option in the future in the hopes of an improving economy or business results – a risky venture this late in the credit cycle.  Borrowers with stable long-term assets want long-term financing and are willing to lock in credit at market-driven pricing. 
  3. Cross-sell opportunities are related to the tenor of a customer relationship.  Customers that agree to PP are also those that align with a community bank’s strategy of growing share of wallet.

 

Conclusion

We are big proponents of PP on commercial credits.  We find that banks that insist on PP can attract more loyal customers, can position their products based on benefits and value rather than price, and can better position their brand relative to the competition.  Many customers that refuse to accept PP are just shopping for the next better deal in the future and view their banker as a commodity provider.