Many banks have a pricing policy that provides only general guidelines for commercial loan pricing, such as three percent over the corresponding treasury, or 2.75 percent over LIBOR, potentially subject to a floor at some level, or maybe not.
However, in today’s intensely competitive markets, these policy based pricing approaches often are rapidly discarded when it is learned that a local competitor has offered a “below market rate” for a prospective high quality credit, especially if this is a current highly profitable customer of the bank.
From this point on in the negotiation, doing “whatever it takes” to retain the customer becomes the overriding consideration versus loan profitability, financial return to the bank or other risk factors. Loan officers in pursuit of a client and acting defensively, will gravitate toward minimum return thresholds generally articulated in the bank’s loan policy.
There is, of course, a better way to price loans. If you start out knowing what the current level of return is on your existing portfolio of commercial loans, you can supplement your traditional loan pricing process with an understanding of the proposal’s return on equity (ROE).
Described below are circumstances that loan officers deal with on a daily basis. Let’s look at an example where a prospective high quality borrower (credit grade is “Excellent” – your highest credit level) requests a $1,000,000 commercial real estate loan. Let’s further assume that this borrower has a strong desire to fix the rate of this loan for as long a period as the market will allow; and you settle on a five-year term, amortized over 240 months. The “negotiation analysis” for this example case is illustrated on the accompanying chart.
Customer’s Initial Request
From whatever the source (presumably, the customer has already talked to a number of other lenders before they talked to you), the borrower communicates to you that they think they should be paying no more than 4.25%, with no fees for a loan of this type. Using your bank’s loan pricing system, you rapidly deduce that this loan would earn the bank an ROE of 14.15 percent over the five-year period. Furthermore, you compare this rate to the rates currently being earned by the bank on similar loans, and to current internal pricing guidelines. You find that the existing loan portfolio is earning 14.75 percent. However, the target rate of return for new loans, based on the current year budget, is set at 16 percent.
Your Initial Offer
Your initial offer was at a rate of 4.75 percent for five years with no fees, understanding that this loan package would earn your bank an ROE of 17.80 percent.
Competitor’s Initial Offer
The challenge arises when the prospective borrower is offered a 4.625 percent rate with an upfront fee of one half percent. You quickly determine that you could match these terms, determining that this loan structure would produce a 17.69 percent ROE for the bank.
However, you further determine that you must now offer this customer something more to keep the loan (simply matching the competitor’s rate at this point won’t get the deal done for you); so you use your loan pricing system to determine that a rate of 4.50 percent with a one half percent fee will in fact provide the bank with an ROE of 16.77 percent.
You make this counterproposal to the prospective borrower, only to later discover that your competitor is willing to beat your price at a level of 4.375 percent, with a one half percent fee.
Your Winning Proposal
Never to be outdone, you have a frank discussion with your prospective borrower, knowing that you cannot beat the competitor’s rate offer this time, as the computed rate of return of 15.86 percent is below your target. You now find out that the borrower is very pleased with the competitor’s rate of 4.375 percent, but is not happy about being required to pay the one half percent fee. You learn further that the client has an additional corporate checking account with another financial institution, which they might be willing to move to the bank that provides the loan. Account analysis shows that over the last 24 months this account has averaged more than $50,000.
Taking into account the enhanced ROE that an additional business checking account can bring to your bank, you offer a rate of 4.375 percent with a one-quarter percent fee, which you have determined will also earn your bank a 16.08 percent ROE. The client accepts the offer. You have effectively out-negotiated your competition.
The crucial element of effectively managing all of your commercial loan negotiations in this manner is having a loan pricing system in place that accurately calculates the profit, ROA and ROE of any loan proposal that is made by either you or your competitor.
Such a system can enlighten your organization with the knowledge of the current level of return of all existing and prospective commercial loans, in a manner that fully coincides with your current or future financial expectations. With a system such as this in place, you can confidently compete aggressively to grow both the absolute size of your commercial loan portfolio, while improving yield, margin and profit.