What Exactly Is Loan Pricing Discipline and Why Does it Matter NOW?

Interest rates have begun to rise, and most forecasters believe they will continue to move higher during 2017 and 2018.  Trump policy initiatives encompassing tax cuts, infrastructure spending and de-regulation are anticipated to fuel higher economic growth rates nationally compared with recent trends.  Inflation expectations are also rising.

The Federal Reserve’s cautious forecast of three 25 basis point hikes to the Fed Funds rate during 2017 does not factor in a significant impact from growth or inflation caused  by the prospective new policies of the Trump Administration. Any early successes related to these potential policy changes could cause inflation and interest rates to move even higher than what most prognosticators have forecasted thus far.

Over the past several years, banks have looked forward to a rising rate environment, where loan rates rise more quickly than deposit rates, leading to improvement in net interest margins and to overall profitability.  The risks associated with this rosy forecast include: continued weak loan demand; deposit disintermediation; declining liquidity, and ongoing intense competition among banks for any available new loan volume.

Banks may have little influence over these market forces.  However, one variable they can easily control is the implementation of a loan pricing discipline within their own institutions.

So what exactly does the implementation of loan pricing discipline entail, and how can a financial institution know when it has achieved it?

In its simplest form, loan pricing discipline exists when a financial institution implements a system that ensures that loan rates and fees move in concert with movements in related market rates.  This system must assure that a variety of objectives are being attained, including that margins are maintained or expanding, desired behaviors are incentivized, and critical performance information is generated. This system must possess at least each of the following functional capabilities:

  • Risk‐based pricing (credit risk)
  • Coverage of duration / extension risk
  • Detailed funds transfer pricing across the term structure of rates
  • Calculations on individual loan products ROE
  • Facilitates establishment of appropriate ROE targets
  • Full relationship profitability determination
  • Simulation of alternative acceptable pricing scenarios
  • Consistency across customer groups

You will know when your institution has arrived at best practice performance levels of loan pricing when:

  • A focus on pricing exists, effectively balancing growth and profitability goals
  • Information on portfolio performance is readily available to track trends, identify problems, and make course corrections when needed
  • Senior executives clearly understand the ROE differences between products and know how to use this information to grow bank profitability
  • Lenders and credit administrators are able to see the whole picture of customer profitability across multiple lines of business
  • Lenders find it easier to manage profitability , and their role is supported and clarified
  • You can implement strategies to grow or shrink individual products based on risk / return trade‐offs, capital requirements, or concentration
  • Profitability and ROE is increasing according to plan

As you can imagine, achieving all of these goals simultaneously requires more than a lender’s good instincts, experience, and awareness of market expectations. A well thought out and accurately calibrated loan pricing system is crucial to the successful management of overall loan portfolio performance.

Characteristics of a Disciplined Loan Pricing Culture

At the center of a disciplined loan pricing culture is the executive management team’s commitment to using a quality commercial loan pricing system capable of accurately calculating customer profitability. Individual loan pricing analysis is being performed on all significant new loan requests and on all significant re‐pricing proposals. A report showing the ROE of the full customer relationship exists in each commercial loan file, and is readily accessible for loan committee review and approval discussions, when required. The existence of these reports saves a considerable amount of time and leads to more objectivity in the approval process.

Senior lending officers know the current ROE performance of each commercial loan product, segmented by account size, industry and credit quality parameters. Individual loan officers know the current ROE of their entire portfolio, as well as where each customer ranks in relationship to average ROE. They are able to quickly identify their Top 10 most profitable customers, and their Top 10 best prospects for profitability improvement.

In today’s rapidly changing banking environment, where rising interest rates and competition make improving the profitability of your loan portfolio extremely challenging, it is difficult to compete without an accurate and comprehensive loan pricing system. If you don’t currently use a quality loan pricing system, your institution should consider options for obtaining one.  If you have one, but it is not being used regularly and effectively, perhaps your assumptions and or loan pricing calculations are in need of a tune-up.  We generally find that these adjustments are easy to isolate and modify.

If you’d like to discuss how implementing best practices in loan pricing discipline for commercial lending in your institution can assist you in improving your profitability in 2017, please feel free to contact me at jmorris@probank.com, or call me directly at 419-517-1775.  To learn more about LoanPricingPRO®, the commercial loan pricing system provided by Austin Associates, please visit our website, www.loanpricingpro.com.