Essential Concepts in Pricing Loans
Imagine this scenario. You’ve purchased loan pricing software. Your team is excited to implement the model to help drive commercial relationship profitability. You install the model, login for the first time, and then the questions start popping up. Where did these assumptions come from? Why don’t the results make sense? Are small dollar loans ever profitable? What should our ROE target be?
Successful loan pricing model implementations rely on many variables including management commitment, lender buy-in, and proper software calibration. Calibration is a 2-step process requiring accurate assignment of product profitability assumptions, and then based on those assumptions, product by product ROE target assignments. In this article, we will take a deep dive into what it takes to ensure your model is accurately configured.
Step 1 – Control Your Assumptions
Your model should be built from the ground up by assigning profitability assumptions at the product level. This should include both loan and deposit products. Important assumption considerations include:
- Selection of a funds transfer pricing curve to assign a cost of funding to loans and credit for funding to deposits. Most institutions utilize either the UST curve, FHLB borrowing curve, LIBOR/Swap curve, or an internal curve.
- Origination, servicing, and overhead cost allocations – The institution’s detailed non-interest expenses should be analyzed and allocated out to loan and deposit products. Allocations can be made on a dollar-per-account or percent-of-balance basis.
- Equity allocation to loans and deposits – Equity is normally allocated to loan products based on risk weighting. 100% risk weighted products receive an allocation equal to the leverage ratio of the institution. 50% risk weighted products receive half of that allocation. And, deposit products receive a low-level of capital usually around 20% of whatever is allocated to commercial loans.
- Provision expense allocation to loans – A thorough review of the institution’s current allowance (ALLL) process will determine the level of expected loss assigned to each product. Historical loss rates and qualitative factors are used as the basis of this allocation. This assumption is then further adjusted based on the credit grade assigned to the loan.
Once these assignments are made, each loan and deposit account’s profitability contribution can be calculated. Account level profitability can then be grouped at the product level to determine the current profitability and ROE of each product. The following is an example of how product profitability is calculated.
Furthermore, individual products can be separated into size tranches to isolate product returns by account size. Most often, smaller dollar-size accounts have lower returns than average and larger size accounts of the same product type.
Step 2 – ROE Targets
After the full product-by-product profitability analysis is completed, you will have a good understanding of the current returns of all loan and deposit types. The analysis will accomplish two goals. First, it allows you to reconcile the total costs allocated to the institution’s financial statements. And, it gives you the basis for product level ROE target assignments. This is important because your pricing model shouldn’t have a single ROE target.
The following illustration shows example ROE targets based on the current ROE of a typical CRE portfolio.
By knowing the current ROE of the various CRE size tranches, minimum and desired ROE targets can be assigned at modestly higher levels. Over time, if new loans are meeting these ROE targets, the profitability of this product type will increase.
By assigning targets at the product level, and in some cases at the account dollar-size level within products, your pricing model will give guidance on the correct weighted average ROE target for each loan and relationship analysis. For example, an existing customer with a mix of loan and deposit accounts will have a different ROE target than a prospective borrower requesting a single new loan.
Also, by using the same assumptions in your live model that are used in the product profitability analysis and ROE target development, you eliminate the argument from lenders about the fairness of the assumptions.