A client was recently presented with a large lending opportunity. The borrower requested pricing and terms on a $6mm loan. Additionally, the borrower guaranteed that they would keep $500k of deposits with the bank. Like many community banks, growing loans was a key priority for our client and they were eager to win this deal.
The loan amount was at the high end of the bank’s legal lending limit, so they contemplated selling a portion of the loan. Also, they worried about the increased interest rate risk of a large, longer term loan and therefore wanted to keep the amortization period short. They turned to LoanPricingPRO® to determine whether to book the entire loan or participate a portion of it.
ROE versus $’s of Profit
On the surface, it appears the better option would be to proceed with the participation option because it produces a higher ROE and carries less interest rate risk. The ROE in the participated scenario is 17.44%. This compares to a ROE of 16.11% if the bank books the entire loan. This is because the outstanding balance and ultimately the allocated capital will be higher if the bank books the entire loan.
After close examination though, the participation scenario produces only $284,305 of profit over the life of the loan compared to $523,393 in the non-participation scenario. This would result in nearly twice the profit impact.
The non-participation scenario carries more interest rate risk because the amount of outstanding principal is twice that of the participation scenario. But, the bank was comfortable given the shorter amortization period on the loan. The effective duration was only a little more than 6 years assuming normal payments. Additionally, the bank had a guarantee on a large piece of the loan from a government agency.
In the end, the bank decided to book the entire loan in order to recognize the full profit impact. Even though the ROE was slightly lower, the bank didn’t have a good interest income alternative for the $3mm dollars they would still need to deploy in the participation scenario.
While it is easy to focus only on the ROE of individual loan requests, it is important to also look at the macro picture and make sure pricing decisions account for total impact to the bottom line.