Introduction
Lender resistance often creates enough inertia to make loan pricing model implementations fall short of expectations. Executives need to solidify a strong commitment to the use of a pricing tool and an in-depth understanding of the assumptions and configuration of the model. There are many roadblocks that can derail a good implementation. This article series explores many of the concepts used in pricing tools and what needs to be considered to successfully implement a model.
Roadblock: The Perceived Accuracy of Assumptions & ROE Targets
One of the biggest hurdles during the implementation of a loan pricing model is lender resistance. Lenders may argue that a pricing model takes away their independence, burdens them with additional bureaucracy, and hinders their ability to add new loan volume. They may ask tough questions regarding model assumptions and return on equity (ROE) targets. Usually, the basis for their resistance is experience with models that didn’t work because they were perceived as onerous and inaccurate.
A model will price us out of the market and won’t allow us to grow our loan portfolios.
What to Consider
Loan pricing models should have the flexibility to be configured with institution-specific assumptions and ROE targets. Assumptions and targets should result from a detailed development process like the following:
- Perform product profitability analysis on existing loans and deposits.
- Scrutinize results to determine existing product ROE.
- Segment loan portfolio into various tranches based on loan size.
- Set specific ROE targets for each product type and size tranche.
Product Profitability Analysis
Most of the data needed to perform a product profitability analysis can be found in the core data system. Balances, interest income on loans, interest expense on deposits, and fee income can all be gathered at the account level directly from the core. Other key data such as credit for funding on deposits, cost of funding loans, provision expense allocation, cost allocation, and capital allocation need to be applied to the account data using a methodology similar to that used in the pricing model.
The credit for funding on deposits and the cost of funding on loans is assigned based on the desired funds transfer pricing methodology. This process factors in the duration of the account and the origination date or last rate change date.
Provision expense is allocated to loans after considering the risk grade of the account and the general reserve allocation for the account’s product type usually found in the allowance for credit loss CECL calculation.
The cost allocation process starts with a determination of which noninterest expenses should be assigned to loans, deposits, and treasury management products. Expenses also are designated as either fixed or variable in nature. These general expense buckets are broken down further by assigning them to individual product types. At the end of the process, each account of a specific product type receives an origination, servicing, and fixed overhead cost assignment. The cost allocation process should use a fully allocated approach where the sum of all allocated costs reconciles with the general ledger.
Capital is allocated to products based on the perceived risk. A good approach is to initially use the risk-weightings of the asset accounts to assign capital with the remainder allocated to deposit accounts. Again, this process should fully reconcile to the general ledger.
Determining Current Product ROE
After completing these various allocations, a full income statement can be produced for each loan and deposit product according to the following tables.
| Loan Income Statement | Source | Deposit Income Statement | Source |
|---|---|---|---|
| Interest Income (+) | Core System | Credit for Funding (+) | Calculated |
| Cost of Funding (-) | Calculated | Interest Expense (-) | Core System |
| Net Interest Margin | Net Interest Margin | ||
| Fee Income (+) | Core System | Fee Income (+) | Core System |
| Provision Expense (-) | Calculated | ||
| Expense Allocation (-) | Calculated | Expense Allocation (-) | Calculated |
| Taxes (-) | If applicable | Taxes (-) | If applicable |
| Net Income | Net Income | ||
| Allocated Capital | Calculated | ||
| ROE | Net Income/Allocated Capital | ||
| ROA | Net Income/Average Balance | ||
Segment Loan Portfolio Into Size Tranches & Adjust ROE Targets
After completing the detailed product profitability analysis and determining the current ROE levels, the results should be further broken down to determine the existing ROE levels of various loan size tranches. These tranches are defined by which loan sizes meet categories like Lender Authority, Committee Approval, and Board Approval. This allows ROE targets to be accurately set within the pricing model. The following is an example target ROE matrix.
| Loans < $500k Lender Authority | > $500k & < $2M Committee Approval | > $2M Board Approval | ||||
|---|---|---|---|---|---|---|
| Product | Current ROE | Target ROE | Current ROE | Target ROE | Current ROE | Target ROE |
| Commercial Real Estate | 10.0% | 12.5% | 15.0% | 17.5% | 17.5% | 20.0% |
| Commercial Construction | 10.0% | 12.5% | 15.0% | 17.5% | 17.5% | 20.0% |
| Other Commercial | 7.5% | 10.0% | 12.5% | 15.0% | 15.0% | 17.5% |
Conclusion
Proper configuration of pricing model assumptions and ROE targets is essential for a successful implementation. By having a firm grasp on the factors that drive the profitability results within your model, your commercial lending team can become stronger advocates and more effective practitioners of your institution’s loan pricing tools and strategies.
Explore the LoanPricingPRO® page to learn more about our strategic loan pricing platform. If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.