Roadblock: Pricing Models Ineffective on Small Loans
A significant complaint our professionals hear from lenders regarding in-house and third-party pricing models is that they don’t work well on small loans. Lenders can become frustrated because no matter what rate assumption they put into their model, the loan never meets the institution’s return on equity (ROE) target levels. Let’s explore how loan profitability is calculated within a pricing model and how a properly calibrated system can allow lenders to be competitive regardless of loan size.
What to Consider
First, look at how pricing models calculate the profitability of loans. Below is a typical income statement.
| Loan Income Statement | Calculation |
|---|---|
| Interest Income (+) | Average Balance * Loan Rate |
| Cost of Funding (-) | Average Balance * Cost of Funding Rate (FTP Rate) |
| Net Interest Margin | Interest Income Minus Cost of Funding |
| Fee Income (+) | Loan Fees (% of Loan Amount or $ Charge) |
| Provision Expense (-) | Average Balance * Provision % (Adjusted for Credit Risk) |
| Expense Allocation (-) | Origination, Servicing, Overhead Allocated as $/Acct. or % of Loan Amount |
| Taxes (-) | % of Pre-Tax Profit, if Applicable |
| Net Income | Net Interest Margin Plus Fees Minus Expenses & Taxes |
Description: Pricing Model Loan Income Statement
Source: LoanPricingPRO®
An analysis of this income statement illustrates that most line items have the same profitability impact for all loan sizes. In other words, these line items scale with loan size. This includes interest income, interest expense, fee income (in most cases), provision expense, and taxes. The only line item that has a different profitability impact for different loan sizes is the expense allocation. Most likely, it’s this assumption that may be causing heartburn when analyzing small loans.
Expense Allocation
The best pricing model implementations generally include a detailed expense allocation study. In these studies, 100% of the institution’s noninterest expenses are distributed among its product lines. A percentage of each expense is allocated to loan, deposit, and treasury management products and further divided into origination, variable servicing, and fixed overhead categories.
After all expenses are allocated, an average cost per account can be calculated based on the number of accounts serviced within each product line. The following table shows an example of the average costs per account.
| Product | Origination Expense | Annual Servicing | Annual Overhead |
|---|---|---|---|
| Commercial Real Estate | $750 | $650 | $1,500 |
| Commercial Construction | $1,000 | $700 | $1,500 |
| Other Commercial | $400 | $450 | $1,500 |
| Mortgage Loans | $250 | $150 | $750 |
| Consumer Loans | $50 | $50 | $150 |
| Non-Maturity Deposits | $100 | $50 | $200 |
| Time Deposits | $50 | $25 | $100 |
Description: Example Product Cost Allocations
Source: LoanPricingPRO®
After the expense allocation study is complete, the results can be loaded into your pricing model for use on new loan analyses going forward. By allocating expense on a “dollar per account” basis, you will see an inversely proportional relationship between loan size and the profitability impact of the expense assumptions. The smaller the loan, the larger the profitability impact of expenses. The larger the loan, the smaller the impact of expenses.
Considerations should be made to see if costs should be adjusted on loans of varying sizes. If there are procedures in place to streamline the origination of smaller loans, then it makes sense to reduce the cost per account assumptions in your pricing model to reflect this. On the flip side, if there is a size threshold for loans to go through the full approval process, including full credit underwriting and loan committee review, it is then reasonable to increase the cost per account in your pricing model for larger loans.
There are alternatives to the cost per account allocation method. Some institutions decide to allocate either a portion or all of their expenses as a percentage of loan amount. By making this change, the expense allocation assumptions will have the same profitability impact on all loan sizes. The question you need to ask is whether a $1 million loan should get 10 times the cost as a $100,000 loan. In a similar manner, some institutions opt to ignore cost allocations in their pricing model entirely. By doing this, the institution has decided to manage the profitability of its loans at the net interest margin level with small adjustments for fees and credit quality. Both methods generally force institutions to adjust their ROE targets higher to compensate for not fully allocating expenses.
Conclusion
If you have implemented a pricing model and are getting frustrated with the analysis on smaller loans, the first place to look is your expense allocation assumptions. Your model should allow you full control over these assumptions, and it is vital to perform a fully allocated cost allocation study to make sure your model is properly calibrated. Once this is completed, you can adjust ROE targets based on loan size tranches to make sure smaller loans are being analyzed fairly, accurately, and competitively. For more tips on navigating loan pricing model implementation, see our FORsights™ article, “Loan Pricing Model Roadblocks: Accuracy of Assumptions & ROE Targets.”
Visit the LoanPricingPRO® page to learn more about Forvis Mazars’ strategic loan pricing platform. If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.