Introduction
Lending executives may run into several concerns when considering commercial loan pricing software, such as cost, a lack of understanding of the benefits of implementation, and full leadership commitment to using the relationship pricing model. While these challenges may be daunting, loan pricing software can help with adding value to your institution’s commercial lending process.
In this three-part series, we will explore ways that a loan pricing model may help your institution achieve a strong return on investment (ROI). This first article will focus on how loan pricing models can help enhance loan yield and increase loan fee collections.
Where to Begin: Know Your Institution
When working with clients in this area, our discussion typically begins with a simple sentiment: make sure that the investment you make is appropriate given your institution’s size and sophistication.
Your efforts can achieve the greatest level of payback when you spend neither too much nor too little on a loan pricing software purchase. Currently, there are a variety of solutions available in the marketplace that vary greatly in functionality and price. Spend too little and you may end up with a system that is little more than an Excel spreadsheet, which doesn’t link with your core data and is incapable of accurately reflecting full customer profitability in an accurate manner. It is also possible to spend too much, perhaps locking your institution into unreasonably large and/or long-term payment streams, making the achievement of a fair ROI difficult and pushing “payback” to a distant future date.
The size of your investment should be tailored to the size of the commercial loan portfolio you will be using the system to manage and to the sophistication and knowledge level of your internal users.
Next, let’s consider a few alternative means that you might deploy to help confirm that the implementation of a loan pricing system in your institution has a strong, positive ROI and a reasonably short payback period. We’ll explore these through hypothetical scenarios that demonstrate the potential benefits and efficiencies brought about by such systems.
Enhanced Loan Yield
Quantitative analysis can be easily used to measure the effectiveness of the loan pricing system implementation on a pre-test/post-test basis. The technique used relies on the same funds transfer pricing (FTP) methodology that a robust loan pricing system uses to calculate customer profitability. To illustrate this, let’s use an example of a $2 billion commercial bank.
This bank has a commercial loan portfolio of approximately $1.375 billion, composed heavily of commercial and agricultural real estate loans (at 71%), and a smaller allocation to a commercial and industrial (C&I) line of credit and construction loans (at 29%). The portfolio consists of approximately 2,750 loans, with an estimated overall average loan size of $500,000. Each loan in the existing portfolio was analyzed for profitability prior to the implementation of a loan pricing model to determine the “pre-test” level of net interest margin.
Using standard FTP methodology, each individual loan was compared to the U.S. Department of the Treasury curve based on its original term at origination to determine the loan’s cost of funding. This cost of funding rate was then compared to the loan’s actual yield, with the difference equaling the loan’s net interest margin. This same process was used for all loans originated or renewed during the following year, using the loan pricing model as the basis for establishing the loan’s rate, with the following results observed:
| Description | Pre-Test | Post-Test | Improvement |
|---|---|---|---|
| Loan Yield | 5.96% | 6.25% | 0.29% |
| Cost of Funding | 2.34% | 2.43% | -0.09% |
| Net Interest Margin | 3.62% | 3.82% | 0.20% |
Source: LoanPricingPRO
It is worth noting that during the post-test period, both the cost of funding and the average new or renewed loan yield increased, with the net result being an improvement in the net interest margin of 20 basis points. (The post-test period covered a modestly rising rate environment, during which time the Fed raised the federal funds rate three times by 75 basis points). During this one-year post-test time frame, approximately $145 million of new or renewed commercial loans were priced using the model, and no other changes were implemented during this time that could have caused a similar expansion in the net interest margin.
The one-year impact of this expansion in the margin equaled $290,000 and delivered a significant, double-digit ROI in a short payback period. This increase in profitability wouldn’t be recognized if the institution hadn’t implemented a loan pricing model when and how it did.
This improvement in loan yield example is only one of several benefits that an institution may experience when implementing a loan pricing solution. Profitability analysis like this is an integral part of any productive loan pricing system, especially the LoanPricingPRO® from Forvis Mazars. When using our tool for loan requests, lenders can immediately see the profitability impact of each loan term and how it relates to institutional goals.
That kind of oversight, where lenders can see the proposed loan’s return on equity (ROE) (and lenders can quickly run scenarios to find the most competitive loan terms with the best ROE), allows companies to compare their competitors’ offerings and helps to make them more competitive.
Increased Collection of Loan Fees
Aside from enhanced loan yields, another value-add area from loan pricing software is commercial loan fees. In today’s highly competitive operating environment with generally weak loan demand, commercial loan fees are often sacrificed to competition or at least underutilized as a tool for increasing commercial customer relationship profitability. In general, the shorter the loan term, the more powerful the impact of loan fees on customer profitability and ROE.
Still, loan fees can sometimes be used to secure a preferred level of ROE from customers who are extremely rate-sensitive. A good loan pricing model will guide lenders toward the strategic use of small but appropriate loan fees in highly competitive loan pricing situations. Most often, this will apply to only a small percentage of the new or refinanced loans analyzed by the model, though it can be a significant pickup in commercial loan profitability when compared to current practices.
Souce: LoanPricingPROIn the case of a smaller example bank with a $250 million commercial loan portfolio, approximately 400 new loans were analyzed each year using the model, with some 300 new loans actually being originated. Using the model as a guide, the example bank implemented a small loan application fee. This was added on all new loans with the intention of slowly increasing this fee amount over time. In addition, the bank began adding a standard quarter-point fee to all new loan proposals.
Over the course of a year, this bank determined that it collected an additional $275,000 in loan fees through these two combined strategies, even though the increase in loan fees collected per new loan was less than $2,500 per loan. On an after-tax basis, this strategy—supported by ROE analysis through the model—more than covered the cost of the system purchase in less than six months.
Increased loan fees are another way that loan pricing models can help enhance your institution’s profitability. Institutions can glean several benefits from loan pricing models based on those covered above (and future ones in our article series). Platforms such as LoanPricingPRO can help lenders build strong client relationships and support profitability goals.
How Forvis Mazars Can Help
At Forvis Mazars, our experienced professionals can assist with strategically pricing loans with real-time profitability analysis and relationship value metrics. Our teams are ready to configure the platform to help meet your institution’s needs and guide you through a profitability analysis of your existing lending products, which can help drive assumptions and targets to balance short-term growth and long-term profitability.
For more information on how we can help grow your loan portfolio or to request a free demo of LoanPricingPRO, please reach out to a professional at Forvis Mazars.