Loan Pricing in 5 Easy Steps
As banks begin to recover from the credit induced problems of the recent past, it's probably a good time to take a look at loan pricing. In fact, a recent blog post suggested that loan pricing is one of the two most important financial decisions you can make at your bank. This is especially true at community banks. Here are a few steps to follow.
- Price the Interest Rate Risk of the Structure.
You must start by determining the market interest rate risk price of the structure. There are several ways to do this, including using matched funding from the Home Loan Banks or examining rates in hedging markets. Remember to consider the credit cost differential between swaps and FHLB. Don't forget to price caps, floors or prepayment options. These easily overlooked add-ons can make or break your profitability. Your funding manager might ultimately decide to use a different funding mix, but you must still charge the market price for the specific interest rate risk of the structure if you want to target profitability.
- Consider the Opportunity Cost of Capital.
As with all loans, capital must be allocated to support it. This capital could be earning income if not deployed on the loan and this opportunity cost must be factored in to your loan pricing.
- Price the Specific Credit Risk.
Analyze the borrowers financial position, including their entire loan portfolio exposure. Don't forget to examine the market price of credit risk. This has two components. First, there is a market price for risky assets. For example, US Treasuries yield less than corporates. Determine the appropriate credit cost for your borrower. Second, there is also a credit cost associated with specific loan structures. For example, secured loans should bear a lower credit cost than unsecured loans. Similarly, loans that provide periodic amortization should bear a lower credit cost than balloon or interest only loans.
- Allocate Operating Costs.
There are two basic methods to do this. Marginal cost allocation, while popular in a "meeting the competition" perspective, typically leads to a race to the bottom ratewise. If you remember your economics, you will also remember that if the marginal cost of the last loan is the only cost allocated to all loans, the loan portfolio will not cover your costs. Full absorption costing requires full and complete allocation of all operating costs and assures that you cover your costs at the bank.
- Relationship Credits.
Be sure to add back credits for deposit relationships or fees collected. If a loan relationship involves substantial fees, or brings in significant non-maturity deposits, this has a real economic benefit to the bank. The borrower's loan rate should reflect this.
After adjusting for all five components of loan pricing, compare the loan rate with your internal pricing hurdle rate. If the adjusted return on equity is too low, you should raise the loan rate and/or add additional fees.
It's better to miss a loan priced too low than to book mispriced assets.
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