Bankers are generally a fairly pessimistic bunch. It’s the nature of the business, really. On each transaction the bank has a capped (and small) potential income, but stands to lose 100% of its principal if things go awry. The best bankers are those who excel at not losing money. They learn to get up every day, go to work, and look for things that might blow up.
But despite the cautious DNA of most bankers, when cycles run long, their actions don’t always match their attitudes. And the recent run of economic expansion was among the longest on record.
Now that the cycle has turned, there will be banks that didn't see it coming in time. The accumulated risks will manifest in the form of lost earnings, lost jobs, and maybe even some failed banks.
How do those risks accumulate? They almost always build up in the form of mispriced loans. As one of our favorite clients once told us, “In 30 years of banking, I’ve found that you win the most what you misprice the worst.” That is gospel truth, and it’s happening today at banks around the world.
Below are the most common ways we’ve seen risk being mispriced, as well as a few thoughts on how the errors can be corrected.
Credit Risk
Any discussion of risk in loan pricing has to start with credit risk. As a wise boss of mine once said, “Interest rate risk might cause you to lose your bonus, but credit risk could cause you to lose your job … and be barred from the industry forever.” He was obviously born to be a banker.
1. Stop Ignoring the E in ROE
Pricing targets are often based on spread instead of Return on Equity, or more accurately, Risk Adjusted Return on Capital (RAROC). Spread is easier to calculate, and in the minds of relationship managers (RMs), is fully within their control. However, spread ignores capital, which is the scarcest resource in banking. Capital is the ultimate constraint, and therefore the resource that should be optimized in each transaction.
Subtle changes in transaction structure can lead to substantial differences in capital allocation, and many of those structure changes are within control of the RM. It may take some education (and convincing) of RMs, but capital is too important to ignore. Your incentives and performance metrics might include spread, but the pricing decision criteria should be based on RAROC, so you aren’t completely ignoring capital.
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2. Evaluate the Whole Truth
All banks take credit risk into account when pricing, but I’m still surprised at how many factor in only a portion of the risk. Most community and small regional banks price based only on the risk grade, which is measuring the probability of default (PD). They know how likely the deal is to default, but not necessarily how much they will lose when it does.
Some other banks try to incorporate this loss given default (LGD) into one all-encompassing risk grade, but that rarely solves the problem. Instead, pricing is based almost entirely on a debt service coverage ratio, with little differentiation between a loan with an LTV of 55% and 75%. It’s like a pass/fail approach: If it meets the policy for LTV, then all is well.
In reality, the bank should be more aggressive in pricing the lower LTV and seek a higher premium on the riskier LTV. If you are the bank in the market ignoring LTV, guess which type of deal you will win more often?
The solution can be relatively simple, even if you have not yet implemented a two-tiered risk rating system. You can evaluate potential loans the same way you do a problem loan - by looking at the potential recovery from collateral and guarantees in comparison to the exposure. Larger expected losses (PD*LGD) should translate to higher spreads, even for loans of the exact same risk grade.
Along those same lines, even as banks have started adopting two-tiered risk rating systems that incorporate an LGD grade (often called a Facility Grade), their portfolio credit risk has actually deteriorated. While these systems may allow a bank to more accurately measure the risk of a loan, that doesn’t necessarily mean they foster better pricing of that risk. Measuring risk and pricing risk are not synonymous.
In this case, the divergence between measurement and action is because LGD grades are an abstraction that don’t connect the RM to real life deal terms that can be negotiated. RMs might be able to see that the pricing difference between a facility grade of A and D is nearly two hundred basis points, but they don’t have an easy means of determining how to turn the D into an A. Instead of trying to decipher the grading system, the solution might be as simple as having your borrower pledge some of their excess cash or real estate as additional collateral until the loan balance is reduced. Those are deal terms that are negotiable, while a letter grade is not.
Interest Rate Risk
The banking industry was able to be largely complacent about interest rate risk for the first 7 years after the financial crisis. Short rates sat near 0%, and long rates were stable within a 200 basis point range. Between the stability and the constraint of a zero lower bound, there was only so much balance sheet management to be done. Now rates are moving, and bankers are dusting off the old ALCO playbooks.
3. Don’t Ignore the Yield Curve When It’s Inconvenient
Over the last decade, nearly all banks have incorporated marginal funding costs into their loan pricing methodology. However, they haven’t exactly been consistent in their application of those costs. Banks claim to follow the yield curve, but they do so very selectively.
With a nice, normal, upward-sloping curve, following the market is easy. It’s even easier when the curve is steep, like it was from 2009 to early 2017. All that changed when the FOMC embarked on their tightening campaign, where they raised overnight rates by 225 basis points from 0.25% to 2.50%. The curve got progressively flatter, with inversions showing up by late 2018.
As soon as bankers started seeing five-year rates lower than three-year rates, they abandoned their market discipline and started putting their thumb on the scale. Many banks are now making yield curve and liquidity premium adjustments in an effort to keep their internal pricing curves upward sloping, no matter what the markets say. This has unintended consequences, though. Our own data shows that bankers are now seeing production shift away from fixed rate structures, booking significantly more floating rate loans over the last year.
If the yield curve is right, then lower rates are around the corner, and bankers will have loaded up on floating rate loans at exactly the wrong time (much like community banks loaded up on fixed rate loans at exactly the wrong time earlier this decade.
Trying to outsmart the global debt markets is rarely a good idea. You might win some of those gambles, but you should be cognizant of the fact that they are gambles. It may look strange to offer lower rates on longer loans, but there are reasons for doing so. You are locking in yield when the markets expect the next significant move to be down. Of course, to maintain those yields you’ll also need to consider prepayment penalties, which is another topic for another time.
Profitability Risk
The final category of mispriced risk is more difficult to define, but it is certainly important. It is also the most frequently overlooked aspect of risk pricing. For lack of a better descriptor, I’m calling these risks to ongoing profitability.
4. Stop Pricing Blind
Some bank management teams struggle with pricing tools, as they fear that giving RMs a clear target or hurdle will cause them to “leave money on the table” by only charging what a model says and not what the borrower is actually willing to pay. This fear can be mitigated with a well-designed pricing platform that is designed for sales enablement instead of rote calculations, but the only way to fully alleviate it is to incorporate soundly derived market pricing data. Without market context, RMs are left to guess at the competitive environment, leading to a choice between two unappealing outcomes. You can compete against mystery bids (likely yourself) in a race to the bottom, “leaving money on the table.” Or, you might be blissfully unaware of the options your borrower has in the market and lose the deal entirely.
Well designed and properly delivered market data allows RMs to evaluate a transaction on its own merits, but with the added context of how other deals like it are priced in the local market. Do they typically have a higher fee? Come with additional deposits? Or are spreads usually 50 basis points lower, putting you in danger of being shopped to a competitor?
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5. Close the Loop on Cross Selling
For the first time in almost a decade, banks are struggling to find funding for their loan growth. Deposits, especially cheap deposits, are once again at a premium . Banks are also faced with shrinking spreads (See chart below), making fee income more important than ever to profitability. This cocktail translates to bankers shifting gears from an obsession with loan growth to a desperate need to cross-sell. Relationship banking, perhaps the oldest cliché in the business, is once again a buzz word.
While the math of pricing for cross selling isn’t complicated, every bank in the world struggles with execution. In even the smallest community banks there are silos based on products, and the timing of the various transactions can be quite different. After getting approval for aggressive loan pricing based in part on the promise of additional fees and deposits coming to the bank, the seemingly simple task of tracking if and when those additional products show up is surprisingly difficult.
Most banks don’t even try; it’s just a glaring weakness they acknowledge and then move on from. Bankers have told us of cases in which RMs have used the same set of deposit accounts sitting at a rival bank to reduce pricing on multiple loans, knowing the loop will probably never be closed to hold them accountable.
To ensure a positive ROI on your cross-selling initiatives, you’ll need more than a kickoff meeting and adjustments to the comp plan. You’ll also need a clear process for tracking promised business and following up until it actually arrives on your books.
6. Protect Your Vulnerable Relationships
Last, but certainly not least, is the risk faced when loans are renewing or being refinanced. Pricing new loans is relatively straightforward, as you can simply compare the expected returns to the bank’s specified targets. It is more difficult when pricing to an existing customer, simply because you have to evaluate how to handle discounting (or not) based on profitability.
Things get downright messy when you are pricing to an existing customer to renew an existing loan. Banks are extremely inconsistent in their approach to renewals. Most deals simply roll over at the existing terms, even when risk has increased. But, once competition is involved, you will need to evaluate not just the new transaction, but also how to protect the rest of the relationship. How do you determine what is really at stake, and where your line in the sand should be drawn?
Banks need to institute a discipline around accurately defining the potential profitability if they win a competitive scenario, and more importantly, comparing that to the profits that remain if they lose that same transaction.
This comparison requires evaluating all existing business on a pro forma basis. When it comes to pricing, it doesn’t really matter how profitable a relationship was last year, or even last quarter. What matters is this: How profitable is the remainder of the business we have on the books? That is the only metric that can then be included in various go-forward scenarios, allowing your RMs to be consistent in how they evaluate the various tradeoffs.
Yes, this means there are loans you will put on the books that are well below your hurdle rates, because it is the optimal outcome once you’ve been put into a competitive bid situation where you have to protect the existing relationship. Just make sure you do so for quantitative reasons, and not just for the RM who yells the loudest.
One last note on this subject. This same pro forma profitability allows you to proactively find your most vulnerable relationships and take action before you find yourself fighting to save them.
Most banks measure profitability on a historical basis. That 10-year fixed rate loan that you booked 5 years ago might not look excessively profitable to you since you funded it with 10 year money. But remember, your customer AND competing banks could not care less what your funding cost was five years ago. They care about the current rate, and how profitable it will be over the remaining five years. Can they take out the back end of the deal for a lower rate? If you measure it the same way, you will see the relationships and individual accounts that have excessive returns and can make strategic decisions about how to handle them before it is forced on you.
Getting Started on Getting Better
As we’ve laid out, there are numerous ways in which banks can improve their approach to pricing for risk. Which begs the question: Where should they start?
These are all tactical improvements, but it’s worth noting that none of them will make an impact if the bank doesn’t have the right systemic approach to risk. It’s not enough to be cautious by nature. If banks aren’t proactive about identifying their risk pricing weaknesses and in incentivizing their RMs to improve in this area, then not much will change.
Finally, when that course is set, banks need to make sure they have the right tools to execute on their strategy. They need a pricing platform that’s more than a static model. It needs to give RMs a full view of each relationship and its profitability, as well as multiple ways to structure deals that can meet client needs while delivering revenue and minimizing risk. And it needs to give pricing managers the ability to steer the portfolio, ensuring that the bank avoids the risks that come with overweighting in any one sector.
That's what PrecisionLender was built to do. Click on the button below to learn how PrecisionLender's pricing platform can help your bank price for risk.
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