When I was a kid, my Grandpa used to teach his grandsons valuable life lessons by laughing at us. He loved to put us in tough situations and then let the inevitable failure become a teachable moment. And an amusing moment for him, of course.
In one of these lessons, I was helping him sort cattle into the barn to be checked by the vet. My job was to herd some of the cows in through the gate, then close the gate and tell him how many were in the stall.
“Okay, Grandpa, now there are seven in the stall. Now another three, and we have … eight total.”
Just a snicker from Gramps.
“Grandpa, four more, and that makes eight. Wait a second …”
Big guffaw from Grandpa.
I finally realized I had left the side gate to our holding stall open. While I was outside desperately chasing cows towards the front gate, the ones I had already caught were calmly sauntering out the side.
Here at PrecisionLender we come across banks every week that have a similar problem. They are desperately chasing cost savings, and aren’t noticing the revenue that leaks away with every transaction.
Banks are facing intense competition, and many are now embarking on the long, difficult journey of digitally transforming their back-office commercial loan operations. Commercial lending is especially tricky to change, as it involves complex manual processes and bespoke structures. Building this into an efficient, repeatable, and accurate digital process takes hard work and big budgets. But it is quickly becoming table stakes in today’s market, and the payoffs are big. At the end of the rainbow are faster processes which lead to happier customers and impressive cost savings. Banks see as much as 33% reductions in origination and servicing costs.
That’s great, but this is where those lost cows come in.
Because while banks focus on this intense rebuild of the back office, the front-office part of the origination process is in dire need of help. Sales teams are still engaging with customers and negotiating live transactions, and they're doing so with cumbersome tools and out-dated models. Many were built more than a decade ago, and have now seen a full generation of add-ons and new complexity to meet evolving market and regulatory requirements. Structuring, pricing, and negotiating transactions is, in short, messy and inefficient. Banks are leaking basis points faster than they can replace them with hard won cost savings in back-office operations.
This isn’t news to most bankers. They fully realize that pricing is broken, or at least it should be better. But, given the BIG cost savings to be had in rebuilding the origination platform, pricing has to wait, right? We can’t put off 33% savings just for pricing, can we?
Let’s put this in perspective with some quick math.
I used the reference bank that we have created in PrecisionLender to price a typical commercial real estate loan. For this bank, we have configured the assumptions based on industry benchmarks. It uses typical funding curves, a standard nine-point risk rating scale, and average overhead costs that we commission from The Kafafian Group. It won’t reflect the exact costs and risks of your bank, but it will be awfully close.
I also used a very typical structure. I priced a $10 million, five-year balloon based on a 20-year amortization with a fixed rate of 5.50%. (Don’t worry if that is not appropriate for your market; we will be looking at relative changes, so the nominal rate is not important.) This generates a marginal ROE (technically a risk adjusted return on risk adjusted capital, subject to regulatory minimums) of 16.7% (red box in image below).
Let’s now assume that your big overhaul is complete and successful, and that you are realizing savings of 33%. I have now adjusted our scenario, and reduced both the origination cost and annual servicing costs down by a third. Again, this is thousands of dollars per transaction. That same 5.50% rate generates a return of 16.87%. That 17 basis point improvement is impressive, and absolutely should be celebrated.
Now for the surprising part; adjusting the rate from 5.50% to 5.479% (purple box in image below) lowers the return back to the generates the original result, 16.7% return (red box in image below).
So, after all the blood, sweat, and tears it took you to squeeze out that 33% cost reduction, your relationship managers could give it away by mispricing a deal by just 2 basis points. Are you that confident that your pricing process is dialed in enough to get those 2 basis points? Are your relationship managers equipped with the right tools to always negotiate that 2 basis points, or are they forced to follow competition, gut feel, and wet fingers in the wind?
I’ll add one more interesting component. Your bank’s pricing is not driven by industry average costs, but by your own overhead allocations. Once those 33% savings are realized, they will be incorporated into the math on pricing. You won’t just accidentally let those two basis points escape some of the time; you will actually systematically refund it to your customer base every time, on purpose!
My intention here is not to dissuade you from reshaping and digitizing your loan origination process. Those 33% savings are substantial across sizable portfolios, and absolutely will impact the bottom line and the customer experience. Allocate the budget, and do it, or you will be left behind.
However, if you don’t have your pricing process in order, including how your relationship managers negotiate deals, you won’t have that bottom line impact for long. Your savings will walk right out the side gate while you aren’t looking.
*By the way, if you think this effect is only generated because of the transaction being $10MM, using $5MM translates to less than 3 basis points. If you get down to $1MM, the difference is nearly 10 basis points. This is why banks are starting the rebuild with their Business Banking units; the economics dictate it.
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