When talking about loan pricing, one banker recently said, “You win the most, what you misprice the most!” He went on to say that when the bank was winning a lot of deals it worried him. I think he was incredibly insightful and right on the money. That said, setting target return on equity (ROE) objectives is one of the most important aspects of creating a strong loan pricing discipline. This will allow you to strategically control which loans you win and which loans end up on the other guys' books.
This post will explore four main topics:
- Setting ROE targets that support your growth and profitability goals
- The importance of tweaking your ROE targets regularly to ensure continuous improvement
- The implications of tweaking your ROE targets vs. your model assumptions
- The ROE targets you use for your loan pricing model vs. the ROE for your bank (hint: they’re not the same)
1. Setting the right ROE targets for your Loan Pricing Model
Let’s begin the discussion about how to actually set ROE targets. There are several things to think about regarding your loan volume and profitability, and the questions you need to ask are very detailed. Aside from overall levels, is your loan mix optimal or do you have concentrations that you are trying to reduce? How does each of the markets you serve vary in terms of your market share, growth potential, risk characteristics, lender expertise, market awareness, competition, and competitor pricing practices?
We need to consider these factors because our current pricing has gotten us to where we are today. Once again, “You win the most, what you misprice the most!” That very powerful statement explains why having good targets is so important to your future balance sheet. In other words, your target ROEs will help to control volume, quality, and loan profitability. Specifically, by setting ROE targets by loan type, loan grade, and by market, management can make sure that lenders are very competitive on the highest quality deals that support your strategic objectives. Conversely, loans that are lesser quality but still pass grade, in categories with concentrations, are given the highest ROE targets. This same fact pattern (no I’m not an attorney, I promise) could even be segregated further depending on the characteristics of your market and your market share.
This is a key point, so I want to say it a little differently and then I’ll move on. Think of your loan portfolio as a limited resource and your ROE targets as helping you ration the loans out. And please remember, while your ROE targets are impacted by your liquidity, this process is just as relevant if you are highly liquid or less liquid.
I also want to stop and make sure I don’t scare you off. You don’t have to drill down as far as I am suggesting when you start the process. In fact, one of the biggest mistakes banks make in the loan pricing software set-up process is taking forever to try and get everything “just right”. This is an area where good people can get lost in unhelpful minutia.
Additional Reading: Setting ROE Targets - What NOT to Do
Another important step in the process to determining target ROEs involves running booked or prospective loans through the loan pricing software to see where they fall out. Thirty days or a representative sample of loans is probably plenty. Examine whether these results are in sync with the strategic objectives discussed above. A future post will discuss how to ensure that things go smoothly during the first 60 days after lenders start using the software. For now, suffice it to say that tweaking the ROE targets is more important than creating a process upfront that tries to “get them perfect” (as there really is no such thing).
I can sense some of you wondering if I am ever going to give you some specific numbers! If it was that easy I could have saved several hours of writing. That said, I will give you some broad ranges and then tell you what not to do. For very high quality loans of the most desired loan products, in competitive markets, ROE targets are typically between 15% and 22%. Weak pass credits of less targeted products tend to have target ROEs typically between 25% and 30%.
Keep in mind that the higher quality loans have lower levels of capital also. Conversely, the lesser quality pass credits have more capital so the required pricing differential between the most and least desired loans typically ranges from 250 to 500 basis points. How to get this additional premium is a long discussion in a future post. For now, let me say that you are probably competing against yourself (not the competition) for these lesser quality pass credits, so begin pricing them more aggressively.
2. Regularly Tweaking the ROE Targets for Your Loan Pricing Model
The most important thing to remember is that setting ROE targets is a continual process. In 2009, when I returned to loan pricing I talked with many bankers who had lost faith in their loan pricing model. The biggest complaint was that the ROEs they were getting seemed unrealistic. What I quickly determined was that they hadn’t updated their assumptions and/or their ROE targets to reflect the new banking environment.
I recommend constantly reviewing and tweaking your ROE objectives to help ensure continued benefit from your loan pricing software. You can literally tweak your objectives all the time. Again, if you are “winning too much” of something, there is a good chance your pricing needs to change.
3. Why Not Just Change the Assumptions Rather Than the ROE Targets?
On the other hand, I recommend changing the assumptions in your loan pricing software very infrequently. Some people will tell you that changing your assumptions leads to the same thing: a change in pricing. These people often prefer to change their assumptions because they can do this without the lenders knowing. For example, if you want the lenders to increase your pricing you can raise the ROE targets or change an assumption input, such as increasing capital. I agree that these will both result in requiring increased pricing but changing your assumptions has one very big difference.
Once you change assumptions, you lose the ability to compare your pricing over time. Let me try to explain why this is such a huge loss. If we want to compare our bank’s pricing over time or a lender’s performance over time or how we priced a borrower this year compared to last year, we should be able to just look at the numbers. Very simply, if our ROE increases, we are better off and if it decreases, we are worse off. However, if we changed our assumptions it is almost impossible to determine if we are better off.
Let’s say we increased our capital by half a percent. Real quick, is a 22.32% ROE with 9.5% capital better or worse than a 22.81% ROE with 10% capital? And for those of you who knew that the 22.32% ROE was better, in two years will you remember each of the changes you made to your assumptions? This leads to a key point: you should change your significant assumptions as infrequently as possible. For example, in 2008 there was no question that banks needed to increase capital levels significantly and this was a great time to update all modeling assumptions.
4. Loan Pricing Model ROE Targets vs Your Bank’s ROE Target
One of the most common mistakes made regarding ROE targets is to set your ROE target a little higher than your bank’s current ROE. Along these lines, many of you were probably wondering why the ROE targets are all so high relative to the industry ROE levels. In other words, I recommended ROE objectives between 15% and 30%, and very few banks have ROEs above 15%, let alone 20% or 30%.
The answer is very simple and goes back to an earlier discussion about loan profitability. The bank’s cash and fixed assets basically earn nothing and the investment portfolio earns very little. Therefore, the loan portfolio has to do the heavy lifting. Unfortunately, consumer lending and mortgage lending are highly commoditized and thus have modest profitability. Commercial lending has a higher level of risk and needs to generate higher profitability than other activities; fortunately it does.
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