Each year, PrecisionLender (PL) partners with The Kafafian Group (TKG) to review and update the PL platform’s default recommendations for loan origination and servicing costs as well as deposit servicing costs and fees. Using TKG’s late 2016 industry analysis as the basis, we have developed an updated recommended set of default values on costs, which we describe below.
As noted in our past year statements: each bank or credit union (bank) must take specific actions to adopt and implement these new default assumptions. They do not happen automatically, and no assumptions will change without a client’s prior approval.
What’s Not Updated?
This article does not address assumptions related to credit capital and annual loss inputs, collateral, facility rating, and guarantee recovery rates, funding costs or Target ROEs. Any questions or assistance needed on these other key assumptions should be directed to your Client Success Manager (CSM).
Some of our clients have developed their own costs for origination and servicing, based on their bank’s internal operations. We continue to believe this represents the best information to use in the PL platform. While the default assumptions that follow are reasonable, they do not represent any one institution by type or size.
Changes in 2017
Increases and Decreases
Most of the changes this year are minor in nature. We continued to use the same structure we introduced last year, only making small adjustments to the levels. In some cases, there was a slight increase in origination and servicing costs. However, there were a few cases, based on our data set, in which the amounts declined. The information we received showed an increase in lending, by both number of loans and total dollars lent compared to previous years. The increase in the lending base allowed the fixed or indirect cost component to be spread further, for a net per unit decrease. This partially offset the increase in expenses due to inflation, salary growth, and compliance costs.
Marginal Costs Method
As we discussed in previous years’ articles, the cost to originate a loan includes both direct (loan officers’ salaries, benefits for credit analysts, etc.) and indirect (accounting expenses, electric utility charges and general marketing, etc.) costs. When determining the appropriate costs to allocate to loans and deposits, we believe using the marginal costs method vs. the “fully absorbed” costs method is the preferred practice. Loan and deposit pricing is based on making the right marginal economic decision for the next loan or deposit.
We will provide, however, both the PL recommendation that uses the marginal cost method as well as the TKG fully-absorbed median for their clients. A more detailed description of the methodology we used can be found in the 2016 article.
General Overhead Expenses
In 2017, the general overhead expenses (i.e. - the senior executive group’s total compensation, general marketing expenses, and various accounting functions like regulatory reporting) have been about 19.7% of total cost, compared to 16.7% in 2016, based on the TKG data. This year, we used a simplified assumption on loan origination that about 53% (compared to 50% last year) of the total cost is marginal direct cost. However, on the servicing side we continued to only remove the general overhead expense. Thus, the PL recommendations are modifications of the TKG figures (Modified TKG).
It is important to note that the TKG information generally provides us with information on commercial loans of about $600,000. The levels in the other categories are based on PL assumptions.
New Loan Recommendations
The loan tables below show our latest recommendations. You can also find these tables in greater detail within this downloadable appendix, which includes how to use new options that are available within PL. The appendix also shows a comparison between PL’s 2017 and 2016 recommendations, though in most cases the changes are minor.
The two tables in this section show the TKG fully-loaded information, which are the basis for the tables in the previous section. This section shows the comparison between their most recent report for 2016 and the data we used in the previous year, 2015.
The data above is the median for a sample of about 30 banks and thrifts. These institutions have a median asset size of about $1.1 billion and are mostly located on the East Coast, particularly the mid-Atlantic region. The average efficiency ratio for these institutions is 67.54%. They also have a loan-to-deposit ratio of about 89.5%. As such, for banks in lower cost areas or those with low efficiency ratios, the default amounts shown might be higher than the bank’s actual experience. However, for institutions in high cost areas or with a high efficiency ratios, these costs may be too low.
New Methods to Account for Costs in PL
Last year PL introduced a new feature to account for origination and servicing costs in the platform. Prior to this introduction, only an absolute dollar amount could be shown for each category. Now, in addition to a dollar level, a percentage of loan amount, a percentage of fees included in the origination, and an average balance applied in the servicing costs can be used. These can be separate or combined (i.e. a set dollar plus a percent of loan amount).
In the past, a loan with a committed amount of $599,999 would show a higher ROE than one at $600,002, because the origination and servicing expense could be considerably higher for the latter loan. Using a percentage of the loan amount in addition to a set dollar can smooth out these discrepancies.
In the appendix, we have included an alternative to the standard tables that account for a percentage of loan balance.
Based on the data, we made some minor increases in the servicing costs for commercial and consumer DDA. While the TKG data showed some other changes, we felt these were not material enough for us to make modifications to the other categories.