“I think the ROE is wrong on my deal.”
When we roll out a new client on our pricing and profitability system, we know that a handful of support tickets with that phrase are inevitable. It happens every time, and not because of faulty calculations. After all, there is really no such thing as proprietary math, and we maintain an AT-101 to ensure that the math engine doesn’t break whenever we deploy new code.
Instead, we consider this message to be a validation that our tool is doing its job. The users are discovering new insights about their own customer base, and learning which customers and deal structures are truly profitable. Sometimes they figure out that some of those deals they were very proud of are actually not quite as profitable as they thought. On the other hand, there also tend to be some pleasant surprises to the upside. Either way, it’s an adjustment period.
Now that we are pricing more than $12 billion in deals per month, a few patterns have emerged that we think are worth sharing. What types of deals and customers tend to surprise bankers most often? Here are my anecdotal top two, including one negative and one positive surprise.
Low Utilization Revolvers
We’ll spend most of this post on the loan type that tends to cause the most heartache.
After the financial crisis, the banking industry, and especially community banks, made a mass exodus away from speculative real estate lending and toward commercial & industrial (C&I) lending.
While this move made sense as a way to reduce concentration risks, the fact that everyone was doing it at the same time made the competition pretty brutal. Plus, there were only so many equipment deals to go around. As a result, a whole lot of banks established revolving lines of credit (RLOCs) for borrowers who either barely needed them or barely qualified for them. In almost every bank we work with, we see a long list of RLOCs with utilization below 25% and aggressive pricing. That is a bad pairing for our profitability calculations.
These lines are generally labor intensive (meaning they have a fairly high overhead) because of the ongoing monitoring and short renewals, and the new capital regulations stipulate that banks must hold capital for the full commitment instead of just the amount outstanding. So, lines with low utilization have few dollars outstanding on which to earn, and costs that stay high no matter how much is drawn. In addition, these lines often fall victim to another common surprise, which is that it is incredibly difficult to make small-dollar loans profitable on a stand-alone basis. Given the reality of the regulatory environment and low interest rates, it is REALLY hard to earn enough interest income to cover costs on low-balance, short-term loans.
Banks have been reluctant to address this issue, especially since they have had plenty of excess capital to handle the dead weight of the unused lines. But as the steady growth of the last few years has slowly been absorbing that capacity, those views are changing. We have seen banks take a number of steps to improve the profitability of these structures, including reducing the commitment size and imposing fees on the unused portions. Neither is all that popular with borrowers, though, so bankers need a better explanation than just blaming “those darned regulators.” We suggest offering two options at renewal: One that is relatively expensive with the higher commitment and one that is cheaper with the “right-sized” commitment that is more commensurate with the actual usage.
When banks flocked to C&I loans, there was also an uptick in Small Business Administration (SBA) lending. The scary part was that we saw a lot of banks with no experience jumping into the deep end of the pool, booking high volumes of SBA loans using undertrained staff. However, assuming that you took the time to get the paperwork handled correctly, SBA loans tend to be some of the most profitable deals in the bank.
The reasons are fairly simple. SBA deals tend to go to borrowers who would not have otherwise qualified, meaning there isn’t as much competition, and the bank can price the deal at above-average spreads and favorable structures. In addition, once you get the guarantee in place, the expected loss (calculated by multiplying probability of default by loss given a default) is actually quite low.
One caveat here: we calculate marginal profitability, and that makes individual SBA loans look great. However, if you are doing two of these per year, you are most likely losing money. Putting a program and expertise in place is expensive, and you have to have enough volume to cover those fixed costs for SBA to be a viable option for you.
Our view is that the first step to improving the profitability of the bank is to fully understand which deals drive dollars to the bottom line. Just beware though, that when you finally do the math, the results might not be quite what you expected!