Why Your Institution Needs a Standardized Loan Pricing Model

How Loan Pricing Models Add Value to the Institution

Implementing a loan pricing model often requires a process change for lenders and business development staff at the institution, and may necessitate a few extra steps. But if the institution evaluates the change bank-wide and the impact that a standardized pricing model could have, the rationale for implementation seems pretty convincing:

1. Generate more fee income and stronger earnings, resulting in improved loan yields and margins
2. Create an efficient and consistent credit risk management process with defensible documentation
3. Foster long lasting and more profitable customer relationships
4. Expedite the process to be competitive with turnaround times
5. Build in staff performance reports to help with accountability
6. Illustrate to lenders when they should say “no” to a loan – which could otherwise be a difficult concept

It’s uncommon that business development officers have a complete and clear understanding of the costs of running a commercial banking organization. As a result, it’s difficult to make decisions based on return. The consistency and transparency afforded by a loan pricing model give the financial institution and its lenders the ability to compare returns across lenders, borrowers, credit risk grades and loan type while ensuring the price is commensurate to risk.

Loan pricing is certain to continue as a hot topic with banks and credit unions, and as institutions evaluate different alternatives, there are a few functions to evaluate.

How Models Help Relationship Profitability

In the past, it was uncommon for most banks and credit unions to spend time analyzing commercial customer profitability or incorporating this analysis into informed pricing decisions. Loan decisions were made in a vacuum relative to other services commercial customers may have had with the institution.

 

Yet this can result in overpricing the institution’s strong relationships and under-pricing its weaker relationships. A hurdle that institutions have to overcome to arrive at relationship profitability is disparate information. Often data regarding actual fees, balances rates, and tax treatments is not captured on the core system and therefore is not available for analysis. Without bridging these data sets, it can be challenging to quantify the worth of the customer relationship.

 

 

A loan is only one part of the overall relationship and can sometimes be a loss-leader. In fact, loans on their own tend to not earn the target ROE for the average bank. Many lines of credit, as one example, lose money due to the risk profile and administration costs. 

 

Deposits and fee income certainly contribute to profitability, but it is important to look at the overall profitability of the relationship, inclusive of deposit, lending and other activities with this institution. It oftentimes affords lenders more flexibility in rates because they are looking at more than loan income. It also creates a more diversified customer, which mitigates risk while enhancing the overall relationship