In today’s highly competitive lending environment, it’s tempting to try to gain a competitive advantage simply by setting your commercial loan prices according to what other banks in your area charge. Of course, competitiveness is an important issue in determining loan prices, but it’s far from the only one. Failing to account for such factors as desired return, cost, risk and credit profile can drastically reduce your competitive advantage. A better way to set loan prices is to conduct a thorough, objective analysis using loan-pricing models.
A loan-pricing model can help you make informed decisions about whether it makes sense for your bank to match competitive rates. And, if you incorporate risk-based pricing into the model, you can more effectively customize prices based on a borrower’s credit profile, its relationship with your bank and the loan’s terms.
Your model should consider a variety of risks. Generally, the higher the risk, the higher the interest rate will be. A key risk to consider is credit risk. This is the risk that borrowers will default, which could cause your bank to lose principal or interest, or both, and to incur higher collection costs. To develop accurate pricing information, banks should track their actual loss experience by loan type, loan-to-value tier, and credit score or grade. This data allows you to better match pricing to the risks associated with particular types of loans or borrowers.
Another form of risk is interest rate risk. There are several kinds of interest rate risk. But the term generally refers to the risk that a loan’s profitability will change as interest rates fluctuate. For example, if a bank funds long-term fixed-rate loans with short-term deposits, a flattening yield curve will cause the bank’s margins to shrink. Its pricing should reflect this risk by charging higher rates for longer-term fixed-rate loans.
In addition, many bank products contain options that can affect a loan’s profitability if exercised; such as the right to prepay a loan or withdraw deposits early with little or no penalty. Option risk, a form of interest rate risk, exists because, when interest rates go up, deposit holders tend to move their funds into higher-yielding investments. And when rates go down, borrowers see an incentive to refinance. Either way, the bank’s margins decline.
A detailed discussion of specific loan-pricing models is beyond this article’s scope. But it’s critical for your bank to select a model that’s appropriate in light of its circumstances. Many models, for example, focus on maximizing risk-adjusted return on capital. This approach may be appropriate when funding is in short supply and capital is scarce. But if your bank is highly liquid, it may make more sense to evaluate loan prices in comparison to alternative investments in which it would otherwise park its cash.
Despite their name, loan-pricing models aren’t necessarily used to price loans, since banks are usually constrained by what the market will bear. But a well-designed model can help you determine whether your bank should offer certain types of loans at competitive rates.
You may find that your funds are better invested elsewhere. For instance, you might consider making loans for which demand is high, but supply is low; such as long-term, fixed-rate fully amortizing commercial real estate loans. Many banks are reluctant to make these loans because of concerns about interest rate risk. But, with the right loan-pricing model, you can charge an appropriate risk premium that allows your bank to hedge that risk. And the market will likely bear the premium because of the high demand compared to supply.
Incorporating risk-based pricing into their models enables banks to align loan prices with expected risk, charging higher interest rates for higher-risk loans and lower interest rates for lower-risk loans. This helps a bank attract and retain customers with the highest credit quality. For questions, please contact Paul Atkinson.
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