Loan pricing: a pricing approach based on risk.

Bexley, James B. ; Ashorn, Leroy W. ; James, Joe F. 等

ABSTRACT

Loan pricing is one of the most critical decisions facing financial institution managers. Competition has forced management to continuously review loan pricing with a "sharper pencil" in light of stiffer competition for a share of the available loan pool. If the institution is to be successful and ensure continued profitable existence, there must be a balance between loan loss control and pricing to generate profitability. This study looks at the loan pricing dilemma from a risk management perspective that minimizes the number of calculations required to arrive at the risk factor.

INTRODUCTION

In the past, substantial lip service has been given to the impact of poor loan decisions upon a bank's profitability. In light of the substantial number of bank failures and declining bank earnings suffered across the nation during the 1980s and 1990s, this lip service obviously was not heeded. When talking of a one percent loan default rate, there is a notion that one percent is not statistically significant. However, the reality of a $100 million bank with a 65% loan-to-deposit ratio and a one percent loan loss equates to a $650,000 impact. Furthermore, a $100 million bank earning a return on average assets of 1.2% would return $1.2 million annually. Now, if there is a one percent loan loss in the $100 million bank which earned $1.2 million, it would be necessary to look at the impact of a reduction in either the loan loss reserve or the charge to earnings, to replenish the loss to the reserve. In either case, the result would be an impact on net earnings reducing the return from $1.2 million to $550,000. In this example, a one percent loss from loans could cost the bank over 50% of its normal earnings!

DEALING WITH THE FOUR CATEGORIES OF RISK

In looking at the loan pricing aspect of a bank from an asset/liability standpoint or risk scenario, several concepts should be instantly considered by the bank practitioner. Prior to establishing a strategy for developing a pricing model, much consideration should be given to the various means of measuring risks. Hempel, et al (1994, pp. 67-68), has developed an excellent concept of measuring risk based on four categories of risk identified as liquidity risk, interest rate risk, capital risk, and credit risk.

The element of liquidity risk addresses the bank's ability to consciously deal with shortfalls in the supply of money either through excess withdrawals or substantial commitments of the bank's funds for loans and other income-producing devices. Therefore, the liquidity of the bank is paramount to being able to stay in business given the approximate 14 to 1 leverage to capital ratio in the average bank. In considering liquidity, the following formula will give you the liquidity risk:

Liquidity Risk = Short Term Securities / Bank deposits

In recent years, most banks have purchased or developed sophisticated modeling packages that give a detailed picture of the various scenarios that would exist for a bank given differing economic conditions. In examining the interest rate risk, the concern lies with the assets of the bank that are subject to interest sensitivity as opposed to balancing these elements with the liabilities, which are also interest-sensitive. In a perfect world, assets and liabilities would be balanced at an equal level. Needless to say, banks do not exist in a perfect world and, as a result, we find the need to constantly look at the bank's position in each scenario. To measure interest rate risk, the following formula should be utilized:

Interest Rate Risk = Interest Sensitive Assets / Interest Sensitive Liabilities

In determining the make-up of interest-sensitive assets, you should include short-term securities and all variable rate loans. Transaction deposits, short-term time and savings deposits, and short-term borrowings should be treated as interest-sensitive liabilities.

A risk that is often taken for granted, which is critical to the foundation integrity of a bank, is that of credit risk. In looking at credit risk, we are seeking to determine the basic exposure of the bank in all areas of credit extension. In the previous example of the bank with a one percent loan loss, it becomes very clear that credit risk evaluation is essential to the viability of the bank. The formula for credit risk is arrived at as follows:

Credit Risk = Medium Loans / Assets

Medium loans would be those loans having average loss potential as opposed to those loans of extremely high or extremely low quality. Although, there is an element of judgment in determining what are medium loans most banks have classified their levels of risk on the loan portfolio in order to easily establish those loans with average loss potential.

Capital risk addresses how much the bank's assets may decline before the depositors, creditors, and shareholders are put at risk. The more capital the bank has, the better the cushion to absorb loss to the bank's at-risk assets. The formula associated with capital risk is as follows:

Capital Risk = Capital / Risk Assets

RETURN OBJECTIVES

Banks have traditionally based their pricing either on what the competition was doing or on what the market would bear. It has become obvious that, in the current competitive environment, those old methods will not work. Before setting pricing parameters, the bank should set some basic return objectives such as return on average assets, return on average equity, and net interest margin. Equally important to meeting the objectives is the establishment of a loan-to-deposit ratio.

Why should the bank be concerned with return on average assets and return on average equity since these are in reality end-result or "big picture" considerations? The answer is very simple. If it is not focused on the desired end-result, the bank cannot ensure a sufficient volume of loans priced at the rate desired in order to reach its goal until it is too late to do anything about the results. In addition, if the desired goal has been established, the bank has a yardstick against which to measure results. The formulas for return on average assets and return on average equity are as follows:

Return on Average Assets = Net Income / Average Assets

Return on Average Equity = Net Income / Average Equity

The net interest margin continues to be impacted by the competition for good loans and considers the interest earned on loans less the interest paid for the money. The formula for net interest margin is as follows:

Net Interest Margin = ( Interest Income - Interest Expense ) / Earning Assets

It is obvious that, as rates become more competitive, there are only so many loans to be divided up among all of the banks and the other entities that have invaded what was for years a market dominated by banks. At the same time, the investor has more options than ever before concerning where to invest his or her money for optimum return. What we see in this picture is the bank being squeezed to pay more for its deposits and charge less for its loans. This equates to a reduced net interest margin. The only way to avoid the impact of such a problem is the competitively price loans with deposit or fee requirements and to strategically price deposits in such a way to avoid being the highest bidder. For example, look at deposit pricing in the market and price at approximately 10% above the average price paid for deposits.

COMPETITION AND PRICING

For years the small-to middle-sized banks escaped the competitive pricing challenges facing the large, regional banks. Given the competition for quality loans from within the banking community as well as the non-banking entities, bankers everywhere must now be creative and price loans off of London Interbank Offer Rate, as well as their time-tested base or prime rates, if they have any hope of staying competitive. Gone are the days when a bank in some small market could assume that it had a "lock" on a loan merely because there was not another bank within miles. Mass communications, computer banking, and the Internet have brought Wall Street and the world to every Main Street, U.S.A. Koch (1995, p. 763) stated, "The fact that loan losses were so high during the 1980s revealed that loans were not priced high enough to compensate for default risk, as well as other risks, and the cost of operating the bank." We agree with Koch and would point out that, since the 1980s, competition has increased. Should banks and other financial institutions fail to price their loans in such a way as to ensure compensation for all of the known risks, they stand to repeat the errors of the 1980s.

HISTORICAL PRICING METHODS

Banks have historically priced their loans utilizing several traditional methods. For years the primary method for loan product pricing was using a variation of a bank's prime lending rate or a regional money center bank's prime rate. This method implied that the bank's best customer (whether judged by risk or deposit balances) was given the prime lending rate. All other customers were priced either at prime or some variation of prime, plus a given percentage rate. This method dominated loan pricing until the mid-to-late 1970s when several occurrences caused the method to lose popularity. First, the competition for quality loans drove the money center banks to look to more exotic pricing methods to attract the large, blue-chip companies. This new methodology based off of LIBOR was then embraced by banks in Middle America. The second occurrence was a series of lawsuits challenging banks' use of the prime rate as the principal method for pricing loans.

Today, in lieu of a prime rate, banks are utilizing the term "base rate" as the rate on which they price their loans. While many banks continue to use the base rate or prime rate (disavowing that it is the best or lowest rate), banks continue to search for a method of loan pricing that incorporates risk and at the same time allows the bank to obtain a reasonable profit index.

CUSTOMER PROFITABILITY ANALYSIS

In the quest for a method of lending money that would price the product being sold by the bank similar to an industrial product, large money center banks and regional banks turned to customer profitability analysis as a means to include all the costs for bank loans and services as well as a profit margin. For the most part, smaller community banks stayed with base rate pricing due to the cost and complexity of establishing and maintaining accurate costs for products and services. This method required an accurate costing of all the bank's products, which was then applied to individual customers on an activity or volume basis. At the same time, the customers were given credit for balances maintained and charged for the cost of reserves and several other items.

COMPENSATING BALANCES

For years, bankers have tried to recognize the deposit balances maintained by their commercial loan customers and give credit, either formally or informally, for those balances when setting a rate for a loan to the customers who maintain deposit balances. This method has been utilized by more community banks than the large money center banks or regional banks. Banks utilizing this method would usually establish a peg or base rate and, depending on how large a balance the customer maintained, the bank would make the loan at the peg or base rate or at a rate of some percentage over the peg or base rate. Some banks would also try to allow for risk as they set the rate, but the calculation was less than scientific.

FEE-BASED LENDING

As competition for loans heated up, corporate financial officers saw an opportunity to play one bank against another. These corporate financiers told the banks in ever-increasing numbers that they preferred to pay a fee rather than be required to maintain what to them amounted to unproductive compensating balances. As Koch (1995, p. 771) pointed out in his discussion of fee income for banks, banks developed three distinct methods of utilizing special fees in the pricing of loans. Those methods (usually some amount less than 1%) were facility fees, commitment fees, and conversion fees. Facility fees were utilized to charge the customer a fee for making funds available, whether they were utilized or not. On the other hand, a commitment fee is charged only on that portion of the committed funds that are not drawn down. Conversion fees were charged on those loans which were converted to another type of loan.

RISK-BASED PRICING

With the concentration by both regulators and bankers on risk management, the time has come for banks to price their loans based on some measure of risk related to loan price or reward to the bank. Several authors support this position although they arrive at the concept in differing ways. Sinkey (1998 pp. 420-422) believes that you should score the creditworthiness of the borrower using a statistical model. Koch (1995, p. 778) is of the opinion that banks have generally underpriced loans because they have understated risk, and therefore, they should identify both expected and unexpected losses, incorporating both in the risk charge for a loan. While we certainly agree that both Sinkey and Koch have developed scholarly and workable approaches to the incorporation of risk, we are more concerned with developing a pricing mechanism that can be utilized equally well by the small community bank and the large regional bank. Our method would assign a numeric value to the various segments of the loan portfolio to be converted to a pricing factor that would be added to a pre-established loan rate based on conventional pricing methods. Possible risk categories to implement the start-up of a risk pricing scenario are as follows:

Risk Defined
Price Risk Within Category

 1 0 Cash or CD Secured, or Government Guaranteed Loan
 2 +0.25% Loans Secured by Stock, Cash Value Life Insurance, or
 Corporate Bonds
 3 +0.45% Average Risk Loans Secured by Real Estate,
 Receivables, etc.
 4 +0.75% Above Average Risk Loans to Firms with Slightly
 Deteriorating Profitabilities, etc.

We would then adjust the risk rates on a historical moving average basis that would be gathered from loss experience in the various grade categories (based on the grade category the loss originated from not where it went to loss). After several years, a migration analysis or historical moving average would be used, much like that currently used on calculations of historical loan loss reserve as required under Banking Circular 201.

For example, let's assume that the bank had set a rate of base +0.50% for a loan with a risk category 2. In our risk pricing scenario, we would add an additional 0.25% to the conventional pricing. Assume that, instead of category 2, the risk were category 4. We would then add 0.75%, which would make the loan price out at base rate plus 1.25%.

CONCLUSION

Regardless of the method chosen, risk must be an integral part of the loan pricing scenario to adequately compensate the bank for credit exposure.

Utilizing the risk based pricing method, a bank over several years time would have a reasonably accurate means of pricing to incorporate risk.

REFERENCES

Hempel, G., Simonson, D., & Coleman, A. (1994) Bank Management Text and Cases; 4th Edition. New York: John Wiley & Sons, Inc.

Koch, T. (1995) Bank Management; 3rd Edition. Austin: The Dryden Press; Harcourt Brace College Publishers.

Sinkey, Jr., J. (1998) Commercial Bank Financial Management; 5th Edition. Upper Saddle River, NJ: Prentice Hall.

James B. Bexley, Sam Houston State University

Leroy W. Ashorn, Sam Houston State University

Joe F. James, Sam Houston State University