Publications & Resources
July/August 2008
Focus: Lending & Credit
Loan Yield Shock Wave. What Can You Do?
By Chris Bledsoe
The market has seen four interest rate cuts totaling more than 225 basis points so far this year –no one expected this much of a drop, this quickly. A shock wave has been sent through earning asset yields in most community banks and one of the primary drivers of earning asset yields, loan yields, is really suffering. The reality is that the rate environment isn’t going to get any better any time soon, so banks must take a close look at the factors they can control in order to manage ever-tightening margins. One area to consider is loan quality and providing your lenders with more specific guidance on pricing in order to maximize loan yields.
Loan pricing models have been around since banking started. Many banks have shied away from them due to the common misconception that they require too much time and are too complex. As a result, the most prevalent approach for loan pricing has become the “seat of the pants” method. The basis of this method involves pricing the loan at a rate you think you can get…without losing it to a competitor down the street (and often this competitor is someone who you think has no idea what they are doing). Beyond this obvious problem, there are clearly other issues with the “seat of the pants” method:
- Risk is typically not priced into a loan;
- There is often a lack of consistency with pricing across loan officer teams; and,
- Deposit relationships aren’t accurately or consistently figured into the equation.
What can you do? Realize that there is a point when matching competitors’ rates no longer makes good business sense. You need to put tools in place to start developing and driving consistency across the board with your pricing decisions. Approaching this area in a methodical manner will ensure that loans are priced at a rate that is competitive yet most advantageous for the bank, so that you can improve bottom line performance – even in today’s volatile environment. If you haven’t been open to adopting a loan pricing model of some sort, now is the time to think about it again. Loan yields are a metric that have one of the greatest correlations to high performance; therefore, it’s no surprise to learn that most high performing banks typically have some form of disciplined loan pricing in place. Take a page out of their books.
There are a couple of considerations that should be made when implementing a loan pricing model. You must keep it simple and build a baseline price into the model. Simplicity is the key to success if you expect loan officers to actually use it and trust the results. Effective loan pricing models are based on certain market indicators, as well as the bank’s current and expected funding structure; this adds a level of comparison that drives knowledge. Reinforce to loan officers that the model is not about dictating what pricing should be, rather, establishing a baseline that they can use to make smart and informed decisions. That said, it’s reasonable to expect some push back from loan officers when implementing any form of pricing model. Old habits are hard to break, but stick with it and hold them accountable. Through this approach, they will be empowered and motivated to drive greater profits for the bank, as they will be more aware of the bottom line implications that each pricing decision has on performance.
Following is a checklist that can assist you in devising a pricing model:
- Keep it simple (the model must be intuitive and easy to use);
- Include real-time market information about rate and risk environments;
- Factor in both credit risk and deposit relationships;
- Ensure that the model is easy to maintain;
- Consider the results a BASELINE, not an end all;
- Make it relevant to expected bank performance; and,
- Require it as a part of your loan approval package.
In a nutshell, there has never been a more critical time to implement a loan pricing model. There are so many factors out of your control in today’s environment (i.e. the shrinking margins, falling earning asset yields), but loan pricing is one thing you can manage. By applying a more disciplined approach and taking advantage of the pricing tools available today, you can put your bank in a better position to drive performance. There's a lot to learn when times are tough, so use this time to your advantage. Establishing consistent practices, such as the use of a loan pricing model, will deliver an even greater benefit to you when the market comes back.
Chris
Bledsoe is CEO and co-founder of Banker’s Dashboard in Stockbridge,
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