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Loan Pricing Profitability Where Asset Liability Management and Transactions Meet , Loan Pricing Profitability key words: loan pricing, rates, RAROC, profitability measure, fund transfer pricing, approaches THC Asset-Liability Management (ALM) Insight Issue 7 Introduction Loan pricing is important to community banks and credit unions, as it can impact customer relationships, change loan volume and margin, and also impacts the balance sheet risk exposures. Because multiple factors affect loan pricing, the process in determining a loan price can be complex. For example, ALCO and loan officers are often motivated differently in loan pricing. The loan officers tend to be pressured by the customer’s needs, while the ALCO tends to be pressured by risk management. The loan pricing process should consider the needs of all stakeholders. In the end, both are unified in efforts to increase risk-adjusted margin. This article describes a systematic methodology in pricing loans ensuring direct costs are covered and indirect and overhead costs are properly allocated. This enables ALCO and loan officers to make informed decisions in product offerings and secondary market transactions. Ultimately, the underlying profitability driver are assumed and pricing objectives are met. In particular, do ALCO and loan officers alike know which products provide the highest value? How much (if any) rate concession can the loan officer offer to borrowers given the loan policy, secondary market pricing and risk analysis? Can ALCO adjust the rate cap to meet the borrower’s needs without changing the loan offer rate? This article explains. In particular, this article describes the Dynamic Cash Flow method in measuring profitability on loan pricing across a broad range of loan types. The relative profitability measure enables the ALCO and loan officers to jointly decide: • the appropriate loan rate in negotiating with a customer in certain occasions; • most profitable loan products given the loan market competitive rates, combining the market intelligence from the loan officers and ALCO balance sheet strategies; • the growth potential of certain profitable loan products as the loan market supply and demand are continually changing • the bank’s risk-adjusted return on capital (RAROC) against the loans in the secondary market to expand profitable opportunities. Figure 1 below depicts the RAROC profitability of loan pricing based on a bank’s loan offer rates and a sample of secondary market loan rates. These results are relative measures of profitability of loans benchmarked against the secondary market offer prices. While the RAROC has adjusted for the expected credit loss rates of the loans, the profitability has not adjusted for the credit risk premium. The risk premium has to be 1 Where Asset Liability Management and Transactions Meet determined by the risk culture of the bank. Therefore, RAROC is institutional specific, depending on the bank’s risk aversion, balance sheet structure and local economic activities. Figure 1. Loan Pricing RAROC: Risk Adjusted Return on Capital based on Bank's Loan Rates and Secondary Market Loan Rates 25.00 20.00 15.00 10.00 RAROC RAROC % 5.00 0.00 Loan Types "market" denotes secondary market rates The RAROC chart enables ALCO and loan officers to determine their pricing strategies in managing their balance sheet profitability. Measures of Profitability Banks often use Net Interest Margin (NIM), as a measure of a loan profitability. However, such a profitability measure has to be adjusted to compare fixed rate residential mortgages (FRM) and adjustable rate mortgages (ARMs) due to the two loan types have significantly different cashflow characteristics. Also, NIM does not consider caps and floors for ARMs and fails to compare profitability across loan types such as commercial real estate (CRE) loans and auto-loans. Indeed, Margin has limited use for pricing loans. One common approach to Loan Pricing is to use the Static Cash Flow Approach. This method uses return on equity (ROE) as a relative profitability measure, where the equity is the allocated capital to support the purchase of the loan. This method uses Fund Transfer Pricing (FTP) and the Risk Adjusted Return on Capital (RAROC) model, which I have described in Insight #3. I will first describe this method in brief below. In the following sub-section, I will describe the Dynamic Cash Flow approach that can mitigate some of the shortcomings of the Static Approach Consider a 30-year fixed rate 1-4 family mortgage: loan size $100,000, FICO 750, current LTV 80%, owner occupied and detached home, with a loan rate of 4.52%. Static Cash Flow Approach: Fund Transfer Pricing (FTP) and Risk Adjusted Return on Capital (RAROC) 2 Where Asset Liability Management and Transactions Meet Step 1. Calculate the loan Net Interest Margin by the loan rate net of the funding cost The bank can calculate the weighted average interest costs and the servicing cost of the deposits. Currently, under regulation, the servicing cost has to be provided in the Economic Value of Equity (EVE) report. Suppose the total funding cost is 0.85%. Then the Net Interest Margin is 4.52% net of 0.85%. Step 2. Calculate the loan loss provision and cost of options embedded in the loan. The bank can use risk- based valuation models to estimate the credit loan loss rate and the prepayment cost (borrowers option cost); the total cost is then used to deduct from the Net Income Margin. Step 3. Calculate the FTP. FTP is the rate spread to compensate for the interest rate sensitivity between the loan and funding portfolio. Using the Fund Transfer Pricing Method, the spread can be calculated to be 0.71% which is the funding cost of the loan cashflows based on the Treasury rates net of the total actual funding cost (%) based on deposits and borrowings as described in Step 2. Step 4. Determine the expense charge in servicing the loans. Assume the bank has calculated the cost of servicing the loan to be 0.15%. Let us also assume the initial origination fees pay for the expense in underwriting the loan. We further assume, for this example0 that the bank does not allocate other overhead cost to holding the loan. I do not make assumptions on cost allocation because assigning overhead costs to business units is a complex process that the bank needs to determine internally. Step 5. Calculate the ROE. I assume that the capital, as assigned to the purchase of the loan, to the loan size is the equity ratio of the bank. That is, C/L = E/A, where C is the assigned capital, L the loan size, E the total equity, and A the total assets of the bank. This way, I do not assume that the bank has certain preference or aversion to certain loan types. The ROE is specified as follows. Since the annualized loan net income is ((Net Income Margin – Provisions – Fund Transfer Pricing – servicing cost)(1 – tax) L), then, the ROE can be derived as shown below: ROE = (Net Income Margin – Provisions – Fund Transfer Pricing – servicing cost)(1 – tax_rate) L]/C = (Net Income Margin – Provisions – Fund Transfer Pricing – servicing cost)(1–tax_rate)/EquityRatio The Table below provides a summary worksheet in calculating the ROE, where I assume the tax rate and equity ratio to be 33% and 11.8%, respectively. Since the ROE has adjusted for the credit risk and interest rate risk, the return on equity is the risk-adjusted return on capital (RAROC). 3 Where Asset Liability Management and Transactions Meet The Static Cash Flow approach provides a methodology that can systematically compare the profitability of all fixed rate loans. Using ROE as a profitability measure, ALCO and loan officers can have a systematic way to compare profitability of loan pricing across a spectrum of loan types and can then determine the loan pricing that meets both the customer’s needs and the bank’s performance requirements. However, this static approach has multiple significant shortcomings. For example, what is the loan income for an ARM, as the loan rate is not fixed? How is the loan Fund Transfer Rate determined when there are caps and floors, where the income depends on the rate scenarios? The static cash flow method fails when the loan cash flows are not predetermined; ARM cashflows and callable CRE depend on the interest rates, for example. Regulators call this the “option risk.” But most balance sheet items have rate dependent interest payments and therefore option risk cannot be ignored. Option risk is an important consideration in loan pricing. To deal with this option risk, I now describe the Dynamic Cash Flow Approach. Dynamic Cash Flow Approach The impact of option risk on the profitability of a whole loan purchase is apparently recognized by the Federal Housing Finance Agency (FHFA). AB-3-2017 Bulletin has suggested that Federal Home Loan Banks(FHLBs) should adopt an Option Adjusted Spread (OAS) approach to measure profitability when purchasing loans. FHFA suggested using the OAS approach not because FHLBs have different loan types or a different loan acquisition process, but because the method is more accurate. In this section, I describe this OAS approach in the context of the balance sheet of a community bank, and the method is called the Dynamic Cash Flow Approach. I will follow the 5-step procedure analogous to the static cash flow approach. They are: Step 1. Calculate the loan’s Risk-Adjusted Margin (RAM) based on the Fund Transfer Pricing (FTP) curve. Step 2. Calculate the weighted average cost of funding (WCF) and servicing cost based on the FTP curve Step 3. Calculate the Customer Contribution on the funding side Step 4. Determine the expense charge 4 Where Asset Liability Management and Transactions Meet Step 5. Calculate the RAROC.
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