Risk and Reward: Consider These Factors When Pricing Commercial Loans

Is your institution one of the many community banks that take a “seat of your pants” approach to pricing commercial loans? In other words, you look at what your competitors are charging and set your rates accordingly.

If this is your M.O., be aware that it can be a dangerous approach — it’s no way to judge whether the pricing is sufficient to cover your costs and risks. A better approach is to use loan-pricing models: financial models that calculate interest rates based on your desired returns, costs, risks and other assumptions.

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, relationship with your bank and the loan’s terms.

What are the risks?

Your model should consider a variety of risks; generally, the higher the risk, the higher the interest rate:

Credit risk. This refers to the risk that borrowers will default, causing the 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. 

Interest rate risk. There are types of interest rate risk but, in general, the term refers to the risk that a loan’s profitability will change as interest rates fluctuate. If, for example, 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.

Option risk. 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.

How can a loan-pricing model help?

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. Or you may choose not to compete, if those rates won’t cover your costs and risks.

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.

Whichever model you choose, it’s only as good as the data and assumptions you plug into it. Review your information systems, processes and procedures to be sure you’re tracking the data you need to price loans effectively.

Benefits of risk-based pricing

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. Flat-rate pricing, on the other hand, often results in a disproportionate number of low-credit-quality loans because it drives the best customers to look elsewhere for better rates.

Consider the whole relationship

One thing that distinguishes community banks from other banks is the relationships they form with customers. Rather than setting prices based solely on the profitability of a loan, you should price loans based on the value of the entire relationship. This approach can ultimately allow your bank to maintain profitability long-term by helping you to retain valued customers.

© 2015