The Federal Reserve elected to cut the federal funds rate by 100 basis points over the last four months of 2024.1 Throughout the past year, banks have anticipated an easing by the Fed, bringing short-term rates lower while the long end of the curve remains elevated. A return of a positive slope to the U.S. Treasury curve should lead to improvement in net interest margins and overall profitability. With economists predicting fewer cuts in 2025, the risks to increased profitability include continued weak loan growth, declining liquidity, and ongoing intense competition among banks for any available new loan volume.
Banks may have little influence over these market forces. However, one variable they can easily control is the implementation of a loan pricing discipline within their own institutions. So, what exactly does implementing a loan pricing discipline entail, and how can a financial institution know when it is achieved?
In its simplest form, loan pricing discipline exists when a financial institution implements a system that ensures that loan rates and fees move in concert with movements in related market rates. This system must assure that a variety of objectives are being attained, including that margins are maintained or expanding, desired behaviors are incentivized, and critical performance information is generated. This system must possess each of the following functional capabilities:
- Risk‐based pricing (credit risk)
- Coverage of duration (extension risk)
- Detailed funds transfer pricing across the term structure of rates
- Calculations on individual loan products’ return on equity (ROE)
- Establishment of appropriate ROE targets
- Full relationship profitability determination
- Simulation of alternative acceptable pricing scenarios
- Consistency across customer groups
The following indicators will help you know when your institution has arrived at best practice performance levels of loan pricing:
- A focus on pricing exists, effectively balancing growth and profitability goals.
- Information on portfolio performance is readily available to track trends, identify problems, and make course corrections when needed.
- Senior executives clearly understand the ROE differences between products and know how to use this information to grow bank profitability.
- Lenders and credit administrators are able to see the whole picture of customer profitability across multiple lines of business.
- Lenders find it easier to manage profitability, and their role is supported and clarified.
- You can implement strategies to grow or shrink individual products based on risk/return trade‐offs, capital requirements, or concentration.
- Profitability and ROE is increasing according to plan.
As you can imagine, achieving these goals simultaneously requires more than a lender’s good instincts, experience, and awareness of market expectations. A well-thought-out and accurately calibrated loan pricing system is crucial to the successful management of overall loan portfolio performance.
Characteristics of a Disciplined Loan Pricing Culture
At the center of a disciplined loan pricing culture is the executive management team’s commitment to using a quality commercial loan pricing system capable of accurately calculating customer profitability. Individual loan pricing analysis is being performed on all significant new loan requests and on all significant re‐pricing proposals. A report showing the ROE of the full customer relationship exists in each commercial loan file and is readily accessible for loan committee review and approval discussions when required. The existence of these reports can save a considerable amount of time and lead to more objectivity in the approval process.
Senior lending officers know the current ROE performance of each commercial loan product, segmented by account size, industry, and credit quality parameters. Individual loan officers know the current ROE of their entire portfolio, as well as where each customer ranks in relationship to average ROE. They are able to quickly identify their top 10 most profitable customers and their top 10 best prospects for profitability improvement.
In today’s rapidly changing banking environment, where fluctuating interest rates and competition make improving the profitability of your loan portfolio extremely challenging, it is difficult to compete without an accurate and comprehensive loan pricing system. If you don’t currently use a quality loan pricing system, your institution should consider options for implementing one. If you have one, but it is not being used regularly and effectively, perhaps your assumptions and/or loan pricing calculations need a tune-up.
For a pricing model that can help you grow, consider LoanPricingPRO®. Contact a professional at Forvis Mazars if you’d like to discuss how implementing best practices in loan pricing discipline with LoanPricingPRO for commercial lending in your institution can assist you in improving your profitability.
- 1 “Fed cuts rates by 25 bps, signals a slower pace ahead,” housingwire.com, December 18, 2024.