This article is the final in our three-part series exploring ways a loan pricing model may help your institution achieve a strong return on investment (ROI). Our first article covers enhanced loan yield and loan fee collection, whereas the second piece focuses on how loan pricing models can help with compensating deposits and decreasing instances of lost lending among customers.
We will close out this series by exploring how active portfolio management and improved discipline, accuracy, and pricing consistency can help facilitate a strong ROI for institutions.
Active Portfolio Management
Utilizing a commercial loan pricing system with an interface to an institution’s core data systems may provide significant new reporting capabilities. These include an enhanced ability to report on and track trends in the commercial loan officer’s portfolios.
For example, senior management can now provide full, customer-level profitability reporting to commercial lenders from their system, ranking the lender’s customers by account size, yield, dollars of profit, return on assets (ROA), and return on equity (ROE). Most organizations that follow this path rank a lender’s overall portfolio based on the risk-adjusted return on capital (RAROC) produced by each lender’s customer group or portfolio. These RAROC totals will include all of the loan and deposit relationships these customers hold with the bank.
Once this information becomes available, it is much easier for individual lenders to allocate their time to outcomes that will have the greatest positive effect on the return level of their portfolios. In addition, it simplifies communication for senior management working with these lenders and helps them share their goals for profitability improvement with lenders. As a result, tracking trends in improvement becomes easier from quarter to quarter as the effects of new loan business, enhanced pricing, increased fee collection, and growth in related deposit portfolios can be seen and measured.
Lenders will now have hard data on which customers within their portfolio are responsible for generating the greatest share of profit dollars, i.e., their top 10 most profitable customers. Thus, time spent building and securing these relationships becomes a high priority for each lender. They will also be able to distinctly delineate any customers with larger balance relationships (which may be currently mispriced such that they are returning a below-average RAROC or ROE). Lenders may wish to develop strategies for adjusting customers’ pricing upon the next renewal date or discuss possibly adding other profitability accounts to the customers’ portfolio, e.g., moving operating accounts to the bank from other financial institutions.
With this very powerful information, senior management teams and lenders may more easily collaborate to incrementally improve the ROE of their largest commercial portfolios. To understand the potential impact of improvements, imagine a commercial lender’s portfolio comprising $30 million in commercial loans and $7.5 million in core deposits.
Suppose this combined portfolio is currently earning an ROE of 13.5%, and active account management enabled by the power of customer, product, and officer-level profitability information provided through a loan pricing system like LoanPricingPRO® is enhanced to 14.5% ROE. In that case, the profitability impact on that portfolio is approximately $32,000. If each lender in the institution could accomplish the same modest improvement, then the impact on the institution would be higher by a multiple based on the number of lenders involved. These improvements can be achieved with or without providing financial incentives to the employees managing each portfolio, especially when supported by enhanced reporting capabilities like those in LoanPricingPRO from Forvis Mazars.
Improved Discipline, Accuracy, & Pricing Consistency
As has been shown, it is possible for senior management teams and lenders working together—aided by an accurate and appropriately calibrated commercial loan pricing system—to significantly improve the return performance and growth rate of the commercial lending client base, including both loan and deposit product profitability improvements.
Critical to this valuable and worthwhile effort is the commitment of senior management to using an objective process for consistently pricing all new business relationships and renewing all existing relationships in a commensurate fashion. When each new loan relationship and all existing relationships are repriced on renewal based on the same objective and analytical process as the RAROC approach offers, a basis for improvement in operating performance becomes actionable in a manner not previously available.
The commitment of senior management to this type of approach needs to exist alongside a fully vetted, proven, analytically accurate commercial loan pricing and/or customer profitability system. It must also be appropriately calibrated to the institution’s current performance level and to the market environment in which the institution operates. It is uncommon to find these conditions occurring simultaneously in the real world, though it is not impossible. In nearly every financial institution today, senior managers have suffered through difficult, expensive, and ultimately unsuccessful implementation attempts at installing a commercial loan pricing system.
Multiple reasons for these past failures exist, including the use of arbitrary and inappropriate ROE targets, lack of a sound basis for the profitability assumptions used in the model, and a lack of senior management commitment to stick with the effort in the face of lender resistance and pushback.
Despite these past and potential problems, the enhanced profitability and portfolio growth that can be achieved is worth the effort and helps to explain why financial institutions of varying types and sizes are actively investing in these systems today. Those that succeed may reap the benefits of a strong, positive ROI; greater institutional independence in the future; and higher-than-average institutional value.
How Forvis Mazars Can Help
Institutions can glean several benefits from loan pricing models based on those covered in our three-part series. Platforms such as LoanPricingPRO can help lenders build strong client relationships and support profitability goals.
At Forvis Mazars, our experienced professionals can assist you in strategically pricing loans with real-time profitability analysis and relationship value metrics. Our teams are ready to configure the platform to help meet your institution’s needs and guide you through a profitability analysis of your existing lending products, which can help drive assumptions and targets to balance short-term growth and long-term profitability.
For more information to help grow your loan portfolio or to request a complimentary demo of LoanPricingPRO, please reach out to a professional at Forvis Mazars.