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High Loan Profitability

Each of the products of a company has varying amounts of profitability.  The same is true in a commercial bank.  The loans, deposits, trust operations, et al each have varying degrees of profitability.  In today’s marketplace, it may well be that the deposit gathering of a bank is an unprofitable, yet essential function of the bank while the loans may be highly profitable.  Therefore, when looking at the profitability of deposits and loans, how much of the profit should be assigned to the loans and how much should be assigned to the deposits?  The largest component of profitability is the cost and/or credit for funds behind the loans and deposits.  The best way to determine the profitability is to use transfer pricing for assigning a cost of funds to the loans and a credit for funds to the deposits.  An accepted method to accomplish this is to first determine the duration of each.  Duration is a mathematical calculation to get the weighted, discounted average “life” of the loan or deposit.  Once that is determined the “economic cost or credit” can be determined.  This can be found by comparing what the cost of duration matched external funding would be to the organization.  This may be the Treasury curve (not recommended), brokered deposit curve (better) or Federal Home Loan Bank curve (perhaps the best).

In the case of the loans, in today’s markets it may very well be there is a significant spread between the duration matched cost of funds and the rate on the loan.  At the same time, due to low rates there is a negative spread to the deposits.  In theory the bank has the option of obtaining the lower cost of external funding versus deposit gathering but because it opts to use deposits, the deposits should absorb the cost of that funding – not the profitability on the loans.

Thought to ponder:  Today a one year fixed rate loan priced at 6% may seem to be an extremely low rate and quite frankly would be very profitable to the bank.  Because the bank has the option of obtaining funding of .80%, the spread would be 5.2%.  A few years back when that funding was at 5%, would the bank have been able to price its one year fixed rate loans at 10.2%?  Probably not and more than likely would have loved to been able to do so.  Yet, in today’s market the idea of pricing that loan at 6% and it being highly profitable is hard to accept.

Just as in other industries, if a bank determines it is losing profitability on an essential portion of its products, such as its deposits in this case, perhaps it should raise its pricing on its other products to bring a higher return on investment.  This is exactly what banks are implicitly doing by obtaining a higher spread and subsequent profitability on its loans.

Phill Rowley