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3 Components of an Effective Commercial Loan Pricing Model

3 Components of an Effective Commercial Loan Pricing Model

Beyond using loan-pricing models to price loans, banks benefit from using models to differentiate the poorly priced loans from the well-priced loans offered in the marketplace. An effective Commercial loan pricing model requires three components:

  1. The bank should maintain pertinent data on fees, origination and cost of servicing their loans.  Know how the loan produces cash flows depending on whether it has a fixed or variable interest rate.
  2. Evaluate all risk types including credit, rate, option and capital risks.  Many pricing models fail to take into all the risks impacting the loan or they incorrectly adjust risks.  For example, the banks cost of funds is often used as a funding expense.  However, the model fails to consider that it is more expensive to fund a 30-year, fixed-rate loan than a variable-rate loan.
  3. Employ the appropriate decision tool.  Most pricing models concentrate on risk-adjusted return on capital.  This is suitable when there is tight funding and limited capital.  However, in the current environment this is the wrong approach for many banks.

Loan or Invest?

If a bank has liquidity, then it already has incurred the cost of funding. A better question is – should the bank lend or put the funds into its investment portfolio?  Perhaps, in today’s market the bank should use a different approach than relying on the bank’s return-on-equity hurdle rate.

What if the bank’s loan-pricing model is able to make a comparison between the yield on loan to a bundle of investments of equal yield after adjusting for the risks and costs of the loan?  The bank might benefit more by making the loan if there is a significant spread over the investment option.

When there is a tight supply of quality loans, a bank should look at the effectiveness of its loan-pricing model.  It might be advisable to price the loan so that the rate generously covers the added risk of a fixed-rate loan.

Appropriate set-up of a loan-pricing model can pick up supply and demand imbalances that are advantageous to the bank.  The hedge created from the rate-risk premium precludes the need to pay for hedging the loan’s risk.  The loan is actually more profitable.

The system providing the loan pricing model needs to be accessible and useable from mobile devices, as lenders today are more mobile than ever.

Sometimes it pays to go outside the box with your loan-pricing model. Contact us for more information on commercial loan pricing.

Alan Lee