Adjusting Commercial Loan Pricing ROA Targets Increases Profitability
Commercial Loan Pricing
Because cash, fixed assets, and the investment portfolio earn very little, it falls upon the loan portfolio of a bank to generate any sort of reasonable income. Consumer lending and mortgage lending typically have modest profitability. That leaves the lion’s share of the job of generating real profit to the commercial lending portfolio. This makes accurate commercial loan pricing essential to the overall health of your bank.
A correctly calibrated loan pricing model involves a number of essential components. One of these is the setting of the correct ROA targets for your model. Why is this so essential? Target ROAs help control volume, asset quality, and loan profitability. If ROAs are specified according to loan type, loan grade, and by your target market, management can ensure that lenders are competitive on the highest quality loans that best support your profitability objectives. In other words, thinking of your loan portfolio as a whole, and determining where you wish to allocate your resources by establishing target ROAs for specific loan types will aid you to meet your overall profitability goals more successfully.
When setting ROA targets, it is a wise practice to run already booked loans as well as prospective loans through your loan pricing software. Taking a snapshot of several previous months will reveal trends in your market and help you to determine if your current ROA targets are set to sync with your objectives.
Does this mean that once your ROA targets are calibrated correctly, you can continue to rely on them indefinitely? The answer is a resounding “no”. The setting of ROA targets for loan pricing is a continual, evolving process for your banking institution. Many lenders fail to get the most from their loan pricing model software for lack of readjusting ROA targets on a regular basis.
While some feel that adjusting assumptions is as efficacious as the re-adjustment of ROA targets, that could be a costly mistake. It is obvious that adjustments must be made, but choosing to change assumption input rather than ROA targets means that you might lose one very important benefit of loan pricing model software. When assumptions are changed, you may lose the ability to compare your pricing over time with your software model. Tweaking ROA targets will not affect the software’s ability to generate comparative reports to the same extent that changing the assumptions will. This comparative function of loan modeling software offers an invaluable tool to management for the purpose of aligning loan pricing correctly in targeted areas of your market. The less you impair its function by changing assumptions, the better your reports will be in terms of illustrating exactly what is and is not working with your loan pricing strategy as it stands.
Additionally, continuous re-adjustment of your loan target ROAs will give your lenders a more agile environment in which to work. Rather than narrowing your loan officer’s options by interest rate alone, this more agile approach allows for adjustments in fees, term, re-pricing, amortization, or deposit levels for associated accounts. Plugging different scenarios for these other variables into your software can help your loan officer give the client and your bank some wiggle room in the deal. Such a flexible strategy can improve your net interest margin and make the loan attractive for the client as well as for your bank.
If you would like more information about commercial loan pricing strategies, please contact us. We will be glad to put our years of experience to work for you.