Model for Pricing Commercial Loans

Many banks continue to use the spread-based commercial loan pricing model. These spread-based loan rates are easy to calculate and present a conservatively positive outlook for the future. The rule is, base your loan rates on the spread between the interest the bank earns on its assets and the interest it pays out to its customers. Interest spreads have been tight over the last several years, and are just beginning to improve. Current rates are comparatively low, just above the cost of bank borrowing, so bank profits based on spread-based loan pricing have been slim.

On average, net interest margins (the proportion of interest income to the bank’s assets) had dropped substantially from 4.5 to just over 3.2 in the years between 1990 and 2007 (a sample of 100 largest banks according to Federal Reserve statistics). Return on equity (ROE) had also dropped from around 15% to under 10% between 1998 and 2007 (according to Federal Reserve statistics). Fortunately, these figures have begun to rise fractionally over the last year or so.

Many banks have assembled substantial assets because they are reluctant to make loans in the tight spread market. The spread-based pricing policy has forced them to pass on the larger and higher quality loans that have to be offered at relatively low rates. However, many are willing to accept smaller, lower-rated quality loans at higher interest rates to satisfy their spread-based rate calculation policy.

Looked at from an ROE perspective, the larger, high quality loans might have a 20% ROE and the smaller, lesser quality loans might have an 8% ROE. The spread-based pricing policy had the consequence of making banks uncompetitive on the quality, highest ROE loans and more competitive on the lower quality loans.

As the economic outlook brightens, many banks are turning to more dynamic Return on Assets (ROA) or Return on Equity (ROE) models. These are systems of commercial loan pricing based on returns on financial leverage. Once the loan pricing policy changes, the bank’s lenders are given the green light to more aggressively price the highest quality loans.

The Hurdle Group provides banks with better pricing of commercial loans. Please contact us to discuss your needs.