Optimistic Loan Projections Might Not Apply
Recent economic news indicates that the long loan drought may be coming to an end for financial institutions. Indeed, many reports state that in the spring/summer of 2013 some institutions experienced loan growth equivalent to that just prior to the 2008 crash.
Whether or not loan growth continues at the recent pace remains to be seen. There are some realities the financial industry should not lose grasp of:
- In general, smaller financial institutions are not enjoying the same loan growth as their larger peers.
- Financial institutions continue to focus their lending efforts on low-risk borrowers.
- Few institutions (particularly smaller ones) use stochastic methods to develop their risk-based loan pricing models.
- Many smaller financial institutions (particularly credit unions) have seen their ROAA decrease 30 to 80 BP in the past two or three years as a result of inaccurate loan pricing and/or diminishing loan portfolios.
Financial institutions experiencing one or more of these issues could well find themselves merged or otherwise out of business in the next two to five years. They will need to improve their profitability and equity positions significantly.
To better assure long-term survival, financial institutions need to do a better job when it comes increasing their loan portfolios and pricing loans profitably. The ingredients to a successful loan program include using empirical risk-based loan pricing models and using effective marketing methods.
Adopting Valid Risk-Based Pricing Models
Financial institutions, which haven’t already, will need to expand their lending efforts to include those borrowers outside the highest-grade segment of the consumer loan market. Reasons for “reaching deeper” into the loan pool include:
- The competition is fierce for “A+ and A” borrowers. In many cases, these loans are priced lower than break-even.
- When priced correctly and managed carefully, making loans to less-than-prime borrowers can increase ROAA by up to 30 BP.
- Many impaired credit grade borrowers are victims of the “Great Recession”. As the economy improves, many less-than-prime borrowers will experience improving credit scores.
- Studies show that less-than-prime borrowers tend to be more loyal to those financial institutions that provide credit than are prime borrowers.
- Less-than-prime borrowers are more apt to use additional services of those institutions providing them credit – further contributing to a financial institution’s income.
- Studies show that those financial institutions that loan to less-than-prime borrowers using stochastically derived, risk-based loan pricing methods often experience increases in their customer bases, increases in loan portfolios, and improvements in profitability
Lending to less-than-prime borrowers requires careful pricing taking into account unique risks and costs associated with each credit-grade of borrower. Careful attention needs to be paid to adopting risk-based loan pricing tools that are stochastically derived and meet these criteria:
- Identifies and quantifies all costs in the lending process unique to each credit grade.
- Utilizes statistically derived methods for measuring and assigning costs to each credit grade.
- Employs a regular validation process to maintain the model and assure pricing accuracy.
- Identifies and creates credit-risk ranges according to statistically derived methods.
- Provides pricing recommendations for each type of loan and risk class of borrower.
- Provides “what if” capabilities so loan pricing changes under consideration can be tested for profitability before implementation.
- Provides a foundation for loan policies including Concentration Risk
Using Effective Loan Marketing Methods
Those financial institutions enjoying profitable loan growth generally have the following traits:
- Develop strategic plans that include detailed loan-growth objectives and mandates.
- Have a clear understanding of return-on-investment concepts.
- An accurate knowledge of the expenses unique to each type of loan, expenses unique to each risk-type of borrower and the net income necessary to at least break even on any marketing program under consideration.
- Employ marketing methods that target borrowers according to specific demographics or needs.
- Can effectively market ancillary services associated with loans (“payment protection” products, etc.)
- Price their loans using empirically derived, risk-based methods described above (as opposed to pricing loans by “guessing” or according to the competitions’ rates)
Many smaller financial institutions are struggling with poor profitability even though the economy and loan market may be showing signs of improving.
By pricing loans according to risk using stochastically derived models and through careful management, an institution can profitability make more loans to less-than-prime borrowers and experience significantly improved net earnings.