Recent economic news indicates that the long loan drought may becoming to an end for financial institutions. Indeed, many reportsstate that in the spring/summer of 2013 some institutionsexperienced loan growth equivalent to that just prior to the 2008crash.

Whether or not loan growth continues at the recent pace remainsto be seen. There are some realities the financial industry shouldnot lose grasp of:

• In general, smaller financial institutions are not enjoying thesame loan growth as their larger peers.
• Financial institutions continue to focus their lending effortson low-risk borrowers.
• Few institutions (particularly smaller ones) use stochasticmethods to develop their risk-based loan pricing models.
• Many smaller financial institutions (particularly creditunions) have seen their ROAA decrease 30 to 80 BP in the past twoor three years as a result of inaccurate loan pricing and/ordiminishing loan portfolios.

Financial institutions experiencing one or more of these issuescould well find themselves merged or otherwise out of business inthe next two to five years. They will need to improve theirprofitability and equity positions significantly.

To better assure long-term survival, financial institutions needto do a better job when it comes increasing their loan portfoliosand pricing loans profitably. The ingredients to a successfulloan program include using empirical risk-based loan pricing modelsand using effective marketing methods.

Adopting Valid Risk-Based Pricing Models

Financial institutions, which haven't already, will need toexpand their lending efforts to include those borrowers outside thehighest-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 manycases, these loans are priced lower than break-even.
• When priced correctly and managed carefully, making loans toless-than-prime borrowers can increase ROAA by up to 30 BP.
• Many impaired credit grade borrowers are victims of the “GreatRecession”. As the economy improves, many less-than-primeborrowers will experience improving credit scores.
• Studies show that less-than-prime borrowers tend to be moreloyal to those financial institutions that provide credit than areprime borrowers.
• Less-than-prime borrowers are more apt to use additionalservices of those institutions providing them credit – furthercontributing to a financial institution's income.
• Studies show that those financial institutions that loan toless-than-prime borrowers using stochastically derived, risk-basedloan pricing methods often experience increases in their customerbases, increases in loan portfolios, and improvements inprofitability

Lending to less-than-prime borrowers requires careful pricingtaking into account unique risks and costs associated with eachcredit-grade of borrower. Careful attention needs to be paid toadopting risk-based loan pricing tools that are stochasticallyderived and meet these criteria:

• Identifies and quantifies all costs in the lending processunique to each credit grade.
• Utilizes statistically derived methods for measuring andassigning costs to each credit grade.
• Employs a regular validation process to maintain the model andassure pricing accuracy.
• Identifies and creates credit-risk ranges according tostatistically derived methods.
• Provides pricing recommendations for each type of loan and riskclass of borrower.
• Provides “what if” capabilities so loan pricing changes underconsideration can be tested for profitability beforeimplementation.
• Provides a foundation for loan policies including ConcentrationRisk

Using Effective Loan Marketing Methods

Those financial institutions enjoying profitable loan growthgenerally have the following traits:

• Develop strategic plans that include detailed loan-growthobjectives and mandates.
• Have a clear understanding of return-on-investmentconcepts.
• An accurate knowledge of the expenses unique to each type ofloan, expenses unique to each risk-type of borrower and the netincome necessary to at least break even on any marketing programunder consideration.
• Employ marketing methods that target borrowers according tospecific demographics or needs.
• Can effectively market ancillary services associated with loans(“payment protection” products, etc.)
• Price their loans using empirically derived, risk-based methodsdescribed above (as opposed to pricing loans by “guessing” oraccording to the competitions' rates)

Many smaller financial institutions are struggling with poorprofitability even though the economy and loan market may beshowing signs of improving.

By pricing loans according to risk using stochastically derivedmodels and through careful management, an institution canprofitability make more loans to less-than-prime borrowers andexperience significantly improved net earnings.

DennisChild is a retired credit union CEO in Logan, Utah,who has been associated with TCT in Boise, Idaho,for 25 years.