As interest rates continue rising, community financial institutions that take a more strategic and data-driven approach to loan pricing and portfolio management will stand to benefit from the strengthening economy. Loans are one of the most profitable ways to leverage an institution’s funds, so banks and credit unions with an extensive understanding of their loan pricing models will be positioned for maximum portfolio growth and profitability.
To price loans, financial institutions oftentimes use the cost of deposits as a guide, especially after a period of historically low interest rates. However, this can result in pricing inconsistencies that leave money on the table, especially as deposit rates begin to increase. Instead, using methodologies like Funds Transfer Pricing (FTP), alongside powerful data analytic tools, supports straight-forward, accurate pricing that drives profitable growth.
Funds Transfer Pricing: Why It Works
Traditional banking methodologies, such as FTP, measure the performance of both deposits and loans and their influence on an institution’s profitability. When individual account interest rates are compared to an institution’s overall data – including loan and lease rates to cost of funds– the institution can confidently price the loan at a rate that supports its growth goals.
This approach gives financial institutions insight on where the break-even point will consistently be for each product to ultimately grow its balance sheet. Methodologies like FTP are generally effective for most institutions, but when these methodologies are combined with data analytics, the path toward profitability becomes even more apparent.
Extend the Use of Data Analytics
According to The Financial Brand’s Jim Marous, “Understanding customers is the foundation to a sustainable competitive advantage in banking.” In lending, this involves understanding how the entire customer relationship can impact the outcome of the loan and the institution’s bottom line. In other words – your institution should understand and measure which products are driving profit and the depth of the customer relationship.
From there, these drivers can be used to assess the impact of new opportunities, such as a new credit product, on the institution’s overall risk and performance. Additionally, by deploying sensitivity analytics to these variables, institutions can determine the pricing elasticity for each customer segment to maximize profitability and ROI on the institution’s current portfolio. Gathering, measuring and analyzing this type of data will help inform the institution whether or not the loan and the rate offered is a viable opportunity for long-term profitability.
Institutions can also review the allocation of capital and risk factors for specific types of loans to reduce potential risk. For instance, companies in certain sectors, such as telecommunications, healthcare and utilities, stand to benefit from rising interest rates, while others, such as title insurers, material producers and industrial producers, are challenged by rising rates. Analyzing these factors can help your institution minimize credit risk in the portfolio and determine the right loan pricing and structure given the current market environment.
By taking a more data-centric and strategic approach to loan pricing, banks and credit unions gain a better understanding of their portfolios’ performance and therefore, can price loans with greater accuracy. The financial institutions accomplishing this will also find themselves well-equipped for the new current expected credit loss standard (CECL), which requires institutions to calculate expected credit loss over the life of the loan, rather than waiting until the threshold of loss becomes probable. This standard will impact how the risk of loss is calculated on a forward-predictive basis and with a better understanding of their portfolio’s performance, institutions can price loans with consideration for the loss allowance to optimize profitability and reduce income volatility.
It may seem daunting, but updating and readjusting your loan pricing model based on data analytics enhances the profitability of the loan portfolio and your institution’s bottom line. As interest rates continue to increase and the deadline for the new CECL standard looms closer, refining your pricing strategy should be a top priority.