Strategies, Best Practices and Thought Leadership

Why Practice Systematic Loan and Relationship Pricing?

Financial institutions can be divided into two groups: those that are generally thorough and systematic about loan pricing, and those that are pricing on the back of a napkin.   The obvious best approach unfolds when examining the best practices of financial institutions that have successfully implemented a loan and relationship pricing solution.   Institutions that practice systematic loan pricing indicate: improved margins; more fee income; stronger earnings; better credit risk management; and more profitable customer relationship management.

Establishing a consistent pricing methodology within the financial institution eliminates questionable approaches to loan pricing by lenders.  This consistency gives a financial institution the ability to compare returns across borrowers, credit risk grades and loan types.  That consistency is critical to any meaningful measurement of the lending process, officer performance, customer ranking or the coaching and development of loan officers.

Another advantage of loan pricing is the ability to make sure that the financial institution is being covered for the credit risk associated with different risk grades of loans.  The financial institution does a better job of risk management and it can look at its lending effort based on risk-adjusted profits, analyzing both customers and lenders based on risk-adjusted performance.

Risk-based pricing of loans meets regulator needs with respect to fair lending practices. Financial institutions using a risk-based model for loan pricing decisions have the documentation proving their pricing is based on risk.

loan pricing

The loan pricing model is used to give lenders better knowledge and to enhance their responsiveness to loan requests. The model is used as a simulation tool, letting the lender know early in the process what kind of price/fee/balance combination will meet or beat financial institution return guidelines.

Additionally, a holistic view of a customer’s position with the institution allows for more cross selling, especially of deposit accounts.  Most loan pricing financial institutions are interested in better, more accurate, customer relationship management.  That could include protecting the financial institution’s most valuable relationships while pricing others into a better posture over time – or pricing them out to another financial institution.

Outlined below are some of the best practices used by leaders of financial institutions that have successfully implemented a loan and relationship pricing solution.

  • Financial institution leadership does not automatically concede pricing to the presumed market or competition.
  • Leadership is alert to the changing banking environment and will adapt to new approaches, renew their leadership efforts internally, and continually improve methods to be successful.
  • Management takes responsibility for understanding and explaining the logic behind its operating expenses, cost of funds, and loss reserves to their staff.
  • Management has identified strategic financial performance goals that will place its organization on a par or on a better standing with industry peers.
  • This leadership team is more concerned with direction than precision and seeks to develop better internal knowledge of a financial institution’s cost and risk structure to continually improve management decisions.
  • The successful financial institutions know that its largest competitors have sophisticated commercial loan pricing capabilities and are using them as both an offensive and defensive marketing tool.
  • Senior management devotes the required attention to achieve desired behavioral and process changes in lending performance and relationship management.
  • The executive team is aware that the use of a pricing model is a way to pull together income and expense information and support a more disciplined risk-based pricing analysis of lending.
  • Financial institution leadership promotes the pricing of loans to achieve pre-set earnings goals, in effect, differentiating borrowers based on the total value of the borrower’s relationship and on a risk-adjusted basis.
  • Leadership promotes the profitability model because it is an effective relationship management tool for lending officers to better rank, segment and serve customer needs.
  • Leadership seeks to measure and continually improve average weighted portfolio returns in order to accomplish corporate financial performance goals.
  • The financial institution uses model-based pricing as a critical tool in any economic environment, regardless of the level of interest rates and other macro-economic factors.

Risk-based pricing modeling is used to avoid the natural tendency to level-price everyone, increasing the chance of defection by profitable customers, and underpricing lower rated credits, risking larger outlays associated with loan losses.

 

Topics: Pricing & Profitability

John Robertson

Written by

John Robertson is part of the Advisory Services team at Baker Hill, specializing in pricing and profitability.

You can reach John at john.robertson@bakerhill.com.

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