High Loan Profitability

Each of the products of a company has varying amounts of profitability.  The same is true in a commercial bank.  The loans, deposits, trust operations, et al each have varying degrees of profitability.  In today’s marketplace, it may well be that the deposit gathering of a bank is an unprofitable, yet essential function of the bank while the loans may be highly profitable.  Therefore, when looking at the profitability of deposits and loans, how much of the profit should be assigned to the loans and how much should be assigned to the deposits?  The largest component of profitability is the cost and/or credit for funds behind the loans and deposits.  The best way to determine the profitability is to use transfer pricing for assigning a cost of funds to the loans and a credit for funds to the deposits.  An accepted method to accomplish this is to first determine the duration of each.  Duration is a mathematical calculation to get the weighted, discounted average “life” of the loan or deposit.  Once that is determined the “economic cost or credit” can be determined.  This can be found by comparing what the cost of duration matched external funding would be to the organization.  This may be the Treasury curve (not recommended), brokered deposit curve (better) or Federal Home Loan Bank curve (perhaps the best).

In the case of the loans, in today’s markets it may very well be there is a significant spread between the duration matched cost of funds and the rate on the loan.  At the same time, due to low rates there is a negative spread to the deposits.  In theory the bank has the option of obtaining the lower cost of external funding versus deposit gathering but because it opts to use deposits, the deposits should absorb the cost of that funding – not the profitability on the loans.

Thought to ponder:  Today a one year fixed rate loan priced at 6% may seem to be an extremely low rate and quite frankly would be very profitable to the bank.  Because the bank has the option of obtaining funding of .80%, the spread would be 5.2%.  A few years back when that funding was at 5%, would the bank have been able to price its one year fixed rate loans at 10.2%?  Probably not and more than likely would have loved to been able to do so.  Yet, in today’s market the idea of pricing that loan at 6% and it being highly profitable is hard to accept.

Just as in other industries, if a bank determines it is losing profitability on an essential portion of its products, such as its deposits in this case, perhaps it should raise its pricing on its other products to bring a higher return on investment.  This is exactly what banks are implicitly doing by obtaining a higher spread and subsequent profitability on its loans.

Phill Rowley

www.hurdlegroup.com

Bank Marketeers

I just returned from giving a day presentation on asset/liability management to the ABA Bank Marketing and Management School at SMU in Dallas, Texas.  I have taught at this particular school for some time and find it to be a fantastic forum for the subject.

First, the students are all bank marketing personnel and I think by the nature they are involved in marketing make them very expressive in the classroom.  They are not afraid to ask questions, all of which are pertinent and to the point.

Secondly, because they are not always included in the asset/liability mangement process in their banks, they absorb the material presented.  They also appear to appreciate the school for presenting something to them that is outside the realm of their expertise.

In the class I emphasize that they have something to contribute to the asset/liability management process in that they probably have a better understanding of the characteristics of the banks’ customers.  An example of the information they can provide is what it takes to get a customer to move from one bank to another in terms of the rate provided on a particular bank account.  This type of information can be invaluable to management in setting financial strategies for a bank.

Competition and Loan Pricing

I have written an article for the Federal Home Loan Bank of Seattle soon to be posted in their “What Counts” publication.  The topic is competition in loan pricing.  The intent of the article is not to eliminate the role of competion when setting the pricing on a commercial loan.  It is, however, intended to point out that there are a lot of reasons why using competiton as the sole criteria for pricing a loan may be detrimental to the profitiability of a commercial bank.

Other issues such as the cost of funds, origination and servicing costs and risk should play a more important role in the pricing than competition.  To do this in a logical and consistent manner, it is imperative financial institutions seek tools to assist them in this process which is exactly why at Hurdlegroup.com a comprehensive, affordable loan pricing model can be found.

Intest Rate Risk Webinar

On April 17, I presented a one hour webinar for the Federal Home Loan Bank of Seattle dealing with interest rate risk management in financial institutitons.  Although I discussed briefly the directive put out by the regulators on January 6, 2010, the emphasis of the presentation was to encourage banks to begin to make more of an effort to measure their interest rate risk and not just use the information to provide the regulators to show they are going through the motions.  This subject is a followup to my blog posted in February.

We had 93 attendees and a high percentage of the FHLB Seattle membership in attendance.  You can view the attendance by clicking on the following link:

http://www.fhlbsea.com/OurCompany/Events/Default.aspx

Regulatory Interest Rate Risk Directive

On January 6th, 2010 the regulators issued a directive dealing with interest rate risk in financial institutions.  It is a reminder to those institutions to review their management the “S” component of the CAMELS rating.  What institutions should take from this directive is that given where interest rates have been over the past couple of years that many banks have possibly booked longer duration assets and funded them with short-term interest sensitive liabilities.  If indeed this is the case, those banks need to be prepared to face a rising rate environment and have methods in place to monitor and control that risk.

What I have seen is that many banks go through the motions of measuring the risk and few actual put into place strategies to mitigate the risk they have created in their balance sheets.  That being the case, the directive should be listened to and implemented rather than just doing for the regulators.

ARE THE BANKS REALLY TAKING THE TAXPAYERS MONEY

What is it that I’m missing here?  Let’s see, the government is borrowing money in the markets at as low a rate as .01% (yes, no mistake on the decimal point) and have provided banks with funding at 8% on over $700 billion.  Now if you take the spread which is the difference at what the funding costs and what is being earned, on that amount of money the interest alone is over $55 billion per year.  Some of that money has been paid back to the government by the banks – to the detriment of the taxpayer!  We as taxpayers have been making out like bandits by getting the spread, at a cost to the banks.  Yet, President Obama continues to say that the banks were bailed out.  Go figure!

What is a Brokered Certificate of Deposit?

To all bankers a brokered certificate of deposit has become an issue which is a constant source of irritation.  In the eyes of the regulators it is considered to be “hot” money.  Yes, it is money received by a bank with no other relationship with the customer and yes, it may go away when it matures.  But, what makes this different than a lot of other “retail” certificates of deposit received by a bank.

If you think about it, the brokered deposit received by a given bank was once considered to be a retail certificate of deposit by the bank that had the certificate of deposit in the first place!

From the regulator perspective the money can flow from the bank easily and leave the bank with no funding or at the mercy of the interest rates in the national market.  Little regard is given to the fact that the average maturity of a brokered certificate of deposit may be much longer than that of a retail certificate of deposit.  Nor, as is often the case, is there any credit given for the fact that the certificate of deposit may have a lower rate than can be received by the bank in its local market.

So, what is a brokered certificate of deposit?  It is a term that without any further thought on the part of the regulators is found in their manual as being a “bad” thing.  Get realistic and get into the 21st century and understand the characteristics of the funding and not just a definition found in a manual.

Duration IS important when pricing a commercial loan

            Along with credit risk, origination and servicing costs, the cost of funding a commercial loan is probably the least understood, and represents the highest cost in the loan pricing process.  There are many methods for determining the funding cost, anywhere from a “guesstimate” to very sophisticated techniques that when all is said and done, none are perfect.  To be perfect, the funding behind the loan needs to have exactly the same re-pricing characteristics as the loan being funded.  If the financial institution “matched funded” every loan it originates, this would indeed eliminate the risk being discussed here.  This is very difficult to do and quite honestly may not be the best from a profitability standpoint.  To match fund every loan eliminates interest rate risk but at the same time eliminates interest rate opportunity.  However, that interest rate risk/return variable should be monitored and controlled by the treasury function of the organization.  The pricing of the loan should not bear that burden, nor benefit if interest rates go up or down.

            Many in-house pricing models use current funding costs for setting the cost of funds which can be significantly different than the economic cost of funds, thereby either inflating or deflating the value of the loan being priced.

            Other models may use a yield curve based on the institution’s certificate of deposit maturity structure.  This is only valid if the institution is indeed booking certificates of deposit of similar duration to the loan being priced.  Oftentimes most certificates of deposit received by an institution have durations of much less than one year while the duration of many fixed-rate loans exceed one year.

            The pricing of the loan should be based on the “economic cost of funds”.  This cost is set based on a proxy of what a matched cost of funds would be had the loan been matched funded.  The only way to get this proxy is to determine what the duration of the loan is and then find a funding source with exactly the same duration.  The cost of that matched funding source then becomes the cost of funds.  Although the institution may have the ability to get funding behind the proxy as an available source of funds, it is up to the treasury area of the bank to take advantage of that funding or not and therefore, taking that funding risk/opportunity from the pricing of the loan.

            This is yet one more reason that a sophisticated analysis of the duration of a loan is extremely important in the pricing of a commercial loan.  We at the hurdle group have spent a great deal of time considering the best of the alternative methods for determining the duration and have incorporated it into its loan pricing model.

Phill@hurdlegroup.com

 

 

Bank Liquidity

  In the banking industry liquidity has become the topic of the moment.  What is liquidity in banking?  Ask any banker and they will give you a different definition.  It can be anything from providing day-to-day funding for the operations of the bank to the ability to pay off the depositors if the bank is liquidated.  These two ends of the spectrum view the assets and liabilities of the bank in a very different light.  As an example, cash in a bank appears to be very liquid.  Cash is indeed liquid if the bank is to be liquidated, but if the bank is an ongoing concern, cash may the one of the least liquid of its assets because part of cash is being held to meet the regulatory reserve requirements behind the transactions accounts of the bank.

  On the liability side of the balance sheet liquidity may be defined as the stability of the funding to the bank for on-going operations.  Although many believe that this stability can be defined in customary terms like “core” deposits, the definition of core is up for debate.  It is out-dated thinking to believe that the traditional definitions of core are still applicable.  Take for instance under $100,000 certificates of deposit.  Although the maturity of these deposits may be very short (usually under 1 year), they are still often considered by many to be a core, stable source of funding.  Nothing could be further from the truth.  With the ability of bank customers to move their money easily from one institution to another anywhere in the United States and even the world, these under $100,000 certificates of deposit will oftentimes at maturity go to the “highest bidder” rather than to the customer’s current bank.  At the same time, a brokered certificate of deposit (often referred to as a non-core deposit) with a longer term maturity may have an even greater stability than the typical short-term under $100,000 certificate of deposit.

  Most regulators are still slow to pick up on this last nuance of brokered deposits.  All brokered deposits are placed in a bucket of being a very volatile source of funding.  Rather than looking at maturity structure of these deposits, the fact that they are “brokered” makes them non-core.  An argument can be made that in today’s market, all certificates of deposit within a certain length of maturity are volatile.  It is up to the bank to set its comfort level for maturity to determine which of the deposits are volatile and those that are stable and that is the key factor in determining the volatility of funding in the bank.

  All of this discussion of liquidity ties into the bank’s loan pricing.  To the extent the bank is pricing its loans on a “duration matched” basis, the length of funding is extremely important.  If this concept of monitoring the amount of duration matched assets to that of the liabilities, the level of interest rate and liquidity risk can be monitored and controlled.  This is one more reason why a good loan pricing model, using duration matching is important to the banker of today.

 

Phill Rowley

www.hurdlegroup.com

Internet Commercial Loan Pricing Model

Jeff Judy, a premier advisor and instructor in credit, recently included an article in his web site www.jeffjudy.com which I wrote detailing the need for a commercial loan pricing model in financial institutions.  In Jeff’s role, he is often asked what is available in the market for assisting lenders in determining the “right” pricing on a commercial loan.  After having viewed various loan pricing models, he requested I provide the article to him to help others determine what is needed.  The article was published on October 29^th of this year.  Since that article was written, a model to make loan pricing even more convenient to the lender is now being offered via the internet at www.hurdlegroup.com.  The internet model still contains the powerful analytics of the company’s current model but on a convenient pay-as-you-go basis.  It is, as is the case with the enterprise model, structured to make it easy to use with minimal training required by the user.  The internet model requires no on-going maintenance by the user, with all tables within the model updated on a timely basis by the Hurdle Group.  A 30 day free trial is available to give the user an opportunity to see the benefits provided by the model.  To get more information on specifics of the model, please log on to www.hurdlegroup.com.

 

Phill Rowley

www.hurdlegroup.com