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Effective Loan Pricing in Today’s Rate Environment

Darryl Mataya
January 19, 2022
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How to Price Loans Effectively 

Effective loan pricing is more imperative than ever for financial institutions, given the outlook on interest rates and other factors.  

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Loan Pricing Essential

Liquidity and loan yields in the current environment

While bankers might have hoped the close of 2021 would also bring an end to the challenging rate environment and the pandemic, it’s clear financial institutions will spend the coming year facing the continued effects of both. The unusual circumstances make effective loan pricing more imperative than ever for banks and credit unions.

Excess liquidity is persisting into 2022, affecting balance sheets and capital and squeezing net interest margins further as banks and credit unions deploy more assets in the lower-margin investment portfolio or in plain cash. Although they were up slightly in the third quarter from a record low, annualized net interest margins are nevertheless 25% below those in 2018. And if you are holding out and banking on future rate increases to help, you are likely to be disappointed. Future rate increases are likely, given the Fed’s recent actions and the persistent inflation. However, we believe that smaller margins are a fact of life for us - the most recent rising rate environment of 2016-2019 had almost no effect on raising net interest margins.

The liquidity boom and slow loan growth have also forced more competitive rates in some sectors, such as 1-4 family residential loans. That, in turn, has additionally pressured yields, despite record-low cost of funds.

Meanwhile, the adoption of the current expected credit loss model, or CECL, is prompting a re-evaluation of credit risk spreads and how those will affect loan pricing and profitability. We’ve spoken to institutions who expect to see noticeable increases in reserves in some lending categories, which eventually have to be paid for in margin.

For financial institutions that rely on interest rate increases to boost loan yield and thus avoid taking on duration risk in the meantime, the lessons from recent history show that this is a potentially high-risk strategy because increases in short-term rates can affect funding costs just as much as they help loan yields. Nevertheless, planning adequate loan yield in the months ahead is critical for a successful year, given that 75 to 80 percent of net income comes from net interest margin.

Meanwhile, fintechs will continue to promote low-fee transaction products, and financial institutions will respond to the competitive pressure, so banks and credit unions will also see added pressure on non-interest income.

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Loan Pricing Essential

Are lower yields inevitable?

Despite the current environment, lower yields are not inevitable. Some financial institutions can and do generate higher yields than their peers, and in many cases, they do it consistently regardless of the rate environment.

The following charts show the relative performance of 248 institutions in the Midwest that we consider high performing and 980 Midwest institutions that we consider low performing. (In these peer groups, the high-performing banks were those with ROE over 16% and asset size less than $1.5 billion. The low-performing banks were those with ROE less than 9% and asset size less than $1.5 billion.)

In examining these institutions’ interest margins, cost of funding, and performance over the last five years, we have noticed some interesting differences between these two groups. For example, we often discover that high loan growth rates do not always translate into more income. We also have noticed that there isn’t a large difference in funding costs between the two groups. And in fact, the funding costs of our high-performing Midwest banks are no different than the lower-performing ones for the past two years. While there are varying reasons why some institutions perform better than peers, we typically see better yields on loans at high-performing institutions, and we have noticed that difference with several peer groups.

Yield on Loans – Midwest High Performing vs. Midwest Low Performing

chart of yield on loans for midwest banks

Cost of Funds – Midwest High Performing vs Midwest Low Performing

chart cost of funding

Loss Allowance Rates – High-performing institutions do not necessarily have lower credit risks

chart of loan loss allowance at midwest banks

*Definition of peer groups.

Midwest High Performing. Midwest banks with ROE over 16% and asset size below $1.5 billion.

Midwest Low Performing. Midwest banks with ROE less than 9% and asset size below $1.5 billion.

 

Loan Pricing-Related

Factors behind lower yields

There are a number of fundamental pricing-related reasons why one institution will earn less yield than another.

Loan mix

If a financial institution is heavily concentrated in retail mortgage loans kept in the portfolio and it prices aggressively, it has a tough time making money because of the commodity nature of these loans. On the other hand, a financial institution that’s doing specialty commercial lending and has a particular expertise is likely to be earning more yield.

Strategy

Some institutions price aggressively with the same products their competitors offer in order to promote growth. So as price leaders, they are willing to accept less yield for the same loans to build volume.

Relative liquidity

Some institutions are better at deploying their excess liquidity in retail loans, which, in this environment, will almost always lead to higher margins.

Risk

The final possible reason some institutions earn less yield on loans is often less obvious. may be earning less on loans because you aren’t being paid enough for the risks you are taking on, or you minimize risk at the cost of spread. Lenders earn a spread on loans because they have to cover their operating costs. But they also take on credit risk, interest rate risk, and liquidity risk. Lenders understand that lending to people with lower credit ratings means they need to charge more to cover the potential additional credit losses. But how much more do you charge? And does the rate adequately charge for the associated interest rate risk and liquidity risk given the current environment? For the majority of institutions we talk to, the lending function looks to market and competitor rates to make these decisions. And with commodity loans like a conventional 30-year mortgage, institutions have to price what the market will bear. Are these market-based rates enough to cover costs, especially when compared to other retail loan alternatives available?

Disciplined Loan Pricing

Options when NIMs are squeezed

An effective loan pricing process starts with a decision framework that evaluates all of your opportunities and makes decisions based on institution-level objectives. For example, some institutions will price to earn a specific loan ROE or ROA, while others will price just enough to earn more than alternative wholesale investments. Once that framework is in place, a model is necessary to evaluate and compare loan types and credit grades.

The next step in the process is critical – and that is determining which loan types and relationships are providing the best spread against the risks you are assuming. Are you offering a very competitive rate to a credit grade that has been turned down by other lenders (at that rate)? You can be giving away margin. Are you avoiding loan segments that appear “risky” but actually more than compensate you for the credit and option risk you are taking on?

With a loan pricing methodology in place, a regular practice can be established to make pricing decisions that drive margin, not just match competitive rates for volume. With commodity or rate sheet loans, a pricing committee will periodically review performance (origination volume) and relative profitability compared to goals and decide when and where to make changes to product configuration and pricing. With commercial loans, a model can be used to evaluate individual loans or loan and deposit relationships to ensure that institution objectives are met while meeting borrower needs where possible. For example, one of the best uses of a model in bidding on commercial deals is learning and knowing when to walk away from unprofitable relationships.

Financial institutions have choices.

Lower yields are not inevitable. We have all seen losses in loan yield and interest margins over the past two years, but an important lesson we can learn from the peer analysis we discussed is that there is no inevitable margin for your strategy. You can likely get paid better for what you are already doing today.

But without a disciplined process using pricing tools, you allow the market to define rates and terms and, therefore, your spread. You have other choices. To create a high yield loan portfolio, you have to understand where and why you earn yield and whether you are being compensated for the risks and costs associated with those opportunities.

Get the latest on inflation and interest rates. Read "Inflation's Impact on Institution Earnings & Margins."

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About the Author

Darryl Mataya

Senior Advisor
Darryl Mataya is a Senior Advisor at Abrigo, where he manages the deposit and loan pricing services and consults regularly with institutions on funding strategies, pricing analysis, and loan strategies. He has been part of the banking industry since the 1980s, first as a designer and developer of software solutions. Before joining Abrigo,

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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