Judging Relationship Profitability

One item that has amazed me in the credit union industry is there seems to be no push to gauge the profitability of the member to the credit union.  Now I do know that we are here to serve the member, but if you are not making what you can, then there are less members you can serve, and if it gets to the point of serious losses, you will go out of existence! 

So if finding a way to hit a target profit level is essential in making our institution viable for the long run, then we must have some manner to figure out the profit from our loans and deposits.  If we set targets for a desired return on assets, we can create a pricing model that will be used to determine thresholds that need to be hit as we price loans and deposits.  This can be used for an individual relationship or for an entire division of your shop, such as auto loans. 

The methodology can become quite complex but it the concept is relatively simple.  Let’s look at a business customer seeking a new loan to purchase a building.  The client already has deposit accounts with you and some other ancillary services.  Your institution decides it has a goal of hitting a 0.80% ROA.  How would you go about figuring where to price the relationship?

In this case, you decide you want to lock the rate for 5 years. Now even though your CU may be flush with deposits, the prudent method of judging the profitability is using a matched-funds principle.  This assumes that every dollar you lend out has to be funded with dollars borrowed for the same maturity as you are locking the interest rate for.  In this case, a 5 year loan is funded with dollars borrowed for 5 years.  Typical indexes used may be US Treasury Notes, LIBOR, or FHLB Advance Rates.  So your cost of funds for that loan will be the underlying index.

On the income side, you have figured that your CU makes an average of $1,000 off other products they purchase from you.  You are also charging fees on the loan, since you don’t work for free.  Points will be amortized over the life of the loan.  Your client also keeps an average balance of around 10% of the requested loan amount with you in accounts that do not pay interest.  These deposits can be treated as a source of “free funding” for that portion of the relationship. All these items are factored in.

On the expense side, you have ongoing costs associated with the loan.  Your CU leadership should have an estimate of how many man hours maintaining that relationship will require each year.  In our case it is a real estate loan that requires annual reporting and annual risk reviews.   An annual total of this price should be considered an expense that comes out of your spread income.  Another expense would be for a loan loss reserve, which can be assigned on a sliding scale based upon the risk rating of the credit. 

In the end, the net income for a year from that loan can then be divided by the expected average balance for the year on the loan, to reach a ROA for that credit.  So what can you do if the ROA does not meet your threshold?  The various factors you can play with are the interest rate, doing things that will lower the risk on the loan, increasing deposits, or adding more services that generate fees. 

I am not saying that you should never enter into a loan where the ROA is below your threshold.  There are business reasons to do that from time to time.  What is more alarming is not even realizing how the rate for a loan has an impact on your ROA in the first place.  Not knowing your cost, may tempt you to price loans as your neighbor does down the street.  Unless he knows what he is doing and has the exact same funding structure as you do, that can be a recipe for disaster.  Also, not taking time to figure out where you are at is sticking your head in the sand and ignoring upcoming problems or actual areas where are excelling.

Another problem is judging long term loan money against a short term index, such as Prime.  This may inflate your earnings spread, but is not a true measure of the true cost of funds associated with that loan. 

So with a little work, you can create pricing models for your CU, to gauge the profitability of individual relationships or even entire divisions of your shop.  Contact us for more ideas.