We are all familiar with using a pricing matrix to assign prices to consumer loans based upon credit score, LTV, age of collateral, or a combination thereof. Those in commercial lending are also familiar with pricing business loans to reflect the risk inherent in the transaction, the underlying cost of funds, and the cost to adequately manage the credit. Most of these prices are figured at the onset of the loan and do not change unless a change date hits in the loan note. These adjustable rates are then tied to an outside index or an inside cost of funds.
But have you considered allowing the interest rate on a credit to adjust in relation to the changes in the risk that the company will see over the life of the loan? Such is known as performance pricing. This pricing strategy is not for every credit, but may be a good way to help reward high performing customers and to receive more interest on the weaker companies.
In some ways, performance pricing business loans helps maintain the margin to the borrower. A higher risk loan should be in a credit risk rating category that will require a larger amount of loan loss reserves than a less risky loan. Also, higher risked loans typically require more staff time, resources, and money to manage the risk on a continual basis compared to a lower risk loan. So if you have a credit that has an interest rate that floats with the company’s risk changes, it can do a better job at locking in your profit margin.
Typically, this strategy will work better for a line of credit or a commercial and industrial loan than it would for commercial real estate. I do suppose the tactic can be used there as well. To begin to set up this pricing strategy, you first need to determine what factors you want to use to monitor the credit risk of the company or farm on an ongoing basis.
I am a fan of keeping this simple and prefer to limit this to two or three factors to measure performance. Some of these may be: advance rate on collateral, a leverage ratio measured by debt/worth or some other variation, debt service coverage, or current ratio. A combination of several of these may also be applicable.
I once had an operating line we had secured with excess equipment the company owned. We set the line up to have the interest rate adjust every quarter, tied to a margin above or below the Prime Rate. We chose factors of an advance rate on the collateral, DSCR based upon the trailing twelve months’ performance and overall leverage ratio of the company. Now this credit was rather complicated, but pricing could vary from below Prime to a few percentage points above Prime depending upon the company’s financials. We also had an unused line fee if the line was not advanced at a certain level.
For an agricultural credit, I could see how a combination of DSCR and leverage ratio could be appropriate to measure the risk, and thus adjust pricing on the loan. A lower DSCR and higher debt/equity ratio will indicate a higher amount of risk in the credit. Using both DSCR and leverage allows the rancher to not be punished in the year he is light on his DSCR but has been building up his herd and holding back stock from going to market.
Once the indexes you are selecting to use are in place, the next step is to look at how you will measure each index. If you have an objective risk rating model that uses each of the components and can create a risk rating for each one, then you could use that range to identify the pricing matrix on your credit. The frequency that you will evaluate the pricing is next. I have rarely seen a monthly adjust for performance, but have seen some quarterly and annual adjustments. Ideally, in each case, the interest rate you are basing the loan on will have a cost of funds that has the same maturity as your repricing term.
This pricing strategy is usually reserved for a larger credit that is complex. Also operating lines of credit tend to work well in this environment as opposed to a term real estate note. But the principal is when your client is performing better, then the risk in the credit is lower, resulting in lower loan loss reserves and less time to manage the file. These are the times when the borrower could enjoy a lower interest rate. On the other side, when times are tougher for the borrower, the risk is higher and you should be compensated for it.