10 Commandments for Loan Pricing

At times, one item that we often question is how commercial and agricultural loans are priced in the credit union world.  The level of sophistication varies from none to those that have highly complex models to forecast the impact of a new lending relationship on return on assets (ROA) and in the banking world, return on equity (ROE).  In my past commercial positions at banks, I had to review the performance of the credit using complex models.  If certain targets were not hit, then there must be some good explaining on why we should do the deal.

It is in this spirit that I offer these:

1.       Thou shalt not publish commercial lending rates in a matrix as you publish consumer lending rates, unless your pricing risk is taken over by a secondary market sale.  There is no way that any matrix can adequately capture the variations in risk, duration, and relationship from one deal to another. 

2.       Thou shalt realize that commercial and agricultural loans are not under the same regulations for fair lending as consumer loans are.

3.       Thou shalt understand how booking a loan will impact your credit union’s balance sheet.  Booking a loan will increase your earning assets.  It will also require that funds are set aside in a loan loss reserve account.  The loan will have to be funded with either deposits or borrowings.  This will impact your required price you want for the loan.  If your institution has a very high loan to share ratio, you may want to charge a higher price for the new loan.

4.      Thou shalt understand how booking a loan will impact your credit union’s income statement.  The new loan will be an earning asset, hopefully without much trouble.  MBLs do require quite a bit of management so you will experience cost of monitoring and reviewing the risk of even the best of credits.  Understand that cost and the cost of capital associated with the loan.  Will the price that you are booking the loan at provide an increase in your ROA or will it drag it down?

5.       Thou shalt understand duration risk.  Duration is the risk that the margin you book the loan for today will not be available tomorrow.  A loan that reprices every time Prime moves, has a short duration and low risk.  A 15-year fixed has a long duration.  There may be a high chance that at some time during the life of the loan, the margin that you originally booked the loan at will be compressed or even worse, negative.

6.       Thou shalt understand margin.  Margin is the difference between the interest rate you are earning on the loan and what you must pay for the deposits to fund the loan.  You need to understand what is an acceptable margin to your institution.

7.       Thou shalt match fund as much as possible.  This is where you pretend that every loan you book requires that you must borrow those funds whether you must or not.  Use a yield curve of interest rates like the US Treasury rate or the Federal Home Loan Bank’s advance rate.  Pick a maturity that matches the reprice period of your loan.  E.g. use a 3-year UST to be your cost of funds for a MBL that reprices every 3 years. 

This does not always work.  You may have some government guaranteed programs that use Prime or some other index to price loans of any repricing maturity.  But as much as you can, match fund your loan pricing to the underlying cost of funds index.

8.       Thou shalt not lower an interest rate solely because a competitor is doing it.  This is the same as sticking your head out the window of your car as you drive down a one lane country road.  Sooner or later you are going to get smacked by a mailbox!  Figure out what you need to price and why.  Then use some discipline to follow your game plan.  There will be some cases that you will be more competitive, but do so on your terms, not because the borrower is asking for it.

9.       Thou shalt understand the present condition of the yield curve, direction of interest rates, and availability of alternative places to invest the institutions money.  A loan is an investment and you ae a steward of the capital entrusted you.  Understand the environment around you before pricing a loan.  We have seen many credit unions who are still pricing loans at rates that were fair last August.  Well, US Treasury rates have risen over 100 basis points since then.  So that same rate will not be very fair to your institution today.

10.   Thou shalt not lead off a conversation with a prospective borrowing relationship with price.  Putting price out on the table in the early part of a discovery period for a new or expanding credit relationship will doom you.  You become a slave to offering a low price since the only way you can set yourself apart from the competition is with a low price.  You either have low price or differentiation.

You must work with the member so they believe they are better when they are with you as their lender than when they are with someone else.  Create value in their mind.  Talk about what this new project will do for them.  Discuss their plans and dreams.  Give yourself time to look through the credit request, assess the environment, and know your institution before you commit to the price.  If you are not strong in this relational area, commit to developing this relational skill.  You will be wiser in your pricing and your institution will perform better.


Quick Bite:  From the Washington Post:  “More Retailers are Going Bankrupt Than Ever”.  Bankruptcies in the retail sector, reached a record high during the first quarter of 2016.  Nine companies reported defaults, including Sears and Claire’s during the period ending March 31, 2018.  Tops Friendly Markets, a supermarket chain and Bon-Ton department stores also filed for bankruptcy.  Defaults on corporate debt from the retail sector make up 1/3 of all defaults by corporations in all industries.  Moody’s predicts that their expected future default rate among retailers will decline next year.