Making Your Loan Portfolio More Profitable
By Steve Simpson
Tell a room full of bankers that they can improve their bank’s return on assets by 20 to 40 basis points by initiating a commercial loan pricing strategy which requires a minimum pricing standard, and they cheer. Then they go home and continue approving loans which negatively impact their profitability, making those 0.85 to 1.25 ROA loans as usual.
Why? Bankers have had loan pricing models available for a few years, yet a survey of Sheshunoff Affiliation members showed that only 30 percent ever used them, and only half that number were still using a loan pricing model today.
They complain they’re too hard to use, that it takes more time to use the model than underwrite the loan, and that the standard expense factors built in to most models don’t reflect the bank’s real costs. One banker told us that using a loan pricing model made him so uncompetitive that he wanted to buy one for the bank across the street.
Standard loan pricing models obviously don’t do enough. With net interest margins flat or declining in most areas, bankers simply can’t afford to not have and use better tools and better ways of doing business.
Creditworthy vs. Loanworthy
At most banks, if a potential borrower has great credit, the bank will compete for his business with low rates and fees. You want those reliable, low-risk loans, right?
Not necessarily. If senior management is doing its job, some baselines should be set that support the bank’s strategic and profit goals. If your bank is going for that 20 to 40 basis point lift on ROA we mentioned earlier, then every loan needs to have a minimum yield to get you there. Make one loan that nets you 1.4 percent and the next needs to net 1.6 percent to keep you at that ideal 1.5 percent.
Better to keep your focus on making every loan within the bank’s pricing standards. Certainly it is recognized that all banks would like to grow their loan portfolios by approving every creditworthy loan. A comprehensive pricing model coupled with effective negotiation skills will allow the bank to maximize those opportunities without sacrificing profit margins.
This also gives your loan officers more time to work on getting those better loans, and managing them to remain profitable. They do less running after any loan they can make to fill a quota (and get a bonus based on volume), and spend more time winning the best loans.
This flies in the face of how most banks evaluate a loan application and reward their loan officers. It requires senior management to change the way the bank looks at loans and pays the lenders.
A Different Scenario
Let’s see how this would look in real life. Business owner Jim Hanks comes to the bank and meets with lending officer Tom Parks. Jim runs a good local company and Tom has been working hard to win his business.
They discuss the loan and Tom offers Jim a rate that will comply with the bank’s pricing standards (earn the bank a 1.5 percent return). Jim knows the ropes and points out that his regular bank quoted him a lower rate, but he hasn’t been completely happy with them and he’d like to give Tom some business. Will he match the rate?
In the old way of doing things, Tom might have offered to waive some fees or even have put the application through to the loan committee with the lower rate. And the loan committee would have looked at Jim’s good credit and approved the loan. Now the bank has used multiple assets – funds, Tom’s time and efforts, the loan committee’s time and effort, processing expenses, etc. — for a loan that misses the profitability baseline.
What could Tom have done differently? He could have refused to meet the competition’s lower rate and lost the business. Or, he could have used negotiation skills and better loan pricing tools to get the rate down without hurting the profitability of the loan.
Tom’s old methods didn’t encourage him to consider the deposit side of the equation, or give him tools to make them a factor in the deal. It takes deposits to fund loans, and when a customer keeps his deposits at the lending institution it directly improves the net interest margin. The bank profits from both the margin on the loan and the use of the customer’s deposits as an asset.
Charging a loan fee is another way to get the numbers to work. Many banks do not charge such fees, and by lowering the rate a bit but charging a modest fee, the ROA baseline goal could still be met (or missed by less).
This changes the overall loan profitability equation beyond the basics of rate and fees and can make it possible for Tom to match those lower rates while still meeting the baseline. Plus, he creates a stronger customer relationship.
What’s Measured Gets Done
So how do you encourage your loan officers to change the way they do things? They’re probably being primarily rewarded for making as many loans as they can (taking risk into account, of course). Surprisingly, the lenders receive little reward for their pricing accomplishments. And they get nothing for bringing in deposits. So many banks discover that a substantial number of commercial loan borrowers have no deposit relationship. So how do you get them to change?
First, you give them better tools. You give them an easy-to-use loan pricing model that uses your bank’s actual costs, and takes fees and deposits into account along with rates.
Next, you give them solid negotiation skills training. Not a one-time seminar or a computer-based lesson, but hands-on training that’s customized to how your bank actually operates so they can apply what they learn. Follow-up sessions reinforce the process.
Finally, you reward them for adding to the bank’s bottom line, not just its portfolio. That means monitoring the loans to track that the terms are being met. For example, a loan at a sub-baseline rate that required a deposit factor to make the profit margin has to be tracked to ensure that the borrower met the terms by initiating and maintaining the required deposits.
At a recent Affiliation meeting, one banker shared a telling story in which he invited all others to investigate the “promised loans” associated with recent loan approvals. He informed the group that this would likely result in the discovery that the promised deposits (which were considered as part of the loan approval) have not materialized. With deposits being at a premium these days, some bankers are starting to add a clause in the loan agreement that a minimum deposit relationship is to be maintained, or the loan rate is bumped a fractional point. A good system automatically checks for these compensating balances.
In addition, quarterly reports showing how each loan officer is doing at meeting the benchmarks set by management provide subtle but very effective peer pressure. This approach, coupled with a comprehensive loan officer incentive plan, will effectively motivate the lender’s performance. When lenders realize their goals, they are rewarded for their accomplishments while the bank enjoys improved profitability.
Measuring performance of lenders for developing and retaining customers is essential. Banks are increasingly recognizing the importance of maximizing relationships versus simply generating transactions. Having a comprehensive program to measure each component of a lender’s performance provides the bank with invaluable information to enhance its lending profitability.
New Ways, New Tools
Now we see why so many CEOs and senior loan officers cheer the idea of raising their ROA by 20 to 40 basis points and then do nothing about it when they get home. They have lacked the tools, training and strategy to make such a different approach work for them.
Not any more. Thanks to our Affiliation Program members and our hands-on approach to helping the banks we work with, Sheshunoff has been able to develop these missing pieces. It starts with commercial loan pricing software which is customized to use your actual numbers (which we help you gather), gives your loan officers the negotiation skills training they need, helps senior management and the board buy into the cultural shift, and puts in place the measurement, monitoring and reporting tools that form the basis of rewarding your lenders for delivering profits rather than more files in the portfolio.
Maximizing commercial loan profitability and related net interest margin issues will continue to be a challenge for most banks. The solutions are here; it’s up to your bank’s management to decide whether business as usual will be good enough.
Steve Simpson is director of product development at Austin-based Sheshunoff Management Services. If you have any questions or would like additional information, please call Kristin Morgan at (512) 703-1577.