Introduction
Imagine this scenario. You’ve purchased loan pricing software. Your team is excited to implement the model to help drive commercial relationship profitability. You install the model, log in for the first time, and then the questions start popping up. Where did these assumptions come from? Why don’t the results make sense? Are small-dollar loans ever profitable? What should our ROE target be?
Successful loan pricing model implementations rely on many variables, including management commitment, lender buy-in, and proper software calibration. Calibration is a two-step process requiring accurate assignment of product profitability assumptions, and then based on those assumptions, product-by-product ROE target assignments. In this article, we’ll explore what it takes to help confirm your model is accurately configured.
Step 1 – Control Your Assumptions
Your model should be built from the ground up by assigning profitability assumptions at the product level. This should include both loan and deposit products. Important assumption considerations include:
- Selection of a funds transfer pricing curve to assign a cost of funding to loans and credit for funding to deposits. Most institutions utilize either the UST curve, FHLB borrowing curve, SOFR/Swap curve, or an internal curve.
- Origination, servicing, and overhead cost allocations – The institution’s noninterest expenses should be analyzed and allocated out to loan and deposit products. Allocations can be made after analyzing statistics based on balances and numbers of accounts by product type and assigned at the product level on a dollar per account or percent of balance basis.
- Equity allocation to loans and deposits – Equity is normally allocated to loan products based on risk weighting. 100% risk-weighted products receive an allocation equal to the leverage ratio of the institution. 50% risk-weighted products receive half of that allocation. Deposit products receive a low level of capital, usually only a fraction of what is assigned to commercial loans, representing the cost of the deposit-gathering infrastructure.
- Provision expense allocation to loans – A thorough review of the institution’s CECL model will assess the level of expected loss assigned to each product. Historical loss rates, weighted average loan lives, and qualitative factors are used as the basis of this allocation. This assumption is then further adjusted based on the credit grade assigned to the loan.
Once these assignments are made, each loan and deposit account’s profitability contribution can be calculated. Account-level profitability can then be grouped at the product level to assess the current profitability and ROE of each product. The following is an example of how product profitability is calculated.
| Product Description | Number of Accounts | Average Account Size | Cur YTD Average | Interest Income | Credit for Funding | Interest Expense | Cost of Funding |
|---|---|---|---|---|---|---|---|
| RE Comm < $350k | 650 | $116,845 | $75,949,514 | $4,031,298 | 5.31% | $1,841,727 | 2.42% |
| RE Comm ≥ $350k and < $1M | 202 | $613,145 | $123,855,362 | $6,438,323 | 5.20% | $2,995,180 | 2.42% |
| RE Comm ≥ $1M and < $2.5M | 79 | $1,645,779 | $130,016,543 | $6,374,878 | 4.90% | $2,937,836 | 2.26% |
| RE Comm ≥ $2.5M | 40 | $5,430,446 | $217,217,836 | $11,071,542 | 5.10% | $4,835,304 | 2.23% |
| Product Description | Net Interest Margin ($) | Margin | Fee Income | Provision | Total Expense | Profit | Current ROE | Capital Allocation |
|---|---|---|---|---|---|---|---|---|
| RE Comm < $350k | $2,189,570 | 2.88% | $5,047 | $759,495 | $901,646 | $421,446 | 6.17% | 9.00 |
| RE Comm ≥ $350k and < $1M | $3,443,144 | 2.78% | $2,941 | $1,238,554 | $350,255 | $1,467,248 | 13.16% | 9.00 |
| RE Comm ≥ $1M and < $2.5M | $3,437,042 | 2.64% | $7,506 | $1,300,165 | $273,962 | $1,477,633 | 12.63% | 9.00 |
| RE Comm ≥ $2.5M | $6,236,239 | 2.87% | $1,525 | $2,172,178 | $277,430 | $2,992,643 | 15.31% | 9.00 |
Furthermore, individual products can be separated into size tranches to isolate product returns based on account size. Most often, smaller accounts have lower returns and larger accounts have higher returns.
Step 2 – ROE Targets
After the product profitability analysis is completed, you should have a good understanding of the current returns of all loan and deposit products. The analysis can help accomplish two goals. First, it allows you to reconcile the total costs allocated to the institution’s financial statements, and secondly, you now have the basis for product-level ROE target assignments. This is important because your pricing model shouldn’t have a single ROE target.
The following illustration shows example ROE targets based on the current ROE of a typical commercial real estate (CRE) portfolio.
| Product Description | Number of Accounts | Average Account Size | Cur YTD Average | Current ROE | Current Min ROE Target | Desired ROE Target |
|---|---|---|---|---|---|---|
| RE Comm < $350k | 650 | $116,845 | $75,949,514 | 6.17% | 7.50% | 9.00% |
| RE Comm ≥ $350k and < $1M | 202 | $613,145 | $123,855,362 | 13.16% | 14.00% | 15.50% |
| RE Comm ≥ $1M and < $2.5M | 79 | $1,645,779 | $130,016,543 | 12.63% | 14.00% | 15.50% |
| RE Comm ≥ $2.5M | 40 | $5,430,446 | $217,217,836 | 15.31% | 16.00% | 17.50% |
By knowing the current ROE of the various CRE size tranches, minimum and desired ROE targets can be assigned at moderately higher levels. Over time, if new loans are meeting these ROE targets, the profitability of this product should increase.
Conclusion
By assigning targets at the product level, and in some cases at the account dollar-size level within products, your pricing model can give guidance on the correct weighted average ROE target for each loan and relationship analysis. For example, an existing customer with a mix of loan and deposit accounts will have a different ROE target than a prospective borrower with no deposits.
Also, by using the same assumptions in your live model that are used in the product profitability analysis and ROE target development, you can eliminate the argument from lenders about the fairness of the assumptions.
Visit our LoanPricingPRO® page to learn more about FORVIS’ strategic loan pricing model. If you have any questions or need assistance, please reach out to a professional at FORVIS.