Loan Pricing and Profitability

As I'm preparing for traveling to the Baker Hill Solution Summit next week, I thought I would revisit the ideas of risk-based loan pricing.

Risk Adjusted Loan Pricing – The Major Parts 

I have referred to risk-adjusted commercial loan pricing (or the lack of it) in previous posts. At times, I’ve commented on aspects of risk-based pricing and risk-based bank performance measurement,  but I haven’t discussed what risk-based pricing is -- in a comprehensive manner. Perhaps, I can begin to do that now, and in my next posts.

Risk-based pricing analysis is a product-level microcosm of risk-based bank performance. You begin by looking at the financial implications of a product sale from a cost accounting perspective. This means calculating the revenues associated with a loan, including the interest income and any fee-based income. These revenues need to be spread over the life of the loan, while taking into account the amortization characteristics of the balance (or average usage for a line of credit). To save effort (and in providing good client relationship management), we often download the balance and rate information for existing loans from a bank’s loan accounting system.

To “risk-adjust” the interest income, you need to apply a cost of funds that has the same implied market risk characteristics as the loan balance. This is not like the bank’s actual cost of funds for several reasons. Most importantly, there is usually no automatic risk-based matching between the manner in which the bank makes loans and the term characteristics of its deposits and/or borrowing. Once we establish a cost of funds approach that removes interest rate risk from the loan, we subtract the risk-adjusted interest expense from the revenues to arrive at risk-adjusted net interest income, or our risk-adjusted gross margin.

We then subtract two types of costs. One cost includes the administrative or overhead expenses associated with the product. Our best practice is to derive an approach to operating expense breakdowns that takes into account all of the bank’s non-interest expenses. This is a “full absorption” method of cost accounting. We want to know the marginal cost of doing business, but if we just apply the marginal cost to all loans, a large portion of real-life expenses won’t be covered by resulting pricing. As a result, the bank’s profits may suffer.

We fully understand the argument for marginal cost coverage, but have seen the unfortunate end-result of too many sales -- that use this lower cost factor -- hurt a bank’s bottom line. Administrative cost does not normally require additional risk adjustment, as any risk-based operational expenses and costs of mitigating operation risk are already included in the bank’s general ledger for non-interest expenses.

The second expense subtracted from net interest income is credit risk cost. This is not the same as the bank’s provision expense, and is certainly not the same as the loss provision in any one accounting period.  The credit risk cost for pricing purposes should be risk adjusted based on both product type (usually loan collateral category) and the bank’s risk rating for the loan in question. This metric will calculate the relative probability of default for the borrower combined with the loss given default for the loan type in question.

We usually annualize the expected loss numbers by taking into account a multi-year history and a one- or two-year projection of net loan losses. These losses are broken down by loan type and risk rating based on the bank’s actual distribution of loan balances.

The risk costs by risk rating are then created using an up-sloping curve that is similar in shape to an industry default experience curve. This assures a realistic differentiation of losses by risk rating. Many banks have loss curves that are too flat in nature, resulting in little or no price differentiation based on credit quality. This leads to poor risk-based performance metrics and, ultimately, to poor overall financial performance. The loss expense curves are fine-tuned so that over a period of years the total credit risk costs, when applied to the entire portfolio, should cover the average annual expected loss experience of the bank.

By subtracting the operating expenses and credit risk loss from risk-adjusted net interest income, we arrive at risk-adjusted pre-tax income. In my next post we’ll expand this discussion further to risk-adjusted net income, capital allocation for unexpected loss and profit ratio considerations.

Part 6

Peer Group 2 fee income
Non-interest income again, as a percent of average total assets, declined to .86 percent from .95 percent in 2007. For Peer Group 2 (PG2), fees have also been steadily declining relative to asset size, down from 1.04 percent of assets in 2005. A smaller, non-interest bearing deposit base with no other new and offsetting sources of fee income will lead to increased pressure on this metric.

Operating expenses
Operating expenses also put more pressure on earnings on these smaller banks. They increased from 2.79 percent to 2.83 percent of average assets. That’s four basis points on the negative. Historically, this metric has been flattering for this size bank and usually moves up or down from year-to-year. It was almost equal at 2.82 percent of assets in 2004.

As a result of the sizeable decline in margins, the continued decline in fee income and the slight increase in operating expenses PG2’s efficiency ratio lost ground from 59.52 percent in 2007 to only 64.72 percent in 2008. That means that every dollar in gross revenue cost them almost 65 cents in administrative expenses this year. This metric averaged 56 cents in 2005/2006. It’s amazing how close these numbers are for banks of very different size where you would expect clear economies of scale.

The total impact of margin performance, fee income and operating expenses, plus the huge increase in provision expense of 59 basis points leads us to a total decline in pre-tax operating income of .96 percent on total assets. That is a total decline from 1.58 percent pre-tax ROA in 2007 to .64 percent pre-tax ROA, a loss of 61 percent from the pre-tax performance in 2007. My same conclusion as above would hold regarding the pricing of risk into bank lending (although the smaller banks didn’t perform a badly as the larger in this regard).

Although all 490 banks are declining in all profit metrics, the smaller banks seem to have an edge in pricing loans, but not deposits. Although up dramatically in 2007, and even more in 2008 for both groups, the PG2 banks seem to be suffering fewer credit losses relative to their asset size than their larger brethren. Both groups have resulting huge profit declines, but the largest banks are under the most pressure through this period.

An interesting point, with higher loan yields and fewer apparent losses, is whether PG2 banks are somewhat better at risk-based pricing (for whatever reason) than the largest bank group. Results are results. The 2009 numbers aren’t expected to show a lot of improvement as the general economy continues to slow and credit and financial risk management issues continue. We’ll probably comment on 2009 as the quarterlies become available this year.

Part 5

This continues the updated review of results from the Uniform Bank Performance Reports (UBPR), courtesy of the FDIC, for 2008. The UBPR is based on the quarterly required Call Reports submitted by insured banks. The FDIC compiles peer averages for various bank size groupings. Here are some findings for the two largest groups, covering 494 reporting banks. I wanted to see how the various profit performance components compare to the costs of credit risk discussed in my previous post. It is even more apparent than it was in early 2008 that banks still have a ways to go to be fully pricing loans for both expected and unexpected risk.

Peer Group 2 (PG2) consists of 305 reporting banks between $1 billion and $3 billion in assets. PG2’s Net Interest Income was 5.75 percent of average total assets for the year. This is also down, as expected, from 6.73 percent in 2007. Net Interest Expense also decreased from 3.07 percent in 2007 to 2.31 percent for 2008.  Net Interest Margin, also declined from 3.66 percent in 2007 to 3.42 percent in 2008, or a loss of 24 basis points. These margins are 31 bps or 10 percent higher than found in Peer Group 1 (PG1), but the drop of .24 percent was much larger than the .05 percent decline in PG1.

As with all banks, Net Interest Margins have shown a steady chronic decline, but the drops for PG2 have been coming in larger chunks the last two years -- -24 basis points last year after dropping 16 points from 2006 to 2007.

Behind the drop in margins, we find loans yields of 6.53 percent for 2008, which is down from 7.82 percent in 2007. This is a decline of 129 basis points or 16 percent. Meanwhile, rates paid on interest-earning deposits dropped from 3.70 percent in 2007 to 2.75 percent in 2008. This 95 basis point decline represents a 26 percent lower cost of interest-bearing deposits. Again, with a steeper decline in interest costs, you would think that margins should have improved somewhat. It wasn’t meant to be. 

We see the same two culprits as we did in PG1. Total deposit balances declined from 78 percent of average assets to 77 percent which means again, that a larger amount had to be borrowed to fund assets. Secondly, non-interest bearing demand deposits continued an already steady decline from 5.58 percent of average assets in 2007 to 5.03 percent. This, of course, resulted in fewer deposit balances relative to total asset size and a lower proportion of interest-cost-free deposits.

Check my next blog for more on an analysis of Peer Group 2’s fee income, operating expenses and their use of risk-based pricing.

 

Part 3

I believe it is quite important to compare your bank or your investment plans in a financial institution to the results of peer group averages. Not all banks are the same, believe it or not. In this column, we use the averages. Again, look for the differences in your target institution. About half of them beat certain performance numbers, while the other half are naturally worse. It can tell a useful story.

This continues the updated review of results from the Uniform Bank Performance Reports (UBPR), courtesy of the FDIC, for 2008. The UBPR is based on the quarterly required Call Reports submitted by insured banks. The FDIC compiles peer averages for various bank size groupings. Here are the findings for the two largest groups that cover 494 reporting banks. I wanted to see how the various profit performance components compare to the costs of credit risk discussed in my previous post. It is even more apparent than it was in early 2008 that banks still have a ways to go to be fully pricing loans for both expected and unexpected risk.

Peer Group 1 (PG1) is made up of the largest 189 reporting banks or those with over $3 billion in average total assets for 2008. Interest income was 5.25 percent of average total assets for the period. This is down, as we might expect, based on last year’s decline in the general level of interest rates from 6.16 percent in 2007. Net Interest Expense was also down from 2.98 percent in 2007 to 2.06 percent average for the year. Net Interest Margin, the difference between the two metrics, was down from 3.16 percent in 2007 to 3.11 percent as a percentage of total assets.

It should be noted that Net Interest Margins have been in a steady, chronic decline for at least 10 years, with a torturous regular drop of 2 to 5 basis points per annum in recent years. Last year’s drop of five basis points is in line with that progression and it does add to continuing difficulty in generating bottom-line profits.

To find out a bit more about why margins dropped, especially in light of the steady increase in lending over the same past decade, we looked first at loan pricing yields. For PG1 these averaged 6.12 percent for 2008, down (again, expectedly) from 7.32 percent in 2007. This is a drop of 120 basis points or a decline of 16 percent. Meanwhile, rates paid on interest-earning deposits dropped from 3.41 percent in 2007 to 2.39 percent in 2008. This 102 basis point decline represents a 30 percent lower interest expense on interest-bearing deposits. Based only on these two metrics, it seems like margins should have improved and not declined for these banks.

Check my next blog for more on the reasons for Peer Group 1’s drop in margins and an analysis of the fee income and operating expenses for these institutions.
 

This post is a feature from my colleague and guest blogger, John Robertson, Senior Process Architect in Advisory Services at Baker Hill, a part of Experian.

Years ago, I attended a seminar at which the presenter made a statement that struck me as odd, but has proven to be quite prophetic.  He simply stated, “margins will continue to narrow … forever!” He was spot on.
At that time, a variety of loan products (such as mortgage loans) were becoming commoditized and this emerging market acted as an intermediary for needed cash to provide banks the wherewithal to continue to lend in their respective locales. The presenter continued by making a call for a systematic and effective pricing methodology then and “forever”.
Pricing loans in a competitive market does not necessarily translate into smaller yields. Nor should banks be willing to accept smaller yields for less than quality loans. There are several viable options to consider when loan pricing in a market where the margins continue to shrink.

Cutting operating expenses
Generally, a financial institution’s first reaction to narrowing margins is to cut operating expenses. Periodically the chaff does need culling, but most banks run efficient shops by depending heavily on technology to create those efficiencies and for risk management. They continually measure themselves with efficiency ratios which, in part, help to drive their strategic operating decisions. So, when the edict comes from above to cut operating expenses, there aren’t too many options.

So, why is a bank’s first reaction usually an all-out call to cut operating expenses? Generally, it’s because these operating expenses are more easily identifiable and banks still lack effective tools to measure the value of their customers and relationships. Couple that with the perception that there is no control over a competitive market with narrowing margins. As a result, banks price accordingly -- just to get the deal. Consequently, their efficiency ratios may look good, but what about the potential impact on yield, service and internal morale? Community banks, in particular, pride themselves on customer service and, in fact, site it as one of their strengths against larger banks. Do you give up that advantage?

Relationship management
To price effectively in a market where margins have narrowed, the bank has to also consider the relationship’s value. The value of deposits should be measured and included to allow for more competitive pricing. The influence of deposits on the relationship allows the bank to be more aggressive in its loan pricing or can enhance the relationship yield itself.
Loan pricing in a competitive market does not have to translate into smaller yields and/or credit quality. The key to staying ahead of competition is measuring the value of the relationship and applying any or all of the outlined effective risk-based pricing methodologies to position the bank to win the deal and still meet the targeted return objectives. While the phrase “margins will continue to narrow … forever” may seem to hold true, banks can counter by using the “power of pricing” to offset the impact to earnings …forever!
 

Part 3

This post continues my discussion of the reasons for going through the time and trouble to analyze risk-based pricing for loans. I mentioned before that the second general major justification for going through the effort to risk-adjust loan pricing as a normal part of the lending function is financial.

I thought it might help put this into perspective by offering rough numbers that relate to risk-adjusted profit performance, bottom line earnings and expand on the premise that risk has a cost. Lending, in the leveraged/banking sense, involves credit risk, market (interest rate) risk and operational risk. The fourth area, the risk of unexpected loss, is covered by capital. Unmitigated risk will eventually impact earnings and common equity.  The question is when and by how much? It’s important to understand that the cost of risk mitigation efforts depend on the various risk characteristics of the bank’s loans and loan portfolio.

The differential cost of market risk
As an example, a floating rate loan that reprices every month involves little market risk, requiring little if any expense to offset. Compare it to a five-year fixed rate, interest-only loan that involves greater exposure to market risk. That risk costs something to offset. The difference in annualized marginal funding cost ranges widely depending on the steepness of the yield curve on the date the loan is closed. The difference between Federal Home Loan Banks 30-day rates and five-year bullet funding today, for instance, is close to 200 basis points. If risk-based loan pricing models don’t reflect this difference by using a matched marginal funding cost, the bank is voluntarily assuming some or all of the market (or interest rate) risk. Multiply an implied 200 bps risk-based funding cost difference by $100M in average loan balances and the implied annualized additional risk-free funding expense is $2,000,000. Multiply that by the average life of the portfolio to get the full risk-adjusted cost difference that the bank is assuming. And that’s just for the market risk.

The implied cost of credit risk
A loan with a pass risk rating of ‘2’ involves a lower likelihood of defaulting than a loan with a pass risk rating of ‘4.’ The lower risk (grade 2) loan, therefore, involves less of an Allowance for Loan Lease and Losses reserve requirement and an implied lower provisioning expense than the higher risk (grade 4) loan.

• Depending on the credit regimen and net loss experience of a given bank, the difference in the implied annualized expected loss due to credit risk could be 40 bps or more.
• Multiply the implied 40 bps credit risk cost difference by $100M in average loan balances and the implied annualized additional risk-adjusted credit expense is $400,000. 
• Multiply that by the average tenor of the portfolio to get the full risk-adjusted cost difference to the bank.

The implied difference in administrative (or operations) expenses
These expenses include all mitigated (insured) operational risk. An owner occupied commercial mortgage is normally much less expensive to monitor than a line of credit backing a construction project. Those cost differences often range into several thousand dollars per annum.

• If, in our example of the $100M portfolio, our average credit is $400K, then we have around 250 loans.
• These loans multiplied by $3,000 in fully-absorbed annual non-interest expense differences would amount to $750K. A competent risk-adjusted loan pricing effort would take this cost difference into account. 
• Again, multiply that yearly amount by the average life of the portfolio to get the full cost difference that the bank is incurring.

In reality, the three sample portfolios above would not overlap perfectly. The total actual assets from the above examples would lie between $100M and $300M. However, the total pretax cost difference of these three sample risk-based costs adds up to $3.15M per annum. The after-tax negative impact on risk-adjusted earnings is therefore about $2M yearly. So, the impact on ROA would be between 2.00% (if the three portfolios overlapped perfectly, for $100M in total assets) down to .67% (if there was no overlap, for $300M in total assets). This is a huge difference in earnings, on a risk-adjusted and fully cost-absorbed basis.

Finally, the amount of risk-based capital needed to back loans with differing risk characteristics, for purposes of unexpected loss, can be substantially different. This can be looked at as a difference in the implied cost of capital or in the performance ratio of ROE.

• In a simple application, the implied required equity might range from say 6% on the lower-risk loans up to 8% for moderate risk (average pass grade risk rating).
• If the portfolio in question is earning 1% ROA, the difference in risk-based equity would result in an ROE of either 12.5% for the higher risk loans versus 16.7% for the lower risk loans. 
• The differences in fully risk-based ROE, or RAROC, could easily be more dramatic than this.

As stated before, if these differences are not “priced” into the loans somehow, the bank is not getting paid for the risk it is incurring or it is charging the lower risk borrowers a rate that pays for the added risk expenses of the higher risk borrowers. The business risk to the bank then becomes losing the better clients over time rather than attracting the riskier deals.

An economic look at performance
We are not talking in terms of “normal” accounting practices or “typical” quarterly reporting periods. We do use general ledger numbers to start the analysis process by relying on actual balances, rates and maturities. But, GAAP doesn’t address risk. So the risk adjustments are a more “economic” look at performance. Eventually, the risk reduction approach and the GL-based results will even out. The question is not “if” risk will eventually surface, but when and how it will manifest itself in GL results. We’ve seen a lot of this in the news the past eighteen months – and there’s likely more to come as the economy is in a downturn phase.

Going through the effort is worth it
Once risk is created by making a loan or placing a bet, someone owns it. The reason to go through the effort to price loans (and relationships) on a fully risk-adjusted basis is to understand the impact of risk at the only point in time when you can do something about getting paid for it – at the time the loan is agreed upon. After that, the bank is pretty much along for the ride. Risk-adjusted pricing is smart banking. It not only puts some teeth in the bank’s already existing risk management policies, it is justifiable to the client and it makes sense to most lending officers. 
 

Part 2

This post continues my discussion of the reasons for going through the time and trouble to analyze risk-based pricing for loans. For the discussion of the key elements involved in risk-adjusted loan pricing, please visit my earlier posts. In my last blog we discussed reason number one: good corporate governance. Governance, or responsible and disciplined leadership, makes a lot of sense and promotes trust and confidence which has been missing lately in many large financial institutions. The results can be seen in the market in multiples now and are associated with both the struggling companies and, through guilt by association, the rest of the industry.  But, let’s move beyond the “soft” reason. The second major justification for going through the effort to risk-adjust loan pricing as a normal part of the lending function is financial.

Profit performance
By financial, we mean profit performance or bottom line earnings. This reason relies on the key belief that risk has a cost. Just because risk can be difficult to measure and/or is not addressed within GAAP, doesn’t mean it can’t ultimately cost you something. If, for any reason, you believe you can get away with taking on any unmitigated risk without it ever costing anything, do not continue reading this or any of my other posts. You are wasting your valuable time.

Risk will surface
The saying that “risk will out,” I believe, is true. The question is not if risk will eventually surface, but when, how and how hard it will bite.  Risk can be transferred (hedges, swaps and so on), but it doesn’t disappear from the universe. Once risk is created, someone owns it. The news headlines of the past 18 months are replete with stories of huge writedowns of toxic assets. The securitized assets and/or their collateral loans always contained risk – from the moment the underlying loan was closed. The loans and their payment streams were sliced a dozen ways, repackaged and resold. The risk was also sliced up, but like mercury, it all remained in the system.  Another familiar casino saying that brings this to mind is: “If you don’t know who the ‘mark’ at the table is, it’s you.” There are now several world class examples of such marks. Some have now failed completely and many more would have without federal intervention.

Lending, in the leveraged/banking sense, involves all major types of risk: credit risk, market risk, operational risk and business risk. And, beyond the identifiable and potentially insurable portions of these risks, like any business, it includes the risk of unexpected loss, which needs to be covered by capital. Banks have developed policies and guidelines to mitigate, identify and measure many of their risks. These all fall under the world of risk management and these efforts all cost something. There is no free way to offset risk – other than not doing the loan at all. But lending is the business of banking, isn’t it?

Further, the risk mitigation efforts cost more or less depending on the various risk characteristics of the bank’s loan portfolio each loan. For instance, a floating rate loan involves little market risk and requires little if any expense to offset. A five-year fixed rate, interest-only loan involves a lot of market risk and that costs something to offset. Alternatively, a loan with a pass risk rating of ‘2’ involves a much lower likelihood of defaulting than a loan with a pass risk rating of ‘4’. The lower risk loan; therefore, involves less of an ALLL (Allowance for Loan and Lease Losses) reserve and provisioning expense.  Also, an owner occupied commercial mortgage is normally much less expensive to monitor than a credit backing a floor plan or construction project. Those cost differences could be reflected in the pricing.

Finally, for today, the amount of risk capital needed to back these kinds of differing loan characteristics, for purposes of unexpected loss, is substantially different. If these kinds of differences are not priced into the loans somehow, one of two situations exists:
 

1. Either the bank is not getting paid for the risk it is incurring; or,
2. If it is, it is charging the lower risk borrowers a rate that pays for added risk-adjusted expenses of the higher risk borrowers.

The business risk to the bank then becomes losing the better clients over time in lieu of attracting the riskier deals. This process has a name: adverse selection.

The ongoing expenses of risk mitigation and the negative impact of unexpected losses on retained earnings, over time, materially hurt the bank’s earnings. Someone is paying for all of the risks of being in the business of lending and it’s usually one of two groups: the customers or the shareholders. In the worst of cases, it’s also the taxpayers. The idea of risk-based pricing, at the loan level, is to have the clients pay for the risks the bank is incurring on their behalf by pricing the loan appropriately from the beginning. As a result:

• This tends to protect, and often enhance, the bank’s financial performance;
• It is clever;
• It puts some teeth in the bank’s already existing risk management policies;
• It is justifiable to the client; and
• It even makes sense to most lending officers. 

Part 1

In my last three posts, we have covered the key parts of how risk-based loan pricing works. We have discussed how the key foundational elements involved in risk-adjusted loan pricing can and should relate to the bank’s accounting results and strategic policies. We went from the pricing analysis of an individual loan on a risk-adjusted basis to solving for a bank-wide target or guideline return. We also mentioned how this analysis can be expanded to the client relationship level, both producing a relationship management view of any existing loans and the impact of pricing a renewal or new credit to impact the client-level return. Finally, I mentioned that although this capability can exist (and does in more banks than ever before), it isn’t an easy undertaking in an industry that is historically keyed to volume goals rather than transaction profit (let alone risk-adjusted profit).

So, why go through the effort? Moving to a risk-adjusted view of lending and relationship management requires serious thought, effort and resolve. It involves change and teaching lenders a new trick. It even suggests that the lending executive (perhaps the next president of the bank) hasn’t been doing the best job possible to protect and advance the bank’s margins. Any new undertaking involves management risk. And, accurate or not, bank executives are not generally viewed as terrific change agents. Is this concept of risk-based pricing worth all the time and trouble? We think so – for two general reasons.

Corporate governance
Almost any business, if not any undertaking of any kind, involves risk to some degree. Finance in general, and commercial banking, specifically, involves several kinds of risk. The most obvious risk is repayment or credit risk. Banks have been lending money successfully for a long time. The funny thing is that often, when we’ve studied the actual loan rates of a bank’s portfolio versus the bank’s own risk ratings (or risk grades), we see almost no difference in loan pricing. The banks have credit policies that discuss the different ratings in some detail. And, the banks usually have some sort of provisioning process or ALLL (Allowance for Loan and Lease Losses) logic that uses these differences in risk rating. Loan review guidelines often use the differences in risk rating to gauge the review frequency and depth.

So, the banks know what’s going on. They know that a higher risk borrower/loan is less likely to be repaid in full than a lower credit risk borrower/loan. But, the lending operation goes on as if they were all about the same. There seems to be a disconnect (kind of like when my arms and brain disconnect when I swing a golf club). I know if I slow down I’ll hit a better shot, but I still swing way too fast. It seems to me that since the bank has all of these terrific policies in place dealing with credit risk, that good governance would require that credit risk be reflected more fully when loans are marketed, negotiated and agreed to – rather than just when they go awry.

I would make the same general argument for management consistency associated with other risk types. If the loan duration is longer, good governance would reflect (pay for) a realistic marginal funding cost of the same duration. This would help to align the loan pricing effort with the guidelines or policies associated with ALCO or Asset and Liability Policy Committee and Interest Rate Risk (IRR) management. If a loan involves higher or lower risk of unexpected loss based on loan/collateral type and risk rating, then the risk capital associated with the loan should vary accordingly. The risk-based allocation of capital will then require different pricing in order for the loan to hit a targeted return. This protection of return, on a risk-adjusted basis, is the final step in good governance – in this case, to protect the shareholders specific contribution (of their equity) to funding the loan in question.

Finally, if I were a director, regulator or an auditor (again), and I reviewed all of these fine policies related to risk management, and did not see them reflected in deal pricing, I would have to ask “why?”.  It would seem that either executive management doesn’t really believe in their own policies, or they are willing to set them aside when negotiating deals for the added business. Maybe loan management doesn’t want to be bothered by the policies while they’re out there in the “real world” fighting for added loan volume. Either way, there seems to be a governance disconnect. Which I know on the golf course, leads to lost balls and unnecessary poor scores.

My second major reason will follow in my next blog.

Part 2

To continue from my previous post discussion, we will now expand the concept of risk adjusted loan pricing to the relationship management level. If we can calculate risk-based returns for individual loans (either exiting credits or proposed renewals/additions), it isn’t too difficult to add them up for a client’s overall profitability picture. Using a similar approach as in my last post, the lender can see the impact of the simulated changes to a new loan on the risk-adjusted return at the client relationship level. It doesn’t have to be a new loan and may just be a renewal/rollover of an expiring line or maturing loan. After all, most of the banks sales in a given period come from existing business.

Let’s look at a quick example.
The bank’s goal is 12% ROE. My client, with their existing loans is at 11% ROE. I’d like to move them higher and definitely not see them decline. I want to use the pricing calculator to look at a renewal of one of their lines that involves about 25% of their outstanding balances. I run a solution on the renewal that produces a risk-adjusted 12% ROE on the renewed loan. I also find that this brings the relationship up to 11.25% ROE. I try some added runs on the renewed credit to see if  I can come up with a structure that gets me over 12% ROE on the loan (and over 11.25% on the relationship), that I think I can sell. I have a couple of options to pursue including one with a fixed rate for the next year, and one that is a floating rate. They each have differing fee amounts, but, they both have a risk-based return that I believe my boss and the loan committee would go along with. I now know where I want to try to end the negotiations with my client. It’s up to me to create the right discussion posture and close the deal.

There’s nothing automatic about this.
It takes a lot of education and effort to succeed and the targets may not be achieved instantly. Do not confuse the benefits of the overall direction (of risk-based performance measurement) with the behavioral adaptation that needs to take place in daily lending practices. Along with the creation of the risk-based pricing and profitability functionality, there needs to be a significant educational investment for management and staff. A risk-based and profit-based lending function isn’t the way banking has been done for most industry participants – ever. This is still new to most of us. So, the explanation, reinforcement and adaptation to the concept will take time and effort. And, it will take a huge quantity of executive resolve.

I’m not finished with this topic. We still have a lot to discuss including deposit profitability and how profitable risk-based pricing and banking can be. So, I’ll continue to come back to this topic in future posts. 
 

Part 1

Risk-based pricing starts as a product-level reflection of a bank’s financial and risk characteristics. In my last few posts we have covered the key parts of how risk-based loan pricing works. In doing so, we have discussed how the key foundation elements involved in risk-adjusted loan pricing can (and should) relate to the bank’s accounting results and strategic policies:

• Loan balance, rate and fee data relates to the bank’s actual general ledger amounts;
• The administrative costs are also derived from actual non-interest expenses; 
• The cost of funds is aligned with the policies used in the ALCO operation and in the IRR management processes; 
• The statistical cost of credit risk used in pricing (providing sensitivity to the loan’s risk rating) is derived partially from the bank’s credit and provisioning policies;
• The taxes are the bank’s actual average experience; and 
• For banks using ROE/RAROC, the equity allocation is related to the bank’s overall (unexpected) risk posture and its capital sufficiency policies.

Once a bank understands risk-adjusted pricing and can calculate the risk-adjusted return (ROA or ROE/RAROC) for a given loan, what more can we do to help the lender close the deal? And, what can we do to help lenders assist the bank with meeting profit goals? The answer to both questions is: “quite a lot”. First, bank management and lending executives can set various risk-based goals or guidelines that are based on the same data and foundation logic that was used to create the risk-based profit calculations. This analytical form of targeting helps take the profit (and therefore pricing) process out of the realm of “blue sky” numbers or simply wishful thinking on the part of management. The risk-based targeting guidelines benefit from the same analytical processes that went into the logic behind creating the profit calculations. The targets should be as well-founded as the analysis that went into the profit calculations.

Then the fun begins.
First at the loan level: Once we have the ability to calculate risk-adjusted loan profit and we have similarly founded targets or guidelines, we can easily use the profit calculations in reverse to solve for a required loan rate and/or origination fee that will meet the target profit. The lender can change a structural aspect of the loan under consideration and quickly see the impact on risk-adjusted profit. More importantly, they can see how these changes relate to the guidelines or target.

In fact, the lender could look at any number of changes to the loan amount, tenor, amortization rate, moving the risk rating up or down, and changing the rate from fixed to floating impact to see what relative impact the change has on risk-adjusted profit. Because knowledge is one key to successful negotiation, the lender is in a substantially stronger position to conduct the sales and negotiation phases of landing the deal. There is a substantially higher likelihood the resulting loan will be a better risk-adjusted return for the bank than would take place by ignoring such pricing practices. Add up all of the loan and lines done in the course of a year and you see a significant impact on the bank’s overall performance.

In my next post, I’ll expand this concept to the relationship management level.

Part 1

In my last post about risk-based pricing, we started a discussion of the major elements involved in the risk adjustment of loan pricing. We got down to a risk-adjusted pre-tax profit amount. Not to divert the present discussion too much, but we often use pre-tax performance numbers for entity level comparisons to avoid the vagaries of tax treatments. Some banks are sub-S corporations, while most are C corporations. There are differences in state tax levels and, there may be other tax deferral strategies such as, leasing activity and/or securities adjustments that can affect these after-tax numbers. So, pre-tax data can be very useful.

After-tax profit and profitability ratios
For internal comparisons across loans, client, lenders and other lines of business; and to better understand how the risk-adjusted profit from a loan or a relationship relate to overall bank performance, we prefer to get to an after-tax profit and profitability ratio. This is also necessary to compare loans or portfolios involving tax-exempt entities to loans with taxable interest income. To do this, we apply the bank’s average effective income tax rate (including federal and state) to the pre-tax result, with the exception of tax exempt loans. This gives us risk-adjusted net income (or profit) at the loan level.

By arriving at risk-based profit estimates at the product level, we then have the opportunity to accumulate these for multi-product client relationships, or at lender or market segment levels. Clients can then go on to analyze the profit results in comparison to their distribution of risk ratings and break the risk-adjusted returns down by loan/collateral type, client geography or industry. Some banks have graphical displays of these results.

In addition to profit level, and to assist with comparative capability, we continue to one or more profitability ratios. You can divide the profit amount by the average loan balance to get a risk-adjusted return on assets (ROA).

ROA =        Profit amount
                   Average loan balance

This is very helpful for looking at asset product performance and has been used historically by the banking industry for risk-based pricing. Many banks have moved beyond ROA and now focus on return on equity (ROE). For a more comprehensive discussion of ROA and ROE see my post from December 6, 2008.

I will continue in my next post about Return on Equity.

I have referred to risk-adjusted commercial loan pricing (or the lack of it) in previous posts. At times, I’ve commented on aspects of risk-based pricing and risk-based bank performance measurement, but I haven’t discussed what risk-based pricing is -- in a comprehensive manner. Perhaps I can begin to do that now and in my next posts.

Risk-based pricing analysis is a product-level microcosm of risk-based bank performance. It begins by looking at the financial implications of a product sale from a cost accounting perspective. This means calculating the revenues associated with a loan, including the interest income and any fee-based income.  These revenues need to be spread over the life of the loan, while taking into account the amortization characteristics of the balance (or average usage for a line of credit). To save effort (and to provide good client relationship management), we often download the balance and rate information for existing loans from a bank’s loan accounting system.

To “risk-adjust” the interest income, you need to apply a cost of funds that has the same implied market risk characteristics as the loan balance. This is not like the bank’s actual cost of funds for several reasons. Most importantly, there is usually no automatic risk-based matching between the manner in which the bank makes loans and the term characteristics of its deposits and/or borrowing. Once we establish a cost of funds approach that removes interest rate risk from the loan, we subtract the risk-adjusted interest expense from the revenues to arrive at risk-adjusted net interest income, or our risk-adjusted gross margin. 

We then subtract two types of costs. One cost includes the administrative or overhead expenses associated with the product. Our best practice is to derive an approach to operating expense breakdowns that takes into account all of the bank’s non-interest expenses. This is a “full absorption” method of cost accounting. We want to know the marginal cost of doing business, but if we just apply the marginal cost to all loans, a large portion of real-life expenses won’t be covered by resulting pricing. As a result, the bank’s profits may suffer. 

We fully understand the argument for marginal cost coverage, but have seen the unfortunate end. Using this lower cost factor can hurt a bank’s bottom line. Administrative cost does not normally require additional risk adjustment, as any risk-based operational expenses and costs of mitigating operation risk are already included in the bank’s general ledger for non-interest expenses. 

The second expense subtracted from net interest income is credit risk cost. This is not the same as the bank’s provision expense, and is certainly not the same as the loss provision in any one accounting period.  The credit risk cost for pricing purposes should be risk adjusted based on both product type (usually loan collateral category) and the bank’s risk rating for the loan in question. This metric will calculate the relative probability of default for the borrower combined with the loss given default for the loan type in question. 

We usually annualize the expected loss numbers by taking into account a multi-year history and a one- or two-year projection of net loan losses. These losses are broken down by loan type and risk rating based on the bank’s actual distribution of loan balances. 

The risk costs by risk rating are then created using an up-sloping curve that is similar in shape to an industry default experience curve. This assures a realistic differentiation of losses by risk rating. Many banks have loss curves that are too flat in nature, resulting in little or no price differentiation based on credit quality. This leads to poor risk-based performance metrics and, ultimately, to poor overall financial performance. The loss expense curves are fine-tuned so that over a period of years the total credit risk costs, when applied to the entire portfolio, should cover the average annual expected loss experience of the bank. 

By subtracting the operating expenses and credit risk loss from risk-adjusted net interest income, we arrive at risk-adjusted pre-tax income. In my next post I’ll expand this discussion further to risk-adjusted net income, capital allocation for unexpected loss and profit ratio considerations.
 

Here’s a further review of results from the Uniform Bank Performance Reports, courtesy of the FDIC, through the third quarter of this year. (See my Dec. 18 post.) The UBPR is based on quarterly call reports that insured banks are required to submit. I wanted to see how the various profit performance components compare to the costs of credit risks discussed in my previous post. The short of it is that banks have a ways to go to be fully pricing for both expected and unexpected risk. (See my Dec. 5 blog dealing with risk definitions.) The FDIC compiles peer averages for various bank size groupings. Here are some findings for the two largest groups, covering 490 reporting banks. Here are the results:

Peer Group 1 consists of 186 institutions with over $3 billion in average total assets for the first nine months.

• Net interest income was 5.34 percent of average total assets for the period. This is down, as we might expect based on this year’s decline in the general level of interest rates, from 6.16 percent in 2007.
• Net interest expense was also down from 2.98 percent in 2007 to 2.16 percent for the nine months to September 30th. 
• Net interest margin, the difference between the two metrics, was down slightly from 3.16 percent in 2007 to 3.14 percent so far in 2008, or a loss of 2 basis points.

It should be noted that net interest margins have been in steady decline for at least ten years, with a torturous regular drop of 2 to 5 basis points per annum in recent years. This year’s drop is not that bad, although it does add to the difficulty in generating bottom-line profits.

To find out a bit more about the drop in margins, especially in light of the steady increase in lending over the same past decade, I looked at loans yields.

• Loan yields averaged 6.22 percent for 2008, down (again, expectedly) from 7.32 percent in 2007. This is a drop of 110 basis points or a decline of 15 percent.
• Meanwhile, rates paid on interest-earning deposits dropped from 3.41 percent in 2007 to 2.48 percent so far in 2008. This 93 basis point decline represents a 27 percent lower cost of interest-bearing deposits.

It seems as though margins should have improved somewhat -- not declined for these banks.

Digging a bit deeper, I see two possible reasons. 

• First, total deposit balances declined from 72 percent of average assets to 70 percent, meaning a larger amount had to be borrowed to fund assets.
• Second, non-interest bearing demand deposits declined from 4.85 percent of average assets to 4.49 percent.
So, fewer deposit balances relative to total asset size, along with a lower proportion of interest-cost-free deposits, appear to have made the difference. Unfortunately, the ”big news” is that margins were only down a bit.

Let’s move on to fee income. Non-interest income, again, as a percent of average total assets, was down to 1.14 percent from 1.23 percent in 2007. For this bank group, fees have also been steadily declining relative to asset size, down from 1.49 percent of assets in 2005. A lot of fee income is deposit based, and largely based on non-interest bearing deposits – and, thus, a source of pressure on fee income.

Operating expenses constituted some good news as they declined from 2.63 percent to 2.61 percent of average assets. That’s 2 basis points to the good. Hey, an improvement is an improvement. Historically this metric has generally moved down, but irregularly from year to year. The number stood at 2.54 percent in 2006, for instance.

As a result of the slight decline in margins and the larger percentage decline in fee income, the Peer Group 1 efficiency ratio lost ground from 57.71 percent in 2007 to only 58.78 percent in 2008. That means the every dollar in gross revenue [net interest income plus fee income] cost them almost 58 cents in administrative expenses so far this year. This metric averaged 55 cents in 2005/2006.

The total impact of margin performance, fee income and operating expenses, if you’ve been tallying along, is a net decline of 0.09 percent on total assets. When we add this to the 2008 increase in provision expense of 57 basis points, we arrive at a total decline in pre-tax operating income of 0.66 percent on total assets. (See my Dec. 18 post.) That is a total decline of 44 percent from the pre-tax performance in 2007 for banks over $3 billion in assets.

It would appear that banks are not pricing enough risk into their loan rates yet – for their own bottom line performance. This would be further confirmed if you compared bank loan rates to the historic risk spreads and absolute rates that the market currently has priced into investment grade and other corporate bonds. They are probably at extremes but still they say more credit risk is present than bank lending rates/yields would indicate.

For Peer Group 2, consisting of 304 reporting banks between $1 billion and $3 billion in assets:

• Net interest income was 5.87 percent of average total assets for the period. This is also down, as expected, from 6.73 percent in 2007.
• Net interest expense was also down from 3.07 percent in 2007 to 2.39 percent for the nine months to September 30th. 
• Net interest margin, was down from 3.66 percent in 2007 to 3.48 percent so far in 2008, or a loss of 18 basis points. These margins are at somewhat higher levels than found in Peer Group 1, but the drop of .18 percent was much larger than the decline in Peer Group 1.

As with all banks, net interest margins have been in steady chronic decline, but the drops for Peer Group 2 have been coming in larger chunks the last two years, down 18 points this year so far, after dropping 16 points from 2006 to 2007.

Behind the drop in margins, loans yields are 6.69 percent for 2008, down from 7.82 percent in 2007. This is a drop of 113 basis points or a decline of 14 percent. Meanwhile rates paid on interest-earning deposits dropped from 3.70 percent in 2007 to 2.85 percent so far in 2008. This 85 basis point decline represents a 23 percent lower cost of interest-bearing deposits. Again, with a steeper decline in interest costs, you’d think margins should have improved somewhat. That didn’t happen. 

I notice the same two culprits.

• Total deposit balances declined from 78 percent of average assets to 76 percent, meaning, again, a larger amount had to be borrowed to fund assets.
• Also, non-interest bearing demand deposits continued an already steady decline from 5.58 percent of average assets in 2007 to 5.08 percent.

Fewer deposit balances relative to total asset size…along with a lower proportion of interest-cost-free deposits…and we know the result.

Now, about fee income for these banks… Non-interest income, again as a percent of average total assets, was down to 0.92 percent from 0.95 percent in 2007. For this bank group, fees have also been steadily declining relative to asset size, down from 1.04 percent of assets in 2005. A smaller non-interest bearing deposit base, without other new and offsetting sources of fee income, will mean pressure on this metric.

Operating expenses constituted some good news here as well. They declined from 2.79 percent to 2.75 percent of average assets. That’s 4 basis points to the good. Historically this metric has been flatter for this size bank, moving up or down a bit from year to year.

As a result of the not-so-slight decline in margins and the continued decline in fee income, the Peer Group 2 efficiency ratio lost ground from 59.52 percent in 2007 to only 61.86 percent in 2008. That means the every dollar in gross revenue cost these banks almost 62 cents in administrative expenses so far this year. This metric averaged 56 cents in 2005/2006.

The total impact of margin performance, fee income and operating expenses is a net decline of 0.17 percent on total assets. When we add this to the 2008 increase in provision expense of 36 basis points, we arrive at a total decline in pre-tax operating income of 0.53 percent on total assets. (See my Dec. 18 post.) That is a total decline of 34 percent from the pre-tax performance in 2007. 

As I concluded above, more credit risk is present than bank lending rates/yields would indicate.

Although all 490 banks are declining in efficiency, the larger banks have a scale edge in this regard. The somewhat smaller banks seem to have an edge in pricing loans, but not regarding deposits. Although up dramatically in 2007 and even more this year for both groups, the Peer Group 2 banks seem to be suffering fewer credit losses relative to their asset size than their larger brethren.

Both groups have resulting huge profit declines, but the largest banks are under the most pressure through this period. It’s interesting to note that, with higher loan yields and fewer apparent losses, Peer Group 2 banks are somewhat better at risk-adjusted loan pricing than the largest bank group.

Results are results. The fourth quarter numbers aren’t expected to show a lot of improvement as the general economy continues to slow and credit issues continue. I’ll comment on entire year’s results in posts early next year.

Next year, too, look for my comments on risk management solutions especially relevant to enterprise risk management.

I reviewed the Uniform Bank Performance Reports (UBPR: (http://www2.fdic.gov/ubpr/ReportTypes.asp ) for selected clients through the third quarter of this year. The UBPR is a compilation of the FDIC, based on the call reports submitted by insured banks. The FDIC reports peer averages for various bank size groupings.

Here are a few findings for the two largest groups, covering 490 banks.

Peer Group 1 consists of 186 institutions over $3 billion in average total assets for the first nine months. Net loans accounted for 67.59 percent of average total assets, up from 65.79 percent in 2007. Loans, as a percent of assets, have increased steadily since at least 2005. The loan-to-deposit ratio for the largest banks was also up to 97 percent, from 91 percent in 2007 and 88 percent in both 2006 and 2005. So, it appears these banks are lending more, at least through the September quarter, as an allocation of their asset base and relative to their deposit source of funding.

In fact, net loans grew at a rate of 11.51 percent for the group through September, which is down from the average growth rate of 15.07 percent for the years 2005 through 2007.  But, it is still growth.

For Peer Group 2, consisting of 304 reporting banks between $1billion and $3 billion in assets, net loans accounted for 72.57 percent of average total assets, up from 71.75 percent in 2007. Again, the loans as a percent of assets have increased steadily since at least 2005. The loan-to-deposit ratio for these banks was up to 95 percent, from 92 percent in 2007 and an average of 90 percent for 2006 and 2005. So, these banks are also lending more, at least through the September quarter, as a portion of their asset base and relative to their deposit source of funding.

In fact, net loans grew at a rate of 12.57 percent for the group through September, which is up from 11.94 percent growth in 2007 and down from an average growth of 15.04 percent for 2006 and 2005.  Combined, for these 490 largest institutions, loans were still growing through September. More loans probably mean more credit risk.

Credit costs were up. The Peer Group 1 banks reported net loan losses of 0.67 percent of total loans, up from 0.28 percent in 2007, which was up from an average of 18 basis points on the portfolio in 2006/2005.  The Group 2 banks reported net loan losses of 0.54 percent, also up substantially from 24 basis points in 2007, and an average of 15 basis points in 2006/2005.

Both groups also ramped up their reserve for future expected losses substantially. The September 30th allowance for loan and lease losses (ALLL) as a percent of total loans stood at 1.52 percent for the largest banks, up from 1.20 percent in 2007 and an average of 1.11 percent in 2006/2005. Peer Group 2 banks saw their allocation for losses up to 1.40 percent from 1.22 percent in 2007 and 1.16 percent in 2006. So, lending is up even in the face of increased write-offs, increased expected losses and the burden of higher expenses for these increased loss reserves.

Obviously, we would expect this to negatively impact earnings. It did, greatly. Peer Group 1 banks saw a decline in return on assets to 0.42 percent, from 0.96 percent in 2007 and an average of 1.26 percent in 2006/2005. That is a decline in return on assets (ROA) of 56 percent from 2007 and a decline of 68 percent from the 2006/2005 era. Return on equity declined even more. ROE was at 5.21 percent through September for the large bank group, down from 11.97 percent in 2007. ROE stood at 14.36 percent in 2005.

For the $1 billion to $3 billion banks, ROA stood at 0.66 percent for the nine months, down from 1.08 percent in 2007, 1.30 percent in 2006 and 1.33 percent in 2005. The decline in 2008 was 39 percent from 2007. Return on equity (ROE) for the group was also down at 7.71 percent from 12.37 percent in 2007. The drops in profitability were not entirely the result of credit losses, but this was by far the largest impact from 2007 and earlier.

The beefed-up ALLL accounts would seem to indicate that, as a group, the banks expect further loan losses in the remainder of 2008 and into 2009.  All of these numbers pre-dated the launch of the TARP program, but it is clear that banks had not contracted lending through the first three quarter of 2008, even in the face of mounting credit issues, cost of credit, challenges regarding loan pricing and profitability, net interest margins,  and the generally declining economic picture. It will be interesting to see how things unfold in the next several quarter


[See my December 5th post about ROE versus ROA.]

Disclosure: No positions.

It is the time of year during which budgets are either in the works or have been completed.  Typically, when preparing budgets, we project overall growth in our loan portfolios…maybe.  Recently we conducted an informal survey, the results of which indicate that loan portfolio growth is still a major target for 2009.  But when asked what specific areas in the loan portfolio -- or how loan pricing and profitability -- will drive that growth, there was little in the way of specifics available.  This lack of direction (better put, vision) is a big problem in credit risk management today.

We have to remember that our loan portfolio is the biggest investment vehicle that we have as a financial institution.  Yes; it is an investment.  We choose not to invest in treasuries or fed funds -- and to invest in loan balances instead -- because loan balances provide a better return.  We have to appropriately assess the risk in each individual credit relationship; but, when it comes down to the basics, when we choose to make a loan, it is our way of investing our depositors’ money and our capital in order to make a profit.

When you compare lending practices of the past to that of well-tested investment techniques, we can see that we have done a poor job with our investment management.  Remember the basics of investing, namely: diversification; management of risk; and review of performance.  Your loan portfolio should be managed using these same basics.  Your loan officers are pitching various investments based on your overall investment goals (credit policy, pricing structure, etc.).  Your approval authority is the final review of these investment options.  Ongoing monitoring is management of the ongoing risk involved with the loan itself.

What is your vision for your portfolio?  What type of diversification model do you have?  What type of return is required to appropriately cover risk?  Once you have determined your overall vision for the portfolio, you can begin to refine your lending strategy.  I’ll comment on that in my next blog entry.

In several posts we’ve discussed financial risk management, the role of risk-based capital, measuring profitability based on risk characteristics and the need for risk-based loan pricing (credit risk modeling). I thought it might be worthwhile to take one step back and explain what we mean by the term “risk.”

“Risk” means unpredictable variability. Reliable predictions of an outcome tend to reduce the risk associated with that outcome. Similarly, low levels of variability also tend to reduce risk. People who are “set in their ways” tend to lead less risky lives than the more adventuresome types. Insurance companies love the former and charge additional premiums to the latter. This is a terrific example of risk-based pricing.

Risk goes to both extremes. It is equally impossible to predict who will win a record amount in the lottery (a good outcome) and who will be struck by a meteor (a very bad outcome for the strikee). Both occurrences represent significant outcomes (very high variability from the norm). However, the probability of either event happening to any one of us is infinitesimally small. Therefore, the actual risk is small – not even enough to bother planning for or mitigating. That is why most of us don’t buy meteor strike insurance. It is also why most of us don’t have a private jet on order.

Most of us do purchase auto insurance, even in states that do not require it. Auto accidents (outcomes) happen often enough that actuaries can and do make a lot of good predictions as to both the number of such events and their cost impact. In fact, so many companies are good at this that they can and do compete on their prices for taking on our risk. The result is that we can economically mitigate our individual inability to predict a collision by buying car insurance.

Financial services involve risk. Banks have many of the same operational risks as other non-financial businesses. They additionally have a lot of credit risk associated with lending money to individuals and businesses. Further, banks are highly leveraged, borrowing funds from depositors and other sources to support their lending activities. Because banks are both collecting interest income and incurring interest expense, they are subject to market, or interest rate, risk.

Banks create credit policies and processes to help them manage credit risk. They try to limit the level of risk and predict how much they are incurring so they can reserve some funds to offset losses. To the extent that banks don’t do this well, they are acting like insurance companies without good actuarial support. It results in a practice called “adverse selection” – incorrectly pricing risk and gathering many of the worst (riskiest) customers.

Sufficiently good credit risk management practices control and predict most of the bad outcomes most of the time, at least at portfolio levels. Bad outcomes (losses) that are not well-predicted, and therefore mitigated with sufficient loan-loss reserves, will negatively impact the bank’s earnings and capital position. If the losses are large enough, they can wipe out capital and result in the bank’s failure.

Market risk is different than credit risk. The bank’s assets are mostly invested in loans and securities (about 90% of average assets). These loans and securities have differing interest rate structures – some are fixed and some are floating. They also have differing maturities. Meanwhile, the bank’s liabilities, deposits and borrowings also have differing maturities and interest rate characteristics. If the bank’s (asset-based) interest income structure is not properly aligned with the (liability-based) interest expense structure, the result is interest rate risk. As market rates change (up or down), the bank’s earning are impacted (positively or negatively) based on the mismatch in its balance sheet structure. 

The bank can offset market risk by purchasing interest rate swaps or other interest rate derivatives. The impact of insufficient attention to interest rate risk can damage earnings and may, again, negatively affect the bank’s capital position.

So, ultimately, the bank’s risk-based capital acts as the last line of defense against the negative impact from, you guessed it, unpredictable variability – or “risk.” That is why equity is considered risk-based capital. Good management, predicting and pricing for all risks leads to safer earnings performance and equity position.

In previous posts, we’ve dealt with the role of risk-based capital, measuring performance based on risk characteristics and the need for risk-based loan pricing. What about risk mitigation? Some of the greatest sins of the financial industry in the current malaise have been the lack of transparency, use of complex transactions to transfer risk and the creation of off-balance-sheet entities to house dodgy investments.

Much has been made of the role of Credit Default Swaps (CDSS) as one of the unregulated markets (and therefore guilty parts) of the current credit meltdown. The regulatory agencies and the media are aghast at the volume (peak of some $62 trillion in notional value) of CDSS that have resulted from a totally private market. The likes of Lehman Brothers, Bear Sterns and AIG were all big issuers of CDSS. And the trillions of notional value of open CDSS is as much as 100 times the underlying value of the actual debt being insured.

There are problems here, but it may be worth clarifying the useful risk management activities from the potentially abusive excesses involving such instruments.

CDSS are derivative contracts whereby one party buys credit protection from a counterparty. The buyer pays a premium to the seller either in a lump sum or periodically over the life of the contract. If a credit event such as a default on a loan or a bond occurs, the seller of the CDSS pays the holder for the loss or purchases the initial debt, the reference obligation, at a pre-set price.  So, a CDSS is in effect a put option that is deep-out-of-the-money. They expire upon termination and most are never exercised. They are subject to fair-value accounting and can change in value from month to month as the credit markets premiums for similar cover moves up or down.

Banks and others can use CDSS to, in effect, adjust the nature of credit risk in their portfolios by both buying and selling such contracts.

Asset securitizations, whether mortgage-backed securities or other formulations, are in fact broken-down and re-packaged forms of assets that can be sold -- transferring certain rights, values and risk to another party for payment received. They are complex and therefore mostly opaque to the general public and even many practitioners. They often involve the use of special purpose entities or trusts that can further confuse investors. These tactics have added to the difficulty of the credit crisis and the collapse of capital markets.

But, CDSS are contingent in nature and act more like fire insurance or a back-up data center. Such operational expenses are intended to control risks. The accounting treatment is complex and, to an extent (especially as regards the tax treatment), still not well defined by accounting authorities. For most banks, and most CDSS contract, the premium is amortized over the life of the contract. The premium expense entry in their general ledgers is an expense of doing business that is intended to alleviate some credit risk. We are now talking about a covered CDSS, where the bank has extended credit or invested in a debt instrument. Those who purchased uncovered CDSS are gambling on a default occurrence and used CDSS as a more cost-effective (and secretive) alternative to shorting securities. It is somewhat like a naked short.

So, a covered CDSS is ultimately an expense associated with protecting the net asset value of a credit transaction. Importantly, this expense should be included in any performance analysis or pricing of the risk-adjusted profitability of the credit obligation and/or client relationship involved. This risk mitigation exercise may be in lieu of a higher required rate or fee on an otherwise uncovered/unmitigated credit transaction, or being satisfied with a lower risk-adjusted return where the bank assumes (self-insures) all of the credit risk.

CDSS quotes/costs, similar to rate spreads on corporate bonds, are the open market’s current feeling regarding an entity’s credit quality or relative probability of default. There are some 400 or so participants in the CDSS market, including writers and dealers. Market data is published for many obligations. Even the previously risk-free Treasury securities now have CDSS quotes – and they have gone up considerably in recent months. It is always the buyers’ responsibility to decide if the quoted prices make sense or not and how such quotes should be used in evaluating credit and negotiating lending opportunities in addition to whether or not to purchase this insurance.

Finally, the quality of the seller is a consideration. There is no good reason to buy fire insurance from someone that might not be able to pay for your building if it burns down. CDSS have been private party transactions and, as stated earlier, there have been solvency problems with some of the sellers of such instruments. There is now a move under way to create a central exchange for such transactions with both regulations governing the sellers, more standardized contracts and financial backing of the instruments from the exchange. Such an exchange will address both the transparency of the process and the efficiency of market prices.

Risk mitigation strategies (risk-based pricing, portfolio risk management, credit risk modeling, etc.) need to be carried out thoughtfully. If something sounds too good to be true, it deserves a deeper look. Your bank’s credit regimen may well be better at evaluating default probability than a marketplace that is prone to feed on its own fears. But, CDSS “insurance” quotes are an outside point of reference and an option to mitigate some credit risk…no pun intended.

Here are two interesting sources of information:

*  BNET Business Network

* Georgetown University -- Law Center

The problem in the 2005 to 2007 home lending frenzy was not just granting credit to anyone who applied. It was giving loans to everyone at essentially the same price range regardless of normal credit risk scrutiny.

While “selling” financial services may be largely an art form, appropriate risk-based pricing is more of a science.

Although the financial press seemed to have discovered sub-prime lending in the last year or so, such high-risk lending isn’t new at all. It has been (and is still being) done since finance and money were invented. And, importantly, sub-prime lending has been done profitably by many lenders all along.  The secret to their success, not surprisingly, has always been risk-based pricing -- even if they didn’t call it that until recent times.

Sub-prime funding has been available in many forms and from many sources. Providers range from venture capitalists to pawn shops. It includes pay-day lenders, micro loans, tax refund loans, consumer finance companies, and even dates to Shakespeare’s merchant of Venice.

We often hear complaints that the effective rates (prices) on loans from such sources are unfairly high and predatory. The cost of that credit is high, but so is the risk of that credit. Without these kinds of sources, and their high rates, there would not be any credit granted from for-profit sources to high-risk borrowers. 

Listed firms that regularly provide pay-day loans or cash advances to sub-prime borrowers have very high gross margins and very high credit charge-offs, compared to banks. They also have much higher risk-based capital (or equity) positions that range from 40 percent to 60 percent of their average assets. This risk-based capital burden is much higher than the 8 to 10 percent found at commercial banks. So the sub-prime lenders have a significantly larger capital cushion than banks. Most of these financial results and ratios are examples of successful risk management where the credit risks are identified, managed, priced and backed by sufficient capital.

Then…along came the rose-colored greed of the housing bubble that resulted in aggressive building and selling of homes, loan originations to all (no-down, no-income, no-assets, no-problem mortgages), securities packaging and attractive ratings, and global leveraged investing -- all by prime-oriented entities and all at prime-oriented prices. Well, obviously, it didn’t work.

Risk-based pricing of mortgages would have dissuaded many home buyers to begin with… but what would we have done with all of those shiny new homes? Realistic credit models (that took into account a full credit cycle and a huge proportion of sub-prime credits) would not have rated mortgage-backed securities as AAA. Regulators that were still focused on earnings correctness (the last major snafu) should have been looking into realistic net asset values. And highly compensated investment bankers, with 30-to-1 leverage ratios, would not have gone overboard with intuitively dodgy investments. Few of these players took risk management seriously.

The new danger is that banks are doing the whole thing in reverse. They are tightening lending standards -- which is, of course, a euphemism for shutting off credit. The danger has nothing to do with so-called credit standards. It’s the general over-reaction of shutting off credit to all borrowers, again, without regard to relative risk. The latest Federal Reserve Board survey of senior loan officers paints a picture of rapid tightening to record levels.

We feel that credit standards should always improve AND that loan pricing should always proportionately reflect risk-adjusted rates and terms. Opening the flood gates and then slamming them shut is a very pro-cyclical behavior pattern on the part of bankers that doesn’t reflect a measured approach, borrower-by-borrower, using reasonable risk management at the client relationship level.