Risk-Based Pricing

--by Tom Hannagan

I was hoping someone would ask about these risk management terms…and someone did. The obvious answer is that the “A” and the “O” are reversed. But, there’s more to it than that. First, let’s see how the acronyms were derived. RORAC is Return on Risk-Adjusted Capital. RAROC is Risk-Adjusted Return on Capital. Both of these five-letter abbreviations are a step up from ROE.

This is natural, I suppose, since ROE, meaning Return on Equity of course, is merely a three-letter profitability ratio. A serious breakthrough in risk management and profit performance measurement will have to move up to at least six initials in its abbreviation. Nonetheless, ROE is the jumping-off point towards both RORAC and RAROC.

ROE is generally Net Income divided by Equity, and ROE has many advantages over Return on Assets (ROA), which is Net Income divided by Average Assets. I promise, really, no more new acronyms in this post.

The calculations themselves are pretty easy. ROA tends to tell us how effectively an organization is generating general ledger earnings on its base of assets.  This used to be the most popular way of comparing banks to each other and for banks to monitor their own performance from period to period. Many bank executives in the U.S. still prefer to use ROA, although this tends to be those at smaller banks.

ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or risk-based capital. This has gained in popularity for several reasons and has become the preferred measure at medium and larger U.S. banks, and all international banks. One huge reason for the growing popularity of ROE is simply that it is not asset-dependent. ROE can be applied to any line of business or any product. You must have “assets” for ROA, since one cannot divide by zero. Hopefully your Equity account is always greater than zero. If not, well, lets just say it’s too late to read about this general topic.

The flexibility of basing profitability measurement on contribution to Equity allows banks with differing asset structures to be compared to each other.  This also may apply even for banks to be compared to other types of businesses. The asset-independency of ROE can also allow a bank to compare internal product lines to each other. Perhaps most importantly, this permits looking at the comparative profitability of lines of business that are almost complete opposites, like lending versus deposit services. This includes risk-based pricing considerations. This would be difficult, if even possible, using ROA.

ROE also tells us how effectively a bank (or any business) is using shareholders equity. Many observers prefer ROE, since equity represents the owners’ interest in the business. As we have all learned anew in the past two years, their equity investment is fully at-risk. Equity holders are paid last, compared to other sources of funds supporting the bank. Shareholders are the last in line if the going gets rough. So, equity capital tends to be the most expensive source of funds, carrying the largest risk premium of all funding options. Its successful deployment is critical to the profit performance, even the survival, of the bank. Indeed, capital deployment, or allocation, is the most important executive decision facing the leadership of any organization.

So, why bother with RORAC or RAROC? In short, it is to take risks more fully into the process of risk management within the institution. ROA and ROE are somewhat risk-adjusted, but only on a point-in-time basis and only to the extent risks are already mitigated in the net interest margin and other general ledger numbers. The Net Income figure is risk-adjusted for mitigated (hedged) interest rate risk, for mitigated operational risk (insurance expenses) and for the expected risk within the cost of credit (loan loss provision).

The big risk management elements missing in general ledger-based numbers include: market risk embedded in the balance sheet and not mitigated, credit risk costs associated with an economic downturn, unmitigated operational risk, and essentially all of the strategic risk (or business risk) associated with being a banking entity. Most of these risks are summed into a lump called Unexpected Loss (UL). Okay, so I fibbed about no more new acronyms. UL is covered by the Equity account, or the solvency of the bank becomes an issue.

RORAC is Net Income divided by Allocated Capital. RORAC doesn’t add much risk-adjustment to the numerator, general ledger Net Income, but it can take into account the risk of unexpected loss. It does this, by moving beyond just book or average Equity, by allocating capital, or equity, differentially to various lines of business and even specific products and clients. This, in turn, makes it possible to move towards risk-based pricing at the relationship management level as well as portfolio risk management.  This equity, or capital, allocation should be based on the relative risk of unexpected loss for the different product groups. So, it’s a big step in the right direction if you want a profitability metric that goes beyond ROE in addressing risk. And, many of us do.

RAROC is Risk-Adjusted Net Income divided by Allocated Capital. RAROC does add risk-adjustment to the numerator, general ledger Net Income, by taking into account the unmitigated market risk embedded in an asset or liability. RAROC, like RORAC, also takes into account the risk of unexpected loss by allocating capital, or equity, differentially to various lines of business and even specific products and clients. So, RAROC risk-adjusts both the Net Income in the numerator AND the allocated Equity in the denominator. It is a fully risk-adjusted metric or ratio of profitability and is an ultimate goal of modern risk management. 

So, RORAC is a big step in the right direction and RAROC would be the full step in management of risk. RORAC can be a useful step towards RAROC. RAROC takes ROE to a fully risk-adjusted metric that can be used at the entity level.  This  can also be broken down for any and all lines of business within the organization. Thence, it can be further broken down to the product level, the client relationship level, and summarized by lender portfolio or various market segments. This kind of measurement is invaluable for a highly leveraged business that is built on managing risk successfully as much as it is on operational or marketing prowess.

Please refer to my blogs five and six for more information about ROE and the term “unpredictable variability:”  http://www.decisionanalyticsblog.experian.com/blog/risk-based-pricing-2

RORAC versus RAROC ?
--by Tom Hannagan

I was hoping someone would ask about these risk management terms…nd someone did. The obvious answer is that the “A” and the “O” are reversed. But, there’s more to it than that. First, let’s see how the acronyms were derived. RORAC is Return on Risk-Adjusted Capital. RAROC is Risk-Adjusted Return on Capital. Both of these five-letter abbreviations are a step up from ROE. This is natural I suppose since ROE, meaning Return on Equity of course, is merely a three-letter profitability ratio. A serious breakthrough in risk management and profit performance measurement will have to move up to at least six initials in its abbreviation. Nonetheless, ROE is the jumping-off point towards both RORAC and RAROC.

ROE is generally Net Income divided by Equity, and ROE has many advantages over Return on Assets (ROA), which is Net Income divided by Average Assets. I promise, really, no more new acronyms in this post.

The calculations themselves are pretty easy. ROA tends to tell us how effectively an organization is generating general ledger earnings on its base of assets.  This used to be the most popular way of comparing banks to each other and for banks to monitor their own performance from period to period. Many bank executives in the U.S. still prefer to use ROA, although this tends to be those at smaller banks.

ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or risk-based capital. This has gained in popularity for several reasons and has become the preferred measure at medium and larger U.S. banks, and all international banks. One huge reason for the growing popularity of ROE is simply that it is not asset-dependent. ROE can be applied to any line of business or any product. You must have “assets” for ROA, since one cannot divide by zero. Hopefully your Equity account is always greater than zero. If not, well, lets just say it’s too late to read about this general topic.

The flexibility of basing profitability measurement on contribution to Equity allows banks with differing asset structures to be compared to each other.  This also may apply even for banks to be compared to other types of businesses. The asset-independency of ROE can also allow a bank to compare internal product lines to each other. Perhaps most importantly, this permits looking at the comparative profitability of lines of business that are almost complete opposites, like lending versus deposit services. This includes risk-based pricing considerations. This would be difficult, if even possible, using ROA.

ROE also tells us how effectively a bank (or any business) is using shareholders equity. Many observers prefer ROE, since equity represents the owners’ interest in the business. As we have all learned anew in the past two years, their equity investment is fully at-risk. Equity holders are paid last, compared to other sources of funds supporting the bank. Shareholders are the last in line if the going gets rough. So, equity capital tends to be the most expensive source of funds, carrying the largest risk premium of all funding options. Its successful deployment is critical to the profit performance, even the survival, of the bank. Indeed, capital deployment, or allocation, is the most important executive decision facing the leadership of any organization.

So, why bother with RORAC or RAROC? In short, it is to take risks more fully into the process of risk management within the institution. ROA and ROE are somewhat risk-adjusted, but only on a point-in-time basis and only to the extent risks are already mitigated in the net interest margin and other general ledger numbers. The Net Income figure is risk-adjusted for mitigated (hedged) interest rate risk, for mitigated operational risk (insurance expenses) and for the expected risk within the cost of credit (loan loss provision).

The big risk management elements missing in general ledger-based numbers include: market risk embedded in the balance sheet and not mitigated, credit risk costs associated with an economic downturn, unmitigated operational risk, and essentially all of the strategic risk (or business risk) associated with being a banking entity. Most of these risks are summed into a lump called Unexpected Loss (UL). Okay, so I fibbed about no more new acronyms. UL is covered by the Equity account, or the solvency of the bank becomes an issue.

RORAC is Net Income divided by Allocated Capital. RORAC doesn’t add much risk-adjustment to the numerator, general ledger Net Income, but it can take into account the risk of unexpected loss. It does this, by moving beyond just book or average Equity, by allocating capital, or equity, differentially to various lines of business and even specific products and clients. This, in turn, makes it possible to move towards risk-based pricing at the relationship management level as well as portfolio risk management.  This equity, or capital, allocation should be based on the relative risk of unexpected loss for the different product groups. So, it’s a big step in the right direction if you want a profitability metric that goes beyond ROE in addressing risk. And, many of us do.

RAROC is Risk-Adjusted Net Income divided by Allocated Capital. RAROC does add risk-adjustment to the numerator, general ledger Net Income, by taking into account the unmitigated market risk embedded in an asset or liability. RAROC, like RORAC, also takes into account the risk of unexpected loss by allocating capital, or equity, differentially to various lines of business and even specific products and clients. So, RAROC risk-adjusts both the Net Income in the numerator AND the allocated Equity in the denominator. It is a fully risk-adjusted metric or ratio of profitability and is an ultimate goal of modern risk management. 

So, RORAC is a big step in the right direction and RAROC would be the full step in management of risk. RORAC can be a useful step towards RAROC. RAROC takes ROE to a fully risk-adjusted metric that can be used at the entity level.  This  can also be broken down for any and all lines of business within the organization. Thence, it can be further broken down to the product level, the client relationship level, and summarized by lender portfolio or various market segments. This kind of measurement is invaluable for a highly leveraged business that is built on managing risk successfully as much as it is on operational or marketing prowess.

Please refer to my blogs five and six for more information about ROE and the term “unpredictable variability:”  http://www.decisionanalyticsblog.experian.com/blog/risk-based-pricing-2

Some articles that I’ve come across recently have puzzled me.

In those articles, authors use the terms “monetary base” and “money supply” synonymously -- but those terms are actually very different.

The monetary base (currency plus Fed deposits) is a much smaller number than the money supply (M1). The huge change in the “base”, which the Fed did affect by adding $1T or so to infuse a lot of quick liquidity into the financial system late in 2007/early 2008, does not necessarily impact M1 (which includes the base plus all bank demand deposits) all that much in the short-term, and may impact it even less in the intermediate-term if the Fed reduces its holdings of securities.  Some are correct, of course, in positing that a rotation out of securities by the Fed will tend to put pressure on market rates.

Some are equivocating the 2007 liquidity moves of the Fed, with a major monetary policy change. When the capital markets froze due to liquidity and credit risks in August/September of 2007, monetary policy was not the immediate risk, or even a consideration. Without the liquidity injections in that timeframe, monetary policy would have become less than an academic consideration.

Tying the “constrained” (which actually was a slowdown in growth of) bank lending to bank reserves on account at the Fed I don’t think their Fed reserve balance was ever an issue for lending. Banks slowed down lending because the level of credit risk increased. Borrowers were defaulting. Bank deposit balances were actually increasing through the financial crisis. [See my Feb 26 and March 5 blogs] So, loan funding, at least from deposit sources was not the problem for most banks. Of course, for a small number of banks that had major securities losses, capital was being lost and therefore not available to back increased lending. But demand deposit balances were growing.

Some authors are linking bank reserves to the ability of banks to raise liabilities, which makes little sense. Banks’ respective abilities to gather demand deposits (insured by the FDIC, at no small expense to the banks) was always wide open, and their ability to borrow funds is much more a function of asset quality (or net asset value) more than it relates their relatively small reserve balances at the Fed.

These actions may result in high inflation levels and high interest rates -- but it will be because of poor Fed decisions in the future, not because of the Fed’s action of last year. It will also depend on whether the fiscal (deficit) actions of the government are: 1) economically productive and 2) tempered to a recovery, or not. I think that is a bigger macro-economic risk than Fed monetary policy.

In fact, the only way bank executives can wisely manage the entity over an extended timeframe is to be able to direct resources across all possibilities on a risk-adjusted basis. The question isn’t whether risk-based pricing is appropriate for all lines of business, but rather how might or should it be applied.

For commercial lending into the middle and corporate markets, there is enough money at stake to warrant evaluating each loan and deposit, as well as the status of the client relationship, on an individual basis. This means some form of simulation modeling by relationship managers on new sales opportunities (including renewals) and the model’s ready access to current data on all existing pieces of business with each relationship. [See my April 24 blog entry.]

This process also implies the ability to easily aggregate the risk-return status of a group of related clients and to show lenders how their portfolio of accounts is performing on a risk-adjusted basis. This type of model-based analysis needs to be flexible enough to handle differing loan structures, easy for a lender to use and quick. The better models can perform such analysis in minutes. I’ve discussed the elements of such models in earlier posts.

But, with small business and consumer lending there are other considerations that come into play. The principles of risk-based pricing are consistent across any loan or deposit. With small business lending, the process of selling, negotiating, underwriting and origination is significantly more streamlined and under some form of workflow control.

With consumer lending, there are more regulations to take into account and there are mass marketing considerations driving the “sales” process.

Agreement covers what the new owner wants now and may decide it wants in the future. This a form of strategic business risk that comes with accepting the capital infusion from this particular source.
 

• Price your transactions during the pre-sales process for differential risk (for all risk types).
• Sell services to your clients through relationship management based on risk-adjusted profit.
• Consider looking at risk-based lender performance metrics in your financial institution.
• Benchmark your entity performance over time.
• Benchmark your entity performance and compare that to your peers.

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.

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

My colleague, Prince Varma, Senior Client Partner -- Portfolio Growth and Client Management, shares his advice on the best practices for portfolio risk management in these trying times.

Boy; this is an interesting time.

Banks today are at a critical threshold -- the biggest question that they are trying to answer is, "How do we continue to grow -- or at least avoid contracting -- without sacrificing profitability or credit quality?”
The urge to overcompensate, or engage in ultra conservative lending practices, must be resisted.  That said, we are already seeing a trend in which mid-sized and regional lenders are abandoning mid-tier credit.
This vacuum is being filled by community banks and credit unions which are implementing aggressive risk-based pricing programs in order to target the small business market.

These organizations are also introducing "safe and secure" campaigns that specifically target existing clients of banks in the news -- and attempting to entice those clients to switch over.

We are strongly urging banks to engage in an analysis of their existing portfolios in order to pinpoint opportunities for expanding their relationships with existing key clients.

Many senior executives are expressing apprehension about undertaking new projects given current levels of uncertainty.  Our best advice is two-fold.. First, focus on identifying those areas where process remediation will have long term and sustained value. Second, do not allow uncertainty to paralyze your internal improvement efforts.  Strong business cases lead to good decisions; don't let fear and apprehension cloud what you know needs to be done.
 

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 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 2

Return on Equity (ROE)
ROE is the risk-adjusted profit divided by the equity amount associated with the loan in question.

ROE =      Risk-adjusted profit
                Equity amount of the loan

There are two large advantages to using ROE. One, you can use it to compare profit performance across asset-based and non-asset-based products. This can’t be done with ROA – if there’s no “A”, you can’t create the ratio. This seems to be a crucial consideration if you are serious about cross-selling non-asset-based products (such as deposits and a long list of non-credit financial services) and if you are serious about being a truly client relationship oriented organization.

Second, by using ROE you have the possibility of risk-adjusting the amount of equity used in the denominator of the calculation.  Adjusting the equity amount based on risk, in a credible manner, creates risk-adjusted ROE, or what is referred to as risk adjusted return on capital (RAROC). The equity amount applied to the loan represents all of the remaining risk or unexpected loss (UL).instance that we did not account for in the steps that got us to the risk-adjusted profit result. RAROC, or risk-adjusted ROE, is a fully risk-adjusted representation of relative value. This level of risk-based performance measurement also has the advantage of relating pricing and relationship management activities to the bank’scapital management process.

So far, we have covered several of the key parts of how risk-based pricing can work. In doing so, we have discussed how the various elements involved in pricing relate to the bank’s books and policies. The loan balance, rate and fee data relates to the banks 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 ALSO and in IRR management processes. The cost of credit risk is related to 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 risk posture and its capital sufficiency policies.

I stated earlier that “Risk-based pricing analysis is a product-level microcosm of risk-based bank performance”. It is that and more. In addition to pricing’s linkage to financial figures and results, risk-based pricing should also be a reflection of the bank’s most critical risk management policies and governance processes.

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.
 

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.