Risk-based pricing

Thomas A. Hannagan – Senior Client Partner, Experian Decision Analytics

Tom Hannagan is a senior client partner with Experian Decision Analytics. He specializes in advising bank management on enhanced profitability strategies in commercial lending -- through better loan pricing simulation and more profit-oriented relationship management.

He has assisted banks with the successful deployment of risk-based pricing and relationship management tools, along with summary reporting of their portfolio performance.

His goals for this blog are to discuss assessing, planning and deploying risk-adjusted and systematic commercial loan pricing methodology and other ways to perform risk management for your organization.

Hannagan is a graduate of the University of Illinois with a Bachelors degree in Finance and Accounting and a Masters degree in Economics. H grew up Champaign, IL and enjoys playing golf and sports car racing.

Amanda Roth -- Analytics and Business Consulting Manager, Experian Decision Analytics

Amanda Roth is the analytics and business consulting manager for Experian Decision Analytics. She is responsible for three of the group’s solutions:  Fast Start,^SM Performance Insight^SM and risk-based pricing.  In addition, she leads a team of consultants focused on providing core product solutions to the small and mid-tier markets.

Joining Experian in 2002, Roth’s expertise is in scoring, risk-based pricing, credit policy and procedure, bankruptcy and scorecard monitoring.  She also has extensive experience in commercial lending, having a prior background as a commercial loan underwriter, commercial portfolio manager, commercial loan officer trainer and pricing and profitability specialist. 

Roth earned a Bachelor of Science Degree in business from Wake Forest University.

--by Amanda Roth

Last week, we discussed how pricing with competition is important to ensure sound decision practices are being implemented in the domains of loan pricing and profitability.  The extreme of pricing too high for the market can obviously be detrimental to your organization.  The other extreme can be just as dangerous.

Pricing for your profitability, regardless of what the competition is charging in your area, has a few potential issues associated with it regarding management of risk.  For example, the statistics state you can charge 5 percent in your “A” tier and still be profitable, but the competition is charging 7.5 percent for the same tier.  You may be thinking that by offering 5 percent you will attract the “best of the best” to your organization.  However, what your statistics may not be showing you is the risk outside of your applicant base.  If you significantly change the customers you are bringing in, does your risk increase as well, ultimately increasing the cost associated with each loan?   Increased costs will reduce or even eliminate the profitability you had expected.

A second potential issue is setting the expectation within the marketplace.  It is often understood with the consumers that when changes occur to the interest rate at the federal level, there will be changes at their local financial institution.  These changes are often very small.  By undercutting your competition by such an extreme amount, your customers may question any attempts to raise rates more than 50bp, if you do experience increased costs as a result of the earlier situation or any other factors.  A safer strategy would be to charge between 6.5 percent and 7 percent, which allows you to obtain some of the best customers, ensure stability within the market, and take advantage of additional profitability while it is available.  This is definitely a winning strategy for all -- and an important consideration as you develop your portfolio risk management objectives.

--by Amanda Roth

Doesn’t that sound strange: Pricing WITH competition?  We are familiar with the sayings of pricing for competition and pricing to be competitive, but did you ever think you would need to price with competition?  When developing a risk-based pricing program, it is important to make sure you do not price against the competition in any extreme.  Some clients decide they want to price lower than the competition regardless of how it impacts their profitability.  However, others price only for profitability without any respect to their competition.  As we discussed last week, risk-based pricing is 80 percent statistics, but 20 percent art -- and competition is part of the artistic portion.

Once you complete your profitability analysis (refer to 12/28/2009 posting), you will often need to massage the final interest rate to be applied to loan applications.  If the results of the analysis are that your interest rate needs to be 8.0 percent in your “A” tier to guarantee profitability, but your competition is only charging 6.0 percent, there could be a problem if you go to market with that pricing strategy.  You will probably experience most of your application volume coming to an end, especially those customers with low risk that can obtain the best rates of a lender.  Creativity is the approach you must take to become more competitive while still maintaining profitability.  It may be an approach of offering the 6.0 percent rate to the best 10 percent of your applicant base only, while charging slightly higher rates in your “D” and “E” tiers. 

Another option may be that you need to look internally at processing efficiencies to determine if there is a way to decrease the overall cost associated with the decision process.  Are there decision strategies in place that are creating a manual decision when more could be automated?  Pricing higher than the market rate can be detrimental to any organization, therefore it is imperative to apply an artistic approach while maintaining the integrity of the statistical analysis.

Join us next week to continue this topic of pricing with competition which is, again, an important consideration when developing a risk-based pricing program.

 

--by Tom Hannagan

Apparently my last post on the role of risk management in the pricing of deposit services hit some nerve ends. That’s good. The industry needs its “nerve ends” tweaked after the dearth of effective risk management that contributed to the financial malaise of the last couple of years. Banks, or any business, can prosper by simply following their competitors’ marketing strategies and meeting or slightly undercutting their prices. The actions of competitors are an important piece of intelligence to consider, but not necessarily optimal for your bank to copy.

One question is regarding the “how-to” behind risk-based pricing (RBP) of deposits. The answer has four parts. Let’s see. First, because of the importance and size of the deposit business (yes, it’s a line of business) as a funding source, one needs to isolate the interest rate risk. This is done by transfer pricing, or in a sense, crediting the deposit balances for their marginal value as an offset to borrowing funds. This transfer price has nothing to do with the earnings credit rate used in account analysis – that is a merchandising issue used to generate fee income. Fees, resulting from account analysis, when not waived, affect the profitability of deposit services, but are not a risk element.

Two things are critical to the transfer of funding credit: 1) the assumptions regarding the duration, or reliability of the deposit balances and 2) the rate curve used to match the duration. Different types of deposit behave differently based on changes in rates paid. Checking account deposit funds tend to be very loyal or “sticky” - they don’t move around a lot (or easily) because of rate paid, if any. At the other extreme, time deposits tend to be very rate-sensitive and can move (in or out) for small incremental gains. Savings, money market and NOW accounts are in-between.

Since deposits are an offset (ultimately) to marginal borrowing, just as loans might (ultimately) require marginal borrowing, we recommend using the same rate curve for both asset and liability transfer pricing. The money is the same thing on both sides of the balance sheet and the rate curve used to fund a loan or credit a deposit should be the same. We believe this will help, greatly, to isolate IRR. It is also seems more fair when explaining the concept to line management.

Secondly, although there is essentially no credit risk associated with deposits, there is operational risk. Deposit make up most of the liability side of the balance sheet and therefore the lion’s share of institutional funding. Deposits are also a major source of operational expense. The mitigated operational risks such as physical security, backup processing arrangements, various kinds of insurance and catastrophe plans, are normal expenses of doing business and included in a bank’s financial statements. The costs need to be broken down by deposit category to get a picture of the risk-adjusted operating expenses.

The third major consideration for analyzing risk-adjusted deposit profitability is its revenue contribution. Deposit-related fee income can be a very significant number and needs to be allocated to particular deposit category that generates this income. This is an important aspect of the return, along with the risk-adjusted funding value of the balances. It will vary substantially for various deposit types. Time deposits have essentially zero fee income, whereas checking accounts can produce significant revenues.

The fourth major consideration is capital. There are unexpected losses associated with deposits that must be covered by risk-based capital – or equity. The unexpected losses include: unmitigated operational risks, any error in transfer pricing the market risk, and business or strategic risk. Although the unexpected losses associated with deposit products are substantially less than found in the lending products, they needs to be taken into account to have a fully risk-adjusted view. It is also necessary to be able to compare the risk-adjusted profit and profitability of such diverse services as found within banking. 

Enterprise risk management needs to consider all of the lines of business, and all of the products of the organization, on a risk-adjusted performance basis. Otherwise it is impossible to decide on the allocation of resources, including precious capital. Without this risk management view of deposits (just as with loans) it is impossible to price the services in a completely knowledgeable fashion. Good entity governance, asset and liability posturing, and competent line of business management, all require more and better risk-based profit considerations to be an important part of the intelligence used to optimally price deposits.

 --by Amanda Roth

The reality of risk-based pricing is that there is not one “end all be all” way of determining what pricing should be applied to your applicants.  The truth is that statistics will only get you so far.  It may get you 80 percent of the final answer, but to whom is 80 percent acceptable?  The other 20 percent must also be addressed.

I am specifically referring to those factors that are outside of your control.  For example, does your competition’s pricing impact your ability to price loans?  Have you thought about how loyal customer discounts or incentives may contribute to the success or demise of your program?  Do you have a sensitive population that may have a significant reaction to any risk-base pricing changes?  These questions must be addressed for sound pricing and risk management.

Over the next few weeks, we will look at each of these questions in more detail along with tips on how to apply them in your organization.  As the new year is often a time of reflection and change, I would encourage you to let me know what experiences you may be having in your own programs.  I would love to include your thoughts and ideas in this blog.

 

--by Tom Hannagan

This blog has often discussed many aspects of risk-adjusted pricing for loans. Loans, with their inherent credit risk, certainly deserve a lot of attention when it comes to risk management in banking. But, that doesn’t mean you should ignore the risk management implications found in the other product lines. Enterprise risk management needs to consider all of the lines of business, and all of the products of the organization. This would include the deposit services arena.

Deposits make up roughly 65 percent to 75 percent of the liability side of the balance sheet for most financial institutions, representing the lion’s share of their funding source. This is a major source of operational expense and also represents most of the bank’s interest expense. The deposit activity has operational risk, and this large funding source plays a huge role in market risk – including both interest rate risk and liquidity risk. It stands to reason that such risks are considered when pricing deposit services. Unfortunately it is not always the case. Okay, to be honest, it’s too rarely the case.

This raises serious entity governance questions. How can such a large operational undertaking, not withstanding the criticality of the funding implications, not be subjected to risk-based pricing considerations? We have seen warnings already that the current low interest rate environment will not last forever. When the economy improves and rates head upwards, banks need to understand the bottom line profit implications. Deposit rate sensitivity across the various deposit types is a huge portion of the impact on net interest income. Risk-based pricing of these services should be considered before committing to provide them.

Even without the credit risk implications found on the loan side of the balance sheet, there is still plenty of operational and market risk impact that needs to be taken into account from the liability side. When risk management is not considered and mitigated as part of the day-to-day management of the deposit line of business, the bank is leaving these risks completely to chance. This unmitigated risk increases the portion of overall risk that is then considered to be “unexpected” in nature and thereby increases the equity capital required to support the bank.

--by Amanda Roth

The final level of validation for your risk-based pricing program is to validate for profitability.  Not only will this analysis build on the two previous analyses, but it will factor in the cost of making a loan based on the risk associated with that applicant.  Many organizations do not complete this crucial step.  Therefore, they may have the applicants grouped together correctly, but still find themselves unprofitable.

The premise of risk-based pricing is that we are pricing to cover the cost associated with an applicant.  If an applicant has a higher probability of delinquency, we can assume there will be additional collection costs, reporting costs, and servicing costs associated with keeping this applicant in good standing.  We must understand what these cost may be, though, before we can price accordingly.  Information of this type can be difficult to determine based on the resources available to your organization.  If you aren’t able to determine the exact amount of time and costs associated with the different loans at different risk levels, there are industry best practices that can be applied.

Of primary importance is to factor in the cost to originate, service and terminate a loan based on varying risk levels.  This is the only true way to validate that your pricing program is working to provide profitability to your loan portfolio.

--by Amanda Roth

To refine your risk-based pricing another level, it is important to analyze where your tiers are set and determine if they are set appropriately.  (We find many of the regulators / examiners are looking for this next level of analysis.)

This analysis begins with the results of the scoring model validation.  Not only will the distributions from that analysis determine if the score can predict between good and delinquent accounts, but it will also highlight which score ranges have similar delinquency rates, allowing you to group your tiers together appropriately.  After all, you do not want to have applicants with a 1 percent chance of delinquency priced the same as someone with an 8 percent chance of delinquency.  By reviewing the interval delinquency rates as well as the odds ratios, you should be able to determine where a significant enough difference occurs to warrant different pricing.

You will increase the opportunity for portfolio profitability through this analysis, as you are reducing the likelihood that higher risk applicants are receiving lower pricing.  As expected, the overall risk management of the portfolio will increase when a proper risk-based pricing program is developed.

In my next post we will look the final level of validation which does provide insight into pricing for profitability.

 

--by Amanda Roth

As discussed earlier, the validation of a risk based-pricing program can mean several different things. Let’s break these options down.

The first option is to complete a validation of the scoring model being used to set the pricing for your program. This is the most basic validation of the program, and does not guarantee any insight on loan profitability expectations. A validation of this nature will help you to determine if the score being used is actually helping to determine the risk level of an applicant. 

This analysis is completed by using a snapshot of new booked loans received during a period of time usually 18–24 months prior to the current period. It is extremely important to view only the new booked loans taken during the time period and the score they received at the time of application. By maintaining this specific population only, you will ensure the analysis is truly indicative of the predictive nature of your score at the time you make the decision and apply the recommended risk-base pricing.

By analyzing the distribution of good accounts vs. the delinquent accounts, you can determine if the score being used is truly able to separate these groups. Without acceptable separation, it would be difficult to make any decisions based on the score models, especially risk-based pricing. 

Although beneficial in determining whether you are using the appropriate scoring models for pricing, this analysis does not provide insight into whether your risk-based pricing program is set up correctly or not. Please join me next time to take a look at another option for this analysis.

--by Amanda Roth

During the past few months, we have been hearing from our clients that there is a renewed focus from the regulators/examiners on risk-based pricing strategies.  Many are requesting a validation of the strategies to ensure acceptable management of risk through proper loan pricing and profitability. 

The question we often receive is “what exactly are they requiring?” In some cases, a simple validation of the scoring models used in the strategies will be sufficient.  However, many require a deeper dive into where the risk bands are set and how pricing is determined.  They are looking to see if applicants of the same risk level are being priced the same, and when the price is increased from tier A to B, for example.  Also, they're checking that the change in rate is in line with the change in risk.  Some are even requiring a profitability analysis to show the expected impact of delinquency, loss and operating expense on net revenue for the product, tier and total portfolio.

We'll address each of these analyses in more detail over the next few weeks.  In the meantime, what are you hearing from your regulators/examiners?

 

--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

Much of the discussion on Capitol Hill revolves around sufficient risk-based capital and the derivation of how much tier 1 capital and/or common equity capital is appropriate. Most of our solution offerings and consulting services address various aspects of risk management, from targeting prospective customers, through loan origination and risk-based pricing, to ongoing relationship management and portfolio monitoring. We have been addressing risk management with our clients long before the recent financial and economic crises. We are both ready and able to assist new and existing clients in many ways: to effectively and efficiently address the management of credit and other risks and to develop strategies that offer optimal risk-based profit performance. We are always monitoring regulatory developments and, as always, will strive to assist our clients with new best practices to operate as effectively as possible under any new regulations affecting risk management policies, processes and governance responsibilities.

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.
 

• Risk isn't evident in the general ledger
• Risk certainly DOES exist
• Risk needs to be identified, measured and managed
• Without (in spite of) Generally Accepted Accounting Practices, banks need other risk analytics
• Risk measures need to assist bankers with product level and relationship-level pricing and profitability

• 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.

Beyond the financial risk management considerations related to a bank’s capital, which would be directly impacted by Troubled Asset Relief Program (TARP) participation, it should be clear that TARP also involves business (or strategic) risk. We have spoken in the past of several major categories of risk: credit risk, market risk, operational risk and business risk. Business risk includes a variety of risks associated with the outcomes from strategic decision making, corporate governance considerations, executive behavior (for better or worse), management succession events (Apple and Steve Jobs, for instance) or other leadership occurrences that may affect the performance and financial viability of the business.

Aside from the monetary impact on the bank’s capital position, TARP involves a new capital securities owner being in the mix. And, with a roughly 20 percent infusion of added tier one capital, we are almost always talking about a very large, new owner relative to existing shareholders. The United States Department of the Treasury is the investor or holder of the newly issued preferred stock and warrants. The Treasury Department says it does not seek voting rights, but none-the-less has gotten them in at least some cases. The real “kicker” is embedded in the Treasury’s Securities Purchase Agreement – Standard Form. 

The most interesting clause, that appears to represent a very open-ended business risk to management decision making, is one relatively small paragraph, named Amendment, in the middle of Article V - Miscellaneous, just ahead of governing law (which is federal law, backed up by the laws of the State of New York).

Amendment begins normally enough, requiring the usual signed agreement of each party, but then states: “provided that the Investor may unilaterally amend any provision of this Agreement to the extent required to comply with any changes after the Signing Date in applicable federal statutes.” Wow. My reading of this is that if in the future Congress enacts anything that Treasury finds applicable to any aspect of the previously signed TARP Agreement, the bank is bound to go along. Regardless of whether the Treasury negotiates any voting rights, once the TARP Agreement is executed by the bank, management is not only bound by what is in the document to begin with, it is subject to future federal law as long as the TARP shares are held by the government. As a result, many banks have said no thank you to TARP.

At least four banks have recently paid back $340 million to repurchase the government’s shares. And, apparently another bank has offered to pay back $1 billion but, according to Andrew Napolitano at Fox Business Channel, the offer was turned down and the bank was threatened with adverse consequences if it persisted in its attempt to get out.

More pointed and public, and much larger in size, is the dance taking place now between Chrysler Corporation, Fiat, the UAW, four lead lenders and, you guessed it, the federal government. The secured loans in question total almost $7 billion and the government wants J.P. Morgan Chase, Goldman Sachs, Citicorp and Morgan Stanley to exchange $5 billion of the loans for Chrysler stock. The banks know they would do better (for their shareholders) by selling off Chryslers assets. This is an example of why bankruptcy exists. The stakes are large and so is the business risk of the influence from the government. It will be interesting to see how things turn out.

So, this new major owner does have a voice. If Congress wants certain lending volumes or terms, or they want certain compensation levels, it needs to be enacted into federal law. Short of having to pass a law, there is the implied threat of the big stick in the TARP agreement. The Purchase 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.

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.