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Financial
Lending Notes
November
28 , 2008
Winning
the War Against Margin Compression
In
today's challenging economic environment,
many community banks are fighting an uphill
battle to maintain acceptable margins
on their small business loans - you might
call it the "war against margin compression."
Winning
this war requires a comprehensive loan
pricing strategy. The first step: use
a pricing model to determine exactly what
you need to earn on each loan to cover
your costs and meet your profit objectives.
You can then create pricing agreements
that communicate these expectations to
borrowers and give you recourse to exercise
remedies for non-compliance if they don't
meet their obligations.
The
Importance of Pricing Agreements Because
When
lending to small businesses, most banks
give borrowers various pricing options
that include different combinations of
interest rates charged, fees assessed
and balances maintained. The bank, in
turn, must weigh these against its primary
expenses - cost of funds, direct product
costs, administrative overhead and risk
premium - to determine the profitability
of each loan.
To
ensure adequate margins, it's critical
that pricing models accurately integrate
each of these variables. The fact is,
it's usually difficult to impossible to
earn an acceptable rate of return on a
small business loan without a corresponding
deposit relationship (a scenario sometimes
referred to as a "hire of the dollar"
loan).
Similarly,
usage on a credit facility is a key determinant
of loan profitability. For example, if
a pricing agreement estimates 50 percent
usage of a line of credit, but a customer
uses 75 percent, this will effectively
lower the yield on the loan. To project
usage more accurately, look at a borrower's
historical performance - or if none is
available, work with the borrower to come
up with a realistic estimate.
A
typical scenario faced by many community
bankers might look something like this:
ABC Bank and XYZ customer agree to a loan
in which the interest rate will be 5.25
percent, the balance maintained will be
no less than $50,000 and the average percentage
of line usage will be 60 percent. However,
one year into the agreement, usage is
80 percent and balances on deposit are
only half.
Without
a formal pricing agreement, the banker's
only recourse is to try to re-price the
loan at maturity and make up the difference
over the next year. However, the bank
will always be playing catch-up, and this
approach may severely damage the customer
relationship.
Higher
Loan Spreads
Using sound loan pricing
models and implementing formal pricing
agreements can lift loan spreads by as
much as 30 to 50 basis points. In addition
to helping ensure profitability, pricing
agreements offer several other benefits
to the bank, such as:
- Enabling
the bank to price for risk, performance
and/or relationship (more details below)
- Giving
the bank recourse to exercise remedies
for non-compliance with loan terms and
covenants, including re-pricing the
loan before it matures and billing the
customer for the value ascribed to deposit
balances that do not materialize.
- Helping
the lender define a walk-away point
at which making a loan is not in the
best interest of the bank.
Pricing for
performance. Performance-based
pricing is based on providing incentives
to borrowers to provide financial statements
to the bank on a periodic basis. Such
statements enable the lender to monitor
key metrics and ratios that will help
him or her gauge the financial health
of the business, including some key performance
indicators that may be in the loan covenants
(such as leverage, liquidity and cash
flow coverage ratios).
If covenants are not met,
or if the borrower fails to provide the
statements within the time period allotted,
the pricing agreement should stipulate
what recourse is available to compensate
the bank for the potentially higher credit
risk and increased administrative costs
that will be incurred. On the flip side,
the agreement may be structured to enable
the business to receive a lower interest
rate if it maintains the proper ratios
and metrics.
Pricing for
relationship. Relationship
pricing is based on the idea of "bundling"
products and services for customers. This
can be a true win-win: Your customer may
benefit from a lower overall cost of banking,
while you benefit from a broader, deeper
relationship with each customer.
Facing
Competitive Realities
Of course, all of these
steps must be viewed in light of the competitive
realities of your marketplace. Strictly
enforcing the terms of a pricing agreement
without considering the circumstances
involved in each relationship may be akin
to throwing the baby out with the bathwater.
The last thing you want to do is chase
off a good customer into the arms of a
competitor, so consider each relationship
on a case-by-case basis If your competitive
environment doesn't allow you to be as
aggressive as you'd like with regard to
drafting and enforcing strict pricing
agreements, you should at least let customers
know you will be monitoring their credit
usage, deposit balance and other variables,
and that you expect them to abide by the
terms of the agreement. Such awareness
is often half the battle.
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Compliments
of:
Porter
Keadle Moore, LLP (PKM) is a full
service accounting firm based in
Atlanta, Georgia. PKM offers audit,
tax and systems services to clients
throughout the country. The firm
focuses its efforts on companies
registered with the Securities and
Exchange Commission (SEC), community
banks, the insurance industry, technology
and life sciences companies and
the real estate/construction industry. |
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