Commercial Loan Pricing and Profitability Analysis

By Ferrari, Richard H. | Journal of Commercial Lending, March 1992 | Go to article overview

Commercial Loan Pricing and Profitability Analysis


Ferrari, Richard H., Journal of Commercial Lending


The proposed model outlined in this article is designed to be used by line lending officers and account managers as a practical decision-making tool for product pricing and other account management decisions. In accordance with this goal, the model follows the same format as a standard income statement, and the various lending expenses are grouped into component categories (see Figure 1). The model is designed so that its calculations are easily performed, the required information is readily obtainable, and its conceptual framework is easily understood.

Model Design

The structure of the model is designed so that each section provides useful component data regarding an account relationship. Many aspects of the model are self-explanatory, and sections can be completed at the user's discretion. The presentation is comprehensive, and for line use, the model can be streamlined to omit unnecessary details. Sections 10 through 18 are designed to provide account management data and can be used at the user's discretion.

Format of Analysis

The format of the analysis is designed to be easy to understand and work with. It also provides a framework and approach for use by line offciers in situations in which a full-scale written analysis is not possible or practical. The premise in the model's design is simple; if the line officers can't understand it, use it, and incorporate its principles into day-to-day thought processes, its utility and consequent impact on bank profitability will be limited.

Loan officers are certainly familiar with the model's income statement format, and most customers will also be familiar with it. The model groups lending costs into categories that can be compared to standard income statement categories in the following manner:

[TABULAR DATA OMITTED]

The component cost format provides a detailed breakdown of the loan costs and separates these costs into meaningful categories that are useful for analytical purposes. The format also highlights the relationships betwen component cost categories, and it facilitates the calculation component cost percentages and other data. A substantial amount of useful information regarding the overall lending relationship can be derived from the analysis of the component cost categories.

The basic approach of the model is geared toward standalone pricing, but the model is designed to be flexible enough to include profit or loss from as many aspects of a relationship as desired. The model is intended to be "loan specific" and designed to analyze a lending relationship while taking into consideration deposit balances supplied by the customer. Each aspect of a borrower's overall relationship should be analyzed separately in a unique product-specific analysis to determine the profit or loss for each aspect of the relationship.

Relevant profit or loss from the relationship not considered in the model's analysis fo the loan and deposit balances can be included in Section 6 of the model, page 36. All items included in Section 6 should be listed separately so that the impact of each aspect of the relationship can be segregated and easily observed. Profitability can be calculated several times, including or deleting various aspects of the overall relationship so that the impact of each element of the relationship on the total relationship's profitability can be readily observed.

Standalone and Relationship

Pricing Issues

The issues posed by the standalone and relationship pricing controversy are complex and appropriately settled by management discretion rather than mathematical formulas. Since a pure relationship pricing model considers all of a customer's income and expense items within a single analysis and computes a sinle profitability measure for the entire relationship, it can be overly ambitious and provide inaccurate, misleading, and, in the worst cases, meaningless results. …

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