How Competitive Can You Get and Still Make the Bank Risk-Adjusted Money? Bank Strategists May Be in for Some Discomfort over the Next 12 Months. after a Number of Years Chasing Market Share and Volume, Banks Are Now Facing Considerable Investor Pressure to Improve Risk Management and to Make Loans Only at a Price That Compensates the Bank for Credit Risk

By Elghanayan, Shahram | The RMA Journal, November 2007 | Go to article overview

How Competitive Can You Get and Still Make the Bank Risk-Adjusted Money? Bank Strategists May Be in for Some Discomfort over the Next 12 Months. after a Number of Years Chasing Market Share and Volume, Banks Are Now Facing Considerable Investor Pressure to Improve Risk Management and to Make Loans Only at a Price That Compensates the Bank for Credit Risk


Elghanayan, Shahram, The RMA Journal


Is there a middle ground that accepts the logic of risk-adjusted pricing but anchors it to the competitive nature of bank lending?

There is, provided that banks aim not to maximize the risk-adjusted price of each stand-alone deal, but to maximize enterprise risk-adjusted profits, taking account of strategic growth objectives.

This means that banks must:

1. Understand the different levers--in addition to price--that determine whether a lending decision is profitable or not (e.g., deal structure and relationship profitability).

2. Analyze the effect of different pricing and structuring de cisions on expected deal volume--a notion that is largely ignored in much of the risk-adjusted pricing literature.

3. Deploy all this information in predictive analytics that help the bank maximize enterprise-risk-adjusted profitability.

[ILLUSTRATION OMITTED]

What Levers Can We Use?

There are many different levers a loan officer can pull to align risk and reward. The most obvious levers are those that reduce risk--including adjustments to maturity, amortization structure, prepayment penalties, commitment size, and the amount and quality of the underlying collateral.

Other levers concern operating expenses and the wider customer relationship. For example, the distribution channel used to acquire customers, and the degree of touch and feel used to service them, influences expenses and, thereby, the risk-adjusted price the bank can offer.

Banks can also take into account the risk-adjusted profitability of the complete relationship. For example, they can incorporate into risk-adjusted return on capital (RAROC) calculations the noninterest fee income generated from deposits and cash management services.

The relative power of these various levers depends on the deal in question and the risk portfolio of the bank, but they can be very effective in allowing the bank to legitimately reduce its target risk-adjusted price for selected deals so that it can compete with local market prices.

Table 1 shows how the required risk-adjusted spread of loans in a typical commercial loan portfolio is driv en by maturity and loss given default. In this example, loss given default is itself driven by each transaction's loan-to-value ratio and the type of collateral.

In this illustrative portfolio, the credit spread ranges from as low as 0.26% for a one-year loan worth less than 60% of the marketable securities posted as collateral, to 1.72% for a nine-year loan worth more than 90% of property/equipment collateral.

What Effect Do Levers and Pricing Have on Acceptance Rates?

Business leaders aren't only interested in how to make an individual deal profitable on a risk-adjusted basis. They are also interested in their chance of winning the deal at any particular pricing point--and in how they can best secure other, similar deals.

Quite right, too, because business volumes matter even in the risk-adjusted world. After all, as a business leader, would you be more interested in 10 deals with 20% RAROC and 60% chance of acceptance, or 10 deals with 21% RAROC and 6% chance of acceptance? However, traditional approaches to risk-adjusted pricing often don't take this critical factor of acceptance rates into account. They assume that higher RAROC is always better.

Once banks have put in place a way to make accurate trade-offs between deal structure and an appropriate risk-adjusted price--usually based on an economic profit model--the next step should be to analyze likely acceptance/rejection rates.

In order to incorporate acceptance rates and their volume effects into the decision-making process, we need to understand what happens to the chance of the deal being accepted as different levers are pulled and as the offered price is raised or lowered.

For example, Table 2 uses the same illustrative data as Table 1, but maps out the bank's risk-adjusted pricing (making some assumptions about expenses, etc. …

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How Competitive Can You Get and Still Make the Bank Risk-Adjusted Money? Bank Strategists May Be in for Some Discomfort over the Next 12 Months. after a Number of Years Chasing Market Share and Volume, Banks Are Now Facing Considerable Investor Pressure to Improve Risk Management and to Make Loans Only at a Price That Compensates the Bank for Credit Risk
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