By: Tom Hannagan
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.
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:
- Either the bank is not getting paid for the risk it is incurring; or,
- 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.
Fortunately, loan pricing analysis is a scalable activity and possible for most any size bank. It is a smarter way of banking than a one-size-fits-all approach — even without considering the governance improvement.