The True Value of Relationship Pricing
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The document discusses key components of loan and relationship profitability in banking, emphasizing the importance of managing interest rates, costs, and risks to ensure profitability. It outlines critical financial indicators such as Return on Assets (ROA), Return on Equity (ROE), and Risk-Adjusted Return on Capital (RAROC), which aid in measuring the financial performance of banking operations. Additionally, it highlights the significance of funds transfer pricing and relationship profitability strategies in response to margin compression and market dynamics.
The True Value of Relationship Pricing
- 1. RELATIONSHIP PRICING Fran Brashares, Marquette Bank John Robertson
- 2. KEY COMPONENTS IN LOAN AND RELATIONSHIP PROFITABILITY
- 3. Confidential & Privileged DocumentConfidential & Privileged Document How can you not make money in banking? • Current commercial loan rates range from 3.00% to 7.00% depending upon the perceived risk • Cost of Funds/Cost of Deposits is much less • Purely a matter of managing the arbitrage
- 4. Confidential & Privileged DocumentConfidential & Privileged Document But you have to be really smart • Simplest form – Collectively all the income producing assets generate income through interest rate charged based upon the perceived risk – Liabilities provide the funds to generate the assets at a cost – Employees pursue both the assets and liabilities at a cost – Investors provide the where-with-all to obtain both with an expected return in mind – So unless you don’t charge enough, risk too much, or pay too much, net, net, a bank should make money
- 5. Confidential & Privileged DocumentConfidential & Privileged Document What fuels the returns? - critical attributes • Interest Rates • Cost of Funds/Cost of Deposits • Non Interest Income/Expense • Spreads – Gross Margin – Net Interest Margin – Net Income
- 6. Confidential & Privileged DocumentConfidential & Privileged Document Key measures • Gross Margin/Revenues – Interest Income plus Fees, less Cost of Funds • Net Interest Margin (NIM) – Interest Income less Cost of Funds • Net Income (pre-tax) – Includes Interest Income plus Fees less Cost of Funds less Non-interest Expense less Risk Expense • Net Profit After Tax
- 7. Confidential & Privileged DocumentConfidential & Privileged Document Critical indicators • Return on Assets (ROA) • Return on Equity (ROE) • Risk Adjusted Return on Capital (RAROC)
- 8. Confidential & Privileged DocumentConfidential & Privileged Document The importance of critical indicators • Consistency in comparing business loan returns • Provide a scale to use in managing customer relationships • Provides risk-adjusted view of loan and relationship returns • Enhances lender knowledge and ability to consider loan structure tradeoffs • Enables risk-adjusted and profit-based reporting
- 9. Confidential & Privileged DocumentConfidential & Privileged Document Return on Assets (ROA) • An indicator of how profitable a loan is relative to its total outstanding balance. • How efficient management is at using its assets to generate earnings • ROA = Net Profit After Tax/Average Asset
- 10. Confidential & Privileged DocumentConfidential & Privileged Document Return on Equity (ROE) • The amount of net income returned as a percentage of shareholders equity • How much profit a loan generates with the money shareholders have invested. • ROE = ROA/Equity
- 11. Confidential & Privileged DocumentConfidential & Privileged Document Risk-Adjusted Return on Capital (RAROC) • Framework for analyzing risk-adjusted financial performance and providing a consistent view of profitability across businesses. • Economic capital is a function of market risk, credit risk, and operational risk • RAROC = ROA/Economic Capital • RAROC = ROA/Value at Risk (aka VaR)
- 12. Confidential & Privileged DocumentConfidential & Privileged Document ROE versus RAROC • The primary value of economic capital is in its application towards decision making and overall risk management – Broadens the evaluation of the adequacy of capital in relation to the bank's overall risk profile – Develops risk-adjusted performance measures that provides for better evaluation of returns and the volatility of returns – Enhances risk management efforts by providing a common indicator for risk
- 13. DEPOSITS HAVE VALUE TOO
- 14. Confidential & Privileged DocumentConfidential & Privileged Document Funds Transfer Pricing (FTP)
- 15. Confidential & Privileged DocumentConfidential & Privileged Document FTP should be consistently applied • Balance sheet and liquidity management – FTP assumptions should be closely synchronized with A/L modeling assumptions; in turn, both should be consistent with investment and Treasury funding decisions • Performance measurement – Results should allocate accurate funds charges and credits to the entire balance sheet • Product pricing – When a new product is to be offered, its interest rate characteristics should be fully understood to derive an appropriate FTP rate and thus have the information necessary for profit/volume tradeoff analysis.
- 17. Confidential & Privileged DocumentConfidential & Privileged Document Reasons banks use relationship profitability • Margin compression – earnings pressure • Relationship management – ranking • Risk management – up front • Performance measurement – a profit aspect • Return on shareholders equity – economic profits • Measurement consistency – equally unfair to all • Business and marketing strategy – compliance
- 18. Confidential & Privileged DocumentConfidential & Privileged Document Example – single loan pricing results Revenues Interest $7,875 Fees $0 ______ Gross revenues $7,875 Expenses Cost of funds $2,250 Deposit credits $0 Administration $2,513 Loss reserve $375 Other expenses $0 ______ Total expenses $5,138 Profit before tax $2,737 Taxes $958 ______ Profit after taxes $1,779 ROA 1.19% Average assets $150,000 One Product: One line $250,000 LOC 60% utilized At prime plus 1% No fees
- 19. Confidential & Privileged DocumentConfidential & Privileged Document Example – relationship profitability results Revenues Interest $7,875 Fees $420 Gross revenues $8,295 Expenses Cost of funds $2,250 Deposit credits ($2,200) Administration $4,163 Loss reserve $375 Other expenses $0 ______ Total expenses $4,588 Profit before tax $3,707 Taxes $1,297 ______ Profit after taxes $2,410 ROA 1.61% Average assets $150,000 Two Products: One line + one deposit $250,000 LOC 60% utilized At prime plus 1% No fees Variable rate FTP at 1.5% Commercial DDA $55,000 average balance Collected less 10% reserve Average FTP at 4%
- 20. PROTECT THE STAKEHOLDER Capital adequacy is crucial
- 21. Confidential & Privileged DocumentConfidential & Privileged Document Tools of the trade • CECL • Dual risk rating • Application of economic capital
- 22. Confidential & Privileged DocumentConfidential & Privileged Document CECL - Where it’s been • GAAP required using an “incurred loss” methodology • Delayed recognition until it is probable a loss has been incurred • GAAP restricted recording credit losses but not yet meet the “probable” threshold
- 23. Confidential & Privileged DocumentConfidential & Privileged Document Challenges • Clarity around acceptable interpretation of the CECL model externally and internally • Level of coordination between finance, credit, risk, IT, and others to execute the implementation • Availability of data • Capability to design, build, and test new models with limited internal resources • Capability to plan and execute a program of this size in parallel with other current initiatives
- 24. DUAL RISK RATING PD and LGD
- 25. Confidential & Privileged DocumentConfidential & Privileged Document Dual risk rating • Examiners review internal ratings of loans to determine the adequacy of credit risk administration • Definitions of credit grades should be detailed and clearly delineate risk levels between grades • Loan grades are becoming more granular
- 26. Confidential & Privileged DocumentConfidential & Privileged Document Prominent factors used when determining dual risk ratings • Probability of default (PD) – Expected credit losses associated with default during a defined time period • Loss given default (LGD) – An estimate of loss given default • Exposure at default (EAD) – Measure of estimated exposure at default • Expected losses ($) = PD(%) * LGD(%) * EAD($)
- 27. Confidential & Privileged DocumentConfidential & Privileged Document Dual risk rating – facility/borrower expected loss (EL) Facility – Increasing loss given default 5% 15% 25% 35% 45% 55% 65% 75% 85% 95% Obligor–Increasingprobabilityofdefault 0.01% 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.01% 0.01% 0.01% 0.05% 0.00% 0.01% 0.01% 0.02% 0.02% 0.03% 0.03% 0.04% 0.04% 0.05% 0.15% 0.01% 0.02% 0.04% 0.05% 0.07% 0.08% 0.10% 0.11% 0.13% 0.14% 0.25% 0.01% 0.04% 0.06% 0.09% 0.11% 0.14% 0.16% 0.19% 0.21% 0.24% 0.35% 0.02% 0.05% 0.09% 0.12% 0.16% 0.19% 0.23% 0.26% 0.30% 0.33% 0.45% 0.02% 0.07% 0.11% 0.16% 0.20% 0.25% 0.29% 0.34% 0.38% 0.43% 0.55% 0.03% 0.08% 0.14% 0.19% 0.25% 0.30% 0.36% 0.41% 0.47% 0.52% 0.65% 0.03% 0.10% 0.16% 0.23% 0.29% 0.36% 0.42% 0.49% 0.55% 0.62% 0.85% 0.04% 0.13% 0.21% 0.30% 0.38% 0.47% 0.55% 0.64% 0.72% 0.81% 1.25% 0.06% 0.19% 0.31% 0.44% 0.56% 0.69% 0.81% 0.94% 1.06% 1.19% 1.75% 0.09% 0.26% 0.44% 0.61% 0.79% 0.96% 1.14% 1.31% 1.49% 1.66% 3.00% 0.15% 0.45% 0.75% 1.05% 1.35% 1.65% 1.95% 2.25% 2.55% 2.85% 6.00% 0.30% 0.90% 1.50% 2.10% 2.70% 3.30% 3.90% 4.50% 5.10% 5.70% 20.00% 1.00% 3.00% 5.00% 7.00% 9.00% 11.00% 13.00% 15.00% 17.00% 19.00% 50.00% 2.50% 7.50% 12.50% 17.50% 22.50% 27.50% 32.50% 37.50% 42.50% 47.50% 100.00% 5.00% 15.00% 25.00% 35.00% 45.00% 55.00% 65.00% 75.00% 85.00% 95.00%
- 28. CAPITAL ADEQUACY
- 29. Confidential & Privileged DocumentConfidential & Privileged Document Capital regulatory evolution
- 30. Confidential & Privileged DocumentConfidential & Privileged Document Relevant Risk vs. a “Flat Charge” - 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00 20.00 1 2 3 4 5 6 7 8 9 Facility A Facility B Facility C Facility D Facility E Facility F Facility G Facility H Facility I Flat Charge ROE = ROA / equity RAROC = ROA / economic capital
- 31. Confidential & Privileged DocumentConfidential & Privileged Document Economic versus Regulatory • Economic capital (EC) is the amount of risk capital that a bank estimates in order to remain solvent at a given confidence level and time horizon. • Regulatory capital (RC) reflects the amount of capital that a bank needs, given regulatory guidance and rules.
- 32. Confidential & Privileged DocumentConfidential & Privileged Document Look what shows up again
- 33. Confidential & Privileged DocumentConfidential & Privileged Document Economic capital distribution
- 34. Confidential & Privileged DocumentConfidential & Privileged Document $10,000,000 low risk loan Interest income 4.5% $450,000 Interest expense 3.0% $300,000 Administrative costs $60,000 Risk of loss $2,000 Taxes $35,000 Net profit $53,000 Capital allocation 3.0% $300,000 RAROC 18% Pricing influence $10,000,000 high risk loan Interest income 6.0% $600,000 Interest expense 3.0% $300,000 Administrative costs $60,000 Risk of loss $46,000 Taxes $78,000 Net profit $116,000 Capital allocation 12% $1,200,000 RAROC 10%
- 35. Questions?
Editor's Notes
- #12: The economic capital is the amount of money which is needed to secure the survival in a worst-case scenario, it is a buffer against unexpected shocks in market values. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate. RAROC system allocates capital for two basic reasons: Risk management Performance evaluation For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure—that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit.
- #18: FB
- #19: FB
- #20: FB
- #23: JR & FB Current generally accepted accounting principles (GAAP) require an “incurred loss” methodology for recognizing credit losses that delays recognition until it is probable a loss has been incurred. Both financial institutions and users of their financial statements expressed concern that current GAAP restricts the ability to record credit losses that are expected, but do not yet meet the “probable” threshold. The global financial crisis underscored those concerns because users analyzed credit losses by utilizing forward-looking information to assess an entity’s allowance for credit losses on the basis of their own expectations. Consequently, in the lead-up to the financial crisis, users were making estimates of expected credit losses and devaluing financial institutions before accounting losses were recognized, highlighting the different information needs of users from what was required by GAAP. Similarly, financial institutions expressed frustration during this period because they could not record credit losses that they were expecting but had not yet met the probable threshold.
- #24: JR & FB
- #25: JR & FB
- #26: JR & FB Why a Dual Risk rating system? Examiners review a sample of banks’ internal ratings of loans to determine the adequacy of credit risk administration and identify loans that show undue risk and may be uncollectible The internal ratings that banks produce for all of their loans, are incorporated into how each bank calculates its allowance for loan and lease loss (ALLL), which is an estimate made according to accounting guidance of incurred losses on loans and leases. Therefore, if additional loans are classified substandard or doubtful, this information is included in a bank’s updated ALLL estimates. If loans are classified loss, they are charged off the bank’s balance sheet. Definitions of credit grades should be detailed and clearly delineate risk levels between grades and applied consistently across all business lines. More granularity, more easily identifiable and subsequently actionable.
- #27: JR & FB Determining factors that impact economic capital Probability of Default (PD) Expected credit losses associated with default can be determined from an estimate of the probability of default (PD) during a defined time period Loss Given Default (LGD) An estimate of loss given default based on recent recovery data (net charge off over a period of time) Exposure at Default (EAD) measure of estimated exposure at default Expected losses ($) = PD (%) * LGD (%) * EAD ($) Everyone intuitively expects increased risk to be associated with lower-quality graded loans or loans with higher loss severity, but the allocation of economic capital estimates the level of risk associated with a particular grade level and differentiates risk among those levels.
- #28: JR & FB
- #30: “internal ratings-based” (IRB) approach.