Many community bankers “look down the street” when pricing commercial loans to see what the competition is doing. Ironically, those bankers are looking at your bank as well to see what rate to offer! What if neither bank knows how to ensure the loan or the borrower’s relationship is profitable?

In the mid-2000s, large and regional banks used pricing tools to help them win more deals and to ensure the loan/relationship met their profitability target. Community bankers were left out due to the complexity and cost of the pricing solutions.

Then from late 2008 until March 2022, rates were so low that almost any loan a bank could make to a credit-worthy borrower was better than investing in Fed Funds. Therefore, loan pricing wasn’t much of a science for many banks. However, in the past two years, rates have gone up dramatically, and liquidity has diminished to a great degree — so once again, precision in loan pricing has become a major consideration.

There are many factors that go into a pricing decision. Size, term, fees, fixed or floating rate, balloon, collateral and, of course, the borrower’s creditworthiness are all important factors.

2024 is the year to look at giving your loan officers the tools they need to win more deals while meeting your profitability goals. Just like loans, size matters when it comes to deposits as well. Let’s look at several of these considerations.

What About the Competition?

Pricing commercial loans for community banks can be daunting, especially in areas where competition is fierce. Often, we have a customer — particularly when the customer is one of our most credit-worthy customers — that indicates they can get a better deal from another bank. What do we do? Blindly match the rate? Let the customer take the competitor’s deal? The largest loan opportunities drive our net interest income — we can’t afford to leave winning or losing to chance.

What should our interest rate be? For what term? Is there a fee involved? Is the rate fixed? Is the loan structured as a balloon or an adjustable? How should the adjustable portion of the loan be structured in terms of price and term?

Loan pricing solutions have been used by the “mega banks” and large regional institutions for years, while community banks sometimes just “throw a dart” to determine what a borrower will pay.

Size is a Driver of Profitability

The three main factors that drive loan profitability are 1) the creditworthiness of the borrower, 2) the term of the loan and 3) the size of the loan. Most financial institutions focus on the first two factors but ignore the third. Worse, the third is often the driver that results in the biggest rate differentiation.

Small-dollar loans are not nearly as profitable as larger loans because the costs associated with underwriting and servicing must be considered. Even when varying the costs based on the size of the loan, this dynamic is still true. The smaller-dollar loans simply don’t produce enough dollars of net interest income to cover even the most modest operating costs.

Does that mean we always have to price up smaller loans to achieve our profit targets? Of course not — not if we have a customer relationship that is profitable enough to carry the smaller loan. However, it then becomes critical for us to have an easy way for our lenders to have customer profitability data at their fingertips.

Overpricing Your Most Profitable Customers and Underpricing the Least Profitable

Most banks overprice their largest, most valuable customers and underprice their smaller, least profitable customers. This is a troubling prospect since, as a result, we end up giving the best deal to those who contribute the least to the bottom line and, at the same time, run the risk of losing our most profitable relationships.

To accomplish this, we must have a way to set profitability targets that are then applied consistently to every pricing decision. The key is consistency and discipline. We want to be consistent from lender to lender, customer to customer, and most importantly, from one point in time to another as the interest rate environment changes.

How Does a Pricing Tool Help My Bank?

An empirically based pricing solution offers lenders the ability to vary rate, fee, risk premium and term structure, among other variables, to understand the drivers of profitability and develop pricing options for borrowers that all achieve the bank’s target profitability objectives. It is critical to apply consistent assumptions for loan origination, loan servicing and cost of funds so that all pricing decisions are considered based on a level playing field.

An effective pricing solution should provide:

• Lenders with the tools needed in an increasingly competitive environment.
• A relationship profitability module so relationship value can be factored into the decision.
• Instant adjustments in a changing rate environment to ensure pricing consistency.
• Rate sheets for consumer loans and interest-bearing deposit products.
• Pricing options that will win more deals.

Over the past 30 years, Strunk has helped over 1,800 community financial institutions increase income with a variety of innovative products and services. A more disciplined and consistent pricing methodology will increase your bank’s net interest income by at least 25-50 basis points. With increasing margin pressure in 2024, now is the time to consider making adjustments to your pricing practices!