Developing and implementing commercial loan pricing models.

Source:
The Journal of Lending & Credit Risk Management
Publication Date: 01-JUN-99
Many banks are re-evaluating their commercial loan pricing models to ensure that they are
accurately pricing loans in relation to increased competition from other banks and nonbanks.
The authors were responsible for developing and implementing such a model at Citizens
Financial Group, a $18 billion multi-bank holding company. The following is a list of various
issues that financial institutions must evaluate in this process.
Why Do We Need a New Pricing Model, Anyway?
Intricate evaluation of the profitability of individual loans and relationships is more costefficient today, thanks to advances in technology. It's fortunate that cost-efficiency is
attainable, because the need to evaluate the risk-reward relationship is more critical to
bankers than ever. Multiple-pricing alternatives and cross-sold relationships mean that bankers
cannot just look at a single loan. Instead, they frequently must use the loss-leader marketing
philosophy to meet competition.
The entry of unregulated competitors and borrowers' willingness to haggle over the last five
basis points indicate that managing interest-rate sensitivity, overall return, and risk-reward
has to be considered at the line level, not just on a macro-basis. So banks must provide
lenders with tools to quickly and efficiently determine the spreads necessary on loans of
various structure, tenor, and pricing level. Whether it's a customer the bank has supported for
40 years or one that the bank would like to add to its portfolio, the customer expects a quick
response to alternate pricing quotes.
Who Should Own the Model?
The pricing analysis incorporates aspects of commercial lending, finance, credit, accounting,
asset liability committee (ALCO), and risk management. The input of all the parties must be
obtained, even though some issues will require compromises. The model, however, must have
one owner to ensure proper documentation, training, applications, and future development.
Often, the function with the proper technical resources and portfolio orientation to manage
this process will be risk management. Care must be taken, however, to ensure that the model
is viewed as our model instead of that model. It is especially important that the commercial
lending department accept ownership of the model, because the loan officers and analysts will
be the people most immediately impacted by its use.
Who Should Calculate Pricing Return?
Some institutions may wish to centralize the loan pricing function and perform pricing analyses
for lenders on a request basis. This structure has the benefit of discouraging "gaming" of the
model and ensures consistency and accuracy in applying the desired methodology. However,
unless this area is adequately staffed and available at all hours (since that is when bankers
work now), it will not provide adequate response time for lenders. This structure also could
convey the concept that management does not trust line staff to manage this aspect of their
relationships. By allowing lenders to immediately access such a model during negotiations with
a customer (so that an appropriate pricing and loan structure can be designed), they are
empowered to add value to the company and serve the customer better.
Logistically, a centralized function also allows for quick, consistent updates of changes to the
model. Technological advances, fortunately, have made it possible for most banks to
disseminate updates quickly and easily via an Intranet site, a network version of the model, or
the less desirable methodology of physically distributing replacement diskettes. Citizens
Financial Group concluded that, notwithstanding the loss of consistency and the need for
lenders and approvers to understand the model, which is a good thing, a distributed approach

yields more preferable results.

How Big Should the Model Be? What Customer Facilities Should It Include?
Any profitability model should be able to capture a number of customer interactions, including
deposits, loans, leases (if any), off-balance sheet facilities, such as letters of credit, and feebased services, such as cash management and trust account relationships. However, the more
complete the coverage, the bigger the model size becomes. Its size may limit the model's
ability to be saved on a single diskette, and it may affect the speed with which it runs on a PC.
After reflection, Citizens Financial Group determined that the vast majority of its accounts
could be covered by a five-loan facility data structure. Larger relationships are handled by
combining smaller loans into a dummy facility (for example, adding three $50,000 term loans
with various maturities into a single $150,000 loan with an averaged maturity).
Clearly, deposit balances are important. The biggest impact of deposits comes from the lower,
or zero, interest rate paid to the depositor. The model calculates the interest expense incurred
by the bank using the lender's input of the interest rate received by the borrower, thereby
giving the model the flexibility to capture both interest-bearing and non-interest-bearing
deposits. After the appropriate reserve balance is withheld, the amount of funds purchased
from treasury is adjusted so that the balance sheet is in equilibrium. Instead of allocating the
deposit benefit to each facility, it is calculated only at the relationship level. This calculation
allows the lender and management to view the incremental value of the deposits with regard
to the overall relationship profitability. With regard to servicing expenses, Citizens Financial
Group chose to apply average account maintenance costs with an override. If the cost of
maintaining the account exceeded the funds credit on balances, the override provided that no
detriment to overall profitability would occur. An account activity fee would be assessed and
collected.
In the case of leases, the multiplicity of depreciation, residual realization, and taxation issues
led Citizens Financial Group to decide that building these computations into the profitability
model would render it far too complex. Others likely will reach the same conclusion. Also,
there are models in the market that analyze the profitability of leases far better than Citizens
Financial Group's loan model. The bank solved the riddle by building an input screen that
injects the net tax-adjusted profitability from a stand-alone leasing model if related leasing
facilities exist.
Loan History or Bond Market as an Indicator of EDF?
Everyone in this industry has heard a cocky lender say, "We've never had a loss on these deals
and I can't imagine the circumstances under which we would." Moreover, many have not
captured historical data to provide a reliable basis over multiple business cycles to estimate
these items. Therefore, since most banks have little else to use, employing bond market
default rates provides a consistent indicator of expected default frequency (EDF) to recognize
both loan rating and tenor if we can establish two things:
1. That there is a strong correlation between the risk implied in a bank's ratings and the
analogous risk in the bond ratings to which the loans are mapped.
2. That a bank's portfolio generally performs as publicly rated debt when default occurs.
The former premise is common for larger banks that carry wholesale loans on their books, but
becomes tenuous when applied to smaller institutions that are primarily community lenders.
To some extent, any bank can validate both correlation and portfolio performance empirically.
It does so by analyzing historical annual loan defaults by risk rating and comparing the result
with what was observed in the bond universe during the same time period. Once this analysis
has been done, it's [TABULAR DATA FOR FIGURE 1 OMITTED] possible to stress-test the
portfolio by applying historical public bond rating transition matrices during times of high
defaults to analyze how closely they conform to the default rates and losses observed during

the years being tested.

The cumulative default rates for the 28-year history ending in 1997, as reported by Moody's
Investors Service, are included in Figure 1. Some smoothing is generally desirable when using
these data due to occasional inversions (as seen in the one-year Aa and A average default
rates). Also, there is a significant jump in default rates when moving into non-investment
grade lending.
Do Collateral and Tenor Matter?
Any model must provide for the higher probability of default over time and lower loss given
default (LGD) when the bank obtains more valuable collateral for its loans. While Citizens
Financial Group has not figured out how to empirically modify pricing for guarantees or other
loss-mitigating structures, the bank again supports the use of bond data to estimate the
incremental probability of defaults in later years. With regard to collateral, a bank can
empirically analyze its workout history to ensure that the appropriate LGD is assigned for
various collateral types. For example, Citizens Financial Group has estimated a range from 5%
for marketable securities to 70% for unsecured loans. (Note that these rates are averages.) A
question, however, that always remains with regard to LGD is how much the current economic
environment affects recoveries on defaulted loans. Most research is inconclusive, however, and
until enough good data can be analyzed, collateral LGD rates should be viewed as directional,
not as absolutes.
The Old Saw - Average Cost or Marginal Cost?
No pricing model would be complete without offsetting some of the income from loans by the
estimated origination and servicing costs of the loans. But these issues raise a plethora of
knotty questions, such as:
* What is the true cost that should be allocated to each loan and relationship?
* Should the bank average its total costs over the portfolio by loan (if the bank has the
accounting and loan administration data to support that) or should the bank presume that the
marginal cost is zero?
One senior manager suggested that one more loan would not cost much to service because
lenders' salaries would have to be paid anyway, thus making the marginal cost zero. This
approach seems too aggressive, but Citizens Financial Group believes that average cost
overstates the proper cost allocation to a new loan origination and that something less is an
appropriate compromise.
Any cost matrix would have to address the fact that larger loans are more expensive to
originate and service than smaller loans, everything else being equal. Additionally, the matrix
would have to address the fact that with everything else equal, more creditworthy borrowers
will cost less to service. Finally, it also is necessary to differentiate the marginal servicing and
origination costs within a loan relationship. Because most of the time and expense is incurred
analyzing the borrower and the first facility, the cost of adding more facilities is significantly
reduced. Although the accounting data to support these exact numbers may be difficult to
obtain, one must at least establish the correct directional relationships so that there is not a
bias introduced that inadvertently encourages lenders to behave in an unintended manner.
Cost of Funds - Another Old Saw
A perennial issue in these matters is the question of whether average cost of funds over the
bank portfolio or marginal cost of funds is appropriate to determine the relative spread
earned. Average cost would work fine if summed over all facilities in the bank. But it will enrich
unfairly or penalize the next transaction (depending on the yield curve and relative funding
levels), which is what the whole model is designed to prevent. Therefore, the only logical
choice is a marginal funds rate for floating debt that approximates the alternative investment

cost the bank faces. Any lower cost deposit accounts that the relationship carries with it and
the explicit rate on the deposits should be included to determine the weighted funding cost for
the relationship.
The case for fixed-rate debt gets even tougher because the match-fund cost presumes no
prepayment. Yet, because of competition, the bank frequently offers an embedded
prepayment option, which results in the bank collecting less than a full-yield maintenance
penalty if the loan is prepaid. Some banks now explicitly calculate the value of a prepayment
penalty and then compare it with the value of the put option to the borrower. They include the
difference in the profitability calculation. Citizens Financial Group found it useful to include a
yield-curve estimator. It calculates a weighted-average cost of funds by interpolating between
bullet and fully amortizing rates for those loans that have unequal amortization and term.
What Is an Adequate Return and How Should We Measure It?
Substantial discussions have occurred in this industry-regarding whether return on assets
(ROA) or return on equity (ROE) is the proper way to value the marginal relationship. No
thunderbolt has come from the sky to settle the matter. The establishment of hurdles requires
a bank to determine which primary approach will be used by the institution and how facilities
or relationships that fail to meet these hurdles will be treated. With capital no longer
constrained in this industry, the ability to add assets is presumed. It is, therefore, more
important than ever for a bank to be able to weigh the expected return of a loan against the
risk it carries. Each new loan also must be viewed in light of the entire portfolio and how the
risk/return trade-off of the loan affects the remaining portfolio. Consequently, a loan whose
return on assets is sub-par may nonetheless be an acceptable part of the portfolio. For this to
happen, the bank's capitalization must provide an equity allocation that is small enough for
the bank to use financial leverage to generate a satisfactory return on that allocated equity.
Of course, the allocation of equity, itself, is an issue on which many bankers are divided. The
Basel standards require a minimum of 8% capital to risk-based assets, and the regulators
have suggested that at least 10% is desirable if a bank is to be considered well capitalized.
However, we do not believe, nor do the regulators, that these requirements mean that every
loan asset requires 8% or 10% capital to be allocated against it. In fact, if capital is viewed as
an economic quantity that provides a cushion for a creditor against possible loss on assets,
then the first step in calculating the required amount of capital is to theorize the possible
default distribution for a portfolio of similar risk assets. This amount is then modified by the
loss anticipated in the event of default, which should be a function of collateral type. The
expected loss is then added to the unexpected loss, a quantity that reflects the variance of
losses over time, as observed historically and modified for other information the bank
possesses. Appropriate pricing will support the annual provision expense to meet the expected
loss on a facility and leave enough left over after origination, servicing, and taxes to provide
an acceptable return on equity. If there is not enough pricing spread, amortized fees or value
provided by balances and other non-fee support, we must shortchange either the reserve
provision or the return on capital - neither of which are acceptable alternatives.
Because bankers recognize that different loss profiles should require different equity
allocations, they are dissatisfied with pure ROE. The dissatisfaction has led to risk-adjusted
return on capital (RAROC) analysis. In RAROC, the return on the facility is risk-adjusted by
charging a loss provision that reflects the normalized long-term loss level. The capital
allocations are adjusted by observing the distribution of possible losses and applying enough
capital to cover some very high proportion of possible losses. While RAROC provides an
elegant analysis, it should not be used alone. Instead, it should be used as a modifier of ROE
and ROA hurdles. RAROC also can be used in conjunction with a broad level management of
the risk/return dynamics of the entire commercial loan portfolio.
Perhaps an example will help define these issues. Many lenders make loans secured by
accounts held by the borrowers at the bank - sometimes at spreads over the deposit yields
paid and sometimes at rates determined by market rates. The former presumes that if banks
do not make the loan, the deposit goes away, while the latter presumes the deposit is

irrelevant. In either case, it is difficult to imagine a loss likelihood (absent fraud or

malfeasance), though default may occur. The loss mitigation provided by the collateral should
reduce the capital required to support this loan, though it is clearly not zero.
[TABULAR DATA FOR FIGURE 2 OMITTED]
What About All Those Assumptions?
By design, the operation of a pricing model assumes that certain attributes, such as loan
rating, current pricing, and present collateral, will all remain over the life of the facility. We
know this is unreasonable, given the dynamics of risk-rating changes, the prevalence of
performance-based pricing grids, and the changing relationship between a bank's cost of funds
and market indicators. To the extent that ratings migration is incorporated in the provision
charge and economic equity allocation, at least the credit risk is captured. Most banks that
attempt to incorporate additional rating migration dynamics and pricing changes will only
further complicate what is already a very complex procedure.
Another related question is whether it is reasonable to prognosticate the renewal or extension
of short-term facilities, such as demand loans or credit lines, to the final maturity of the
longest-term loans the bank has on the books. It is inappropriate to build into the model any
assumptions that are not contractual. Citizens Financial Group has dealt with this issue by
making the model flexible enough so that a lender can quickly quantify the impact of a
facility's term. For example, one can view the profitability of a relationship that includes a oneyear line of credit that is analyzed as a one-year line and analyzed from an ex-post
perspective where the line may be continually renewed for as long as the relationship exists.
This analysis gives the lender the flexibility to view "what-if" scenarios based on the lender's
best judgment.
Output Example
After considering all of the above, one may wonder how all of the information is synthesized
and ultimately presented. Obviously, Citizens Financial Group cannot share the details of how
the model calculates, but the bank can provide what the output looks like. This output is
provided in Figure 2 for a simple two-loan relationship, with the expectation of additional
balances and cash management revenue after the second facility closes.
Are We Done Yet?
There is no perfect pricing model available (if it were, Citizens Financial Group and your bank
would have bought it from some rich vendor by now), nor is there likely to be one in the near
future. Each institution must use a model that is flexible with the types of loans it typically
pursues. Also, it should be updated regularly to include the most recent default, loss, and cost
data. Citizens Financial Group is working on the fourth revision of its model in a year and it is
not perfect yet. The involvement of lenders and administrators to test and push the envelope
on applying any model are a key determinant of its continuing value to the institution. Finally,
it should be clear that with so many assumptions, the results of the analysis are relative
(rather than absolute) measures of the contribution of the relationship to the bank's bottom
line.
Fadil can be contacted by e-mail at Michael_W_Fadil@Fleet.com. Hershoff can be reached at
lawrence.hershoff@citizensbank.com.
Michael Fadil is credit risk portfolio manager for Fleet National Bank's Business &
Entrepreneurial Group, which is Fleet's small business lending line of business. Larry Hershoff
is vice president in the Commercial Loan Syndication Group at Citizens Bank of Rhode Island
and an adjunct lecturer in finance at Bryant College in Smithfield, Rhode Island.