Those Optimistic Loan and Profitability Projections Might Not Apply to You

By Dennis Child

Recent economic news indicates that the long loan drought may be coming to an end for financial institutions. Indeed, many reports state that in  the spring/summer of 2013 some institutions experienced loan growth equivalent to that just prior to the 2008 crash. Whether or not loan growth continues at the recent pace remains to be seen.

There are some realities the financial industry should not lose grasp of:

  • In general, smaller financial institutions are not enjoying the same loan growth as their larger peers  
  • Financial  institutions continue to focus their lending efforts on low risk borrowers
  • Few institutions (particularly smaller ones) use stochastic methods to develop their risk based loan pricing models
  • Many  smaller financial institutions (particularly credit unions) have seen their ROAA decrease 30 to 80 BP in the past two or three years as a result of inaccurate loan pricing and/or diminishing loan portfolios

Financial institutions experiencing one or more of these issues could well find themselves merged or otherwise out of business in the next two to five years. They will need to improve their profitability and equity positions significantly.

To better assure long term survival, financial institutions need to do a better job when it comes increasing their loan portfolios and pricing loans profitably.

The ingredients to a successful loan program include using empirical risk-­‐based loan pricing models and using effective marketing methods.

Adopting empirical, statistically validated risk based loan pricing models

Financial institutions, which haven’t already, will need to expand their lending efforts to include those borrowers outside the highest-­‐grade segment of the consumer loan market. Reasons for “reaching deeper” into the loan pool include:

  • The competition is fierce for “A+ and A” borrowers. In many cases, these loans are priced lower than break-even
  • When priced correctly and managed carefully, making loans to less-­‐than-­‐prime borrowers can increase  ROAA by up to 30 BP
  • Many impaired-­‐credit borrowers are victims of the “Great Recession”. As the economy improves, many less-­‐than-­‐prime borrowers will experience improving credit scores
  • Studies show that less-­‐than-­‐prime borrowers tend to be more loyal to those financial institutions  that provide credit compared to prime borrowers
  • Less-­‐than-­‐prime borrowers are more apt to use additional services of those institutions providing  them credit; this further contributes to a financial institution’s income
  • Studies  show that those financial institutions that loan to less-­‐than-­‐prime borrowers using stochastically derived risk-­‐based loan pricing methods often experience increases in  their customer bases, increases in loan portfolios, and improvements in profitability

Lending to less-­‐than-­‐prime borrowers requires careful pricing taking into account unique risks and costs associated with each credit-­‐grade of borrower.

Careful attention needs to be paid to adopting risk-­‐ based loan pricing tools that are stochastically derived and meet these criteria:

  • Identifies  and quantifies all costs in the lending process unique to each credit grade
  • Utilizes  statistically derived methods for measuring and assigning costs to each credit grade
  • Employs  a regular validation process to maintain the model and assure pricing accuracy
  • Identifies  and creates credit-­‐risk ranges according to statistically derived methods
  • Provides  pricing recommendations for each type of loan and risk-­‐class of borrower
  • Provides  “what if” capabilities so loan pricing changes under consideration can be tested for profitability  before implementation
  • Provides  a foundation for loan policies including Concentration Risk
Using  effective loan marketing methods:

Those  financial institutions enjoying profitable loan growth generally have the following traits:

  • Develop  strategic plans that include detailed loan-­‐growth objectives and mandates
  • Have  a clear understanding of return-­‐on-­‐investment concepts
  • An accurate knowledge of the expenses unique to each type of loan, expenses unique to each risk-­‐type of borrower and the net income necessary to at least break-­‐even on any marketing program under consideration
  • Employ  marketing methods that target borrowers according to specific demographics or needs
  • Can effectively market ancillary services associated with loans (“payment protection” products, etc)  
  • Price their loans using empirically derived risk-­‐based methods described above (as opposed to pricing  loans by “guessing” or according to the competitions’ rates)

Many  smaller financial institutions are struggling with poor profitability even though the economy and loan market may be showing signs of improvement. By pricing loans according to risk using stochastically derived models and through careful management, an institution can profitability make more loans to less-­‐than-­‐prime borrowers and experience significantly improved net earnings.

TCT is based in Boise, Idaho. Dr. Randy Thompson, CEO of TCT, designs his training and management tools using empirically based, statistically validated methods and research. TCT has provided services to credit union professionals for 25 years. TCT’s clientele include credit unions, credit union trade associations, and federal and state regulatory agencies. TCT can be reached at (208) 939 8366 or

About the Author
Dennis Child

Dennis Child is a 40 year veteran credit union CEO recently retired. He has been associated with TCT for 25 years. Today, Dennis enjoys providing solutions and training for credit union managers. He also uses his financial credentials and advisory skills to assist the Boomer generation plan and prepare for their retirement years. He and his wife, Geri, live in Logan, Utah. Dennis can be reached at