Leveraging ALLL to Support Pricing and Profitability

John Robertson

Pricing is powerful, three times as powerful as expense reduction in impacting earnings. An increase of 2.5 percent in loan interest income equals a gain of more than 7 percent in net income; a decrease of 2.5 percent in operating expenses increases net income by the same amount. A dollar in added pretax income equals almost three dollars in added earnings.

Fundamental truths related to earnings:

  • Margins will continue to narrow – forever. Since 2011, margins have dropped between 15 and 20 basis points. To counter, price more effectively.
  • Regulations will heighten competitive pressures. A global bank reporting to shareholders noted that it committed 13,000 employees from 2012-2014 to regulatory compliance and control.
  • Ranking the order of risk in pricing and profitability is important (know the return being generated). Transaction pricing can contribute more to income than deposits.
  • Additional production can have a positive or negative effect, depending on pricing, on the portfolio.

Pricing is important to address because it:

  • Provides consistency in comparing business loan returns.
  • Provides a scale to use in managing customer relationships.
  • Provides a risk-adjusted view of loan and relationship returns.
  • Enhances lender knowledge and the ability to consider loan structure tradeoffs.
  • Enables risk-adjusted and profit-based reporting.

Returns are fueled by the interest rate, the cost of funds and deposits, non-interest income, spreads (interest less cost of funds and G&A expenses) and risk expense (expected losses). The majority of impact on returns comes from risk expense, non-interest income and non-interest expense.

Regulators’ objective is to protect the bank’s stakeholders. The most recent of Basel Committee directives deals primarily with capital conservation and a discretionary countercyclical buffer. Tools banks use to protect capital include a dual risk-rating system, application of economic capital and migration analysis.

In a dual risk-rating system, the first rating looks to the borrower’s risk and potential loss; the facility rating differentiates risk associated with types of loans, which is essential to ALLL and capital estimates.

Economic capital is a measure of risk, the amount of money needed to secure the survival of the bank in a worst-case scenario, and a way of measuring incrementally to the portfolio how much risk there is going forward. It enhances risk management as a common indicator for risk. And it provides a pricing metric that includes expected and unexpected losses.

Credit risk migration analysis provides for identification of the impact of migration on a loan. Detailed analysis of loans is crucial to long-term profitability.

CECL will require changing from reactive to predictive loan grading. Key to allocating reserves is directional consistency of expected losses, which can be achieved through migration analysis. An increase in loss percentage would indicate a change in the risk profile, and pricing should be adjusted to reflect the additional risk and required capital allocation.

Coming full circle, the process cycle involves periodically measuring risk factors, adjusting the measurements to be directionally consistent, adjusting capital allocations accordingly, and adjusting pricing to reflect risk, remain competitive and be profitable.