Mega banks and major regional banks all have very advanced loan pricing solutions. Not only that, but they are also getting more and more sophisticated.
The complexity found within “big bank” pricing tools underscores the reason why community banks need to act and make progress toward adopting a more empirically based, formal pricing solution or they will ultimately risk getting relegated to the low end of the market. Just like the large consumer lenders ultimately pushed community banks out of the consumer lending business, large banks will do the same with commercial lending.
What does that mean? Banks using pricing solutions are varying capital assumptions based on risk grade, and a variety of other considerations. On top of this, they are also lowering ROE targets on the best credit grades. The ultimate result of that is the customers with the best risk characteristics are being offered more and more aggressive rates on commercial loans by these big lenders.
Why does that matter for the typical community bank? The typical community bank is going to become less and less competitive in terms of the rates offered to their biggest and most profitable clients and prospects. Over time, the vast majority of these prime borrowers will migrate to the best offer. The notion that service will make up the difference is a complete fallacy. We tell ourselves that is true, so we don’t lose as much sleep worrying about losing all of our prime business! The reality is – of course service matters – but it isn’t going to offset 50, 100 or 200 basis points in price. This is particularly the case on larger loans because those basis points add up to a lot of dollars the bigger the loan gets. We see this on the vast majority of demos we do at Strunk. Bankers are quoting rates today in the 8% range on loans larger banks are doing for 100 or more basis points less.
The math behind this notion is pretty simple, these large banks are allocating less capital to the best credits, which means the rate required to achieve their target ROE is lowered – i.e. if I lower my capital (the ‘E’) I don’t need as much return (the ‘R’) to achieve my target ROE percentage. Then, if we lower the target ROE to boot, that’s kind of a double whammy for the community banks to be competitive.
Since the advent of credit cards and the expansion of large auto lenders, consumer lending has gradually declined to next to nothing for community banks. These big lenders found far more efficient ways to service consumer loans and to offer the most competitive risk-based rates to the consumer. As a result, community banks have been left with dribs and drabs of consumer loans – and for the most part they are sub-prime consumers. If community FIs allow the large banks to continue to get more and more technical with their approach to commercial lending without an appropriate response, the same thing will happen to their commercial business.
Pricing should be the number one priority over anything else, including exams and systems conversions. This is the portion of a community bank’s business that essentially generates all of their profit. The time to implement a sophisticated pricing tool like Strunk’s Pricing Manager, is now!
