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The True Value of Relationship Pricing

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In a competitive environment, just giving the customer a good rate may not be enough. Financial institutions must value the complete relationship in order to understand how valuable that customer truly is.

Veröffentlicht in: Wirtschaft & Finanzen
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The True Value of Relationship Pricing

  1. 1. RELATIONSHIP PRICING Fran Brashares, Marquette Bank John Robertson
  2. 2. KEY COMPONENTS IN LOAN AND RELATIONSHIP PROFITABILITY
  3. 3. Confidential & Privileged DocumentConfidential & Privileged Document How can you not make money in banking? • Current commercial loan rates range from 3.00% to 7.00% depending upon the perceived risk • Cost of Funds/Cost of Deposits is much less • Purely a matter of managing the arbitrage
  4. 4. Confidential & Privileged DocumentConfidential & Privileged Document But you have to be really smart • Simplest form – Collectively all the income producing assets generate income through interest rate charged based upon the perceived risk – Liabilities provide the funds to generate the assets at a cost – Employees pursue both the assets and liabilities at a cost – Investors provide the where-with-all to obtain both with an expected return in mind – So unless you don’t charge enough, risk too much, or pay too much, net, net, a bank should make money
  5. 5. Confidential & Privileged DocumentConfidential & Privileged Document What fuels the returns? - critical attributes • Interest Rates • Cost of Funds/Cost of Deposits • Non Interest Income/Expense • Spreads – Gross Margin – Net Interest Margin – Net Income
  6. 6. Confidential & Privileged DocumentConfidential & Privileged Document Key measures • Gross Margin/Revenues – Interest Income plus Fees, less Cost of Funds • Net Interest Margin (NIM) – Interest Income less Cost of Funds • Net Income (pre-tax) – Includes Interest Income plus Fees less Cost of Funds less Non-interest Expense less Risk Expense • Net Profit After Tax
  7. 7. Confidential & Privileged DocumentConfidential & Privileged Document Critical indicators • Return on Assets (ROA) • Return on Equity (ROE) • Risk Adjusted Return on Capital (RAROC)
  8. 8. Confidential & Privileged DocumentConfidential & Privileged Document The importance of critical indicators • Consistency in comparing business loan returns • Provide a scale to use in managing customer relationships • Provides risk-adjusted view of loan and relationship returns • Enhances lender knowledge and ability to consider loan structure tradeoffs • Enables risk-adjusted and profit-based reporting
  9. 9. Confidential & Privileged DocumentConfidential & Privileged Document Return on Assets (ROA) • An indicator of how profitable a loan is relative to its total outstanding balance. • How efficient management is at using its assets to generate earnings • ROA = Net Profit After Tax/Average Asset
  10. 10. Confidential & Privileged DocumentConfidential & Privileged Document Return on Equity (ROE) • The amount of net income returned as a percentage of shareholders equity • How much profit a loan generates with the money shareholders have invested. • ROE = ROA/Equity
  11. 11. Confidential & Privileged DocumentConfidential & Privileged Document Risk-Adjusted Return on Capital (RAROC) • Framework for analyzing risk-adjusted financial performance and providing a consistent view of profitability across businesses. • Economic capital is a function of market risk, credit risk, and operational risk • RAROC = ROA/Economic Capital • RAROC = ROA/Value at Risk (aka VaR)
  12. 12. Confidential & Privileged DocumentConfidential & Privileged Document ROE versus RAROC • The primary value of economic capital is in its application towards decision making and overall risk management – Broadens the evaluation of the adequacy of capital in relation to the bank's overall risk profile – Develops risk-adjusted performance measures that provides for better evaluation of returns and the volatility of returns – Enhances risk management efforts by providing a common indicator for risk
  13. 13. DEPOSITS HAVE VALUE TOO
  14. 14. Confidential & Privileged DocumentConfidential & Privileged Document Funds Transfer Pricing (FTP)
  15. 15. Confidential & Privileged DocumentConfidential & Privileged Document FTP should be consistently applied • Balance sheet and liquidity management – FTP assumptions should be closely synchronized with A/L modeling assumptions; in turn, both should be consistent with investment and Treasury funding decisions • Performance measurement – Results should allocate accurate funds charges and credits to the entire balance sheet • Product pricing – When a new product is to be offered, its interest rate characteristics should be fully understood to derive an appropriate FTP rate and thus have the information necessary for profit/volume tradeoff analysis.
  16. 16. RELATIONSHIP PROFITABILITY
  17. 17. Confidential & Privileged DocumentConfidential & Privileged Document Reasons banks use relationship profitability • Margin compression – earnings pressure • Relationship management – ranking • Risk management – up front • Performance measurement – a profit aspect • Return on shareholders equity – economic profits • Measurement consistency – equally unfair to all • Business and marketing strategy – compliance
  18. 18. Confidential & Privileged DocumentConfidential & Privileged Document Example – single loan pricing results Revenues Interest $7,875 Fees $0 ______ Gross revenues $7,875 Expenses Cost of funds $2,250 Deposit credits $0 Administration $2,513 Loss reserve $375 Other expenses $0 ______ Total expenses $5,138 Profit before tax $2,737 Taxes $958 ______ Profit after taxes $1,779 ROA 1.19% Average assets $150,000 One Product: One line $250,000 LOC 60% utilized At prime plus 1% No fees
  19. 19. Confidential & Privileged DocumentConfidential & Privileged Document Example – relationship profitability results Revenues Interest $7,875 Fees $420 Gross revenues $8,295 Expenses Cost of funds $2,250 Deposit credits ($2,200) Administration $4,163 Loss reserve $375 Other expenses $0 ______ Total expenses $4,588 Profit before tax $3,707 Taxes $1,297 ______ Profit after taxes $2,410 ROA 1.61% Average assets $150,000 Two Products: One line + one deposit $250,000 LOC 60% utilized At prime plus 1% No fees Variable rate FTP at 1.5% Commercial DDA $55,000 average balance Collected less 10% reserve Average FTP at 4%
  20. 20. PROTECT THE STAKEHOLDER Capital adequacy is crucial
  21. 21. Confidential & Privileged DocumentConfidential & Privileged Document Tools of the trade • CECL • Dual risk rating • Application of economic capital
  22. 22. Confidential & Privileged DocumentConfidential & Privileged Document CECL - Where it’s been • GAAP required using an “incurred loss” methodology • Delayed recognition until it is probable a loss has been incurred • GAAP restricted recording credit losses but not yet meet the “probable” threshold
  23. 23. Confidential & Privileged DocumentConfidential & Privileged Document Challenges • Clarity around acceptable interpretation of the CECL model externally and internally • Level of coordination between finance, credit, risk, IT, and others to execute the implementation • Availability of data • Capability to design, build, and test new models with limited internal resources • Capability to plan and execute a program of this size in parallel with other current initiatives
  24. 24. DUAL RISK RATING PD and LGD
  25. 25. Confidential & Privileged DocumentConfidential & Privileged Document Dual risk rating • Examiners review internal ratings of loans to determine the adequacy of credit risk administration • Definitions of credit grades should be detailed and clearly delineate risk levels between grades • Loan grades are becoming more granular
  26. 26. Confidential & Privileged DocumentConfidential & Privileged Document Prominent factors used when determining dual risk ratings • Probability of default (PD) – Expected credit losses associated with default during a defined time period • Loss given default (LGD) – An estimate of loss given default • Exposure at default (EAD) – Measure of estimated exposure at default • Expected losses ($) = PD(%) * LGD(%) * EAD($)
  27. 27. Confidential & Privileged DocumentConfidential & Privileged Document Dual risk rating – facility/borrower expected loss (EL) Facility – Increasing loss given default 5% 15% 25% 35% 45% 55% 65% 75% 85% 95% Obligor–Increasingprobabilityofdefault 0.01% 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.01% 0.01% 0.01% 0.05% 0.00% 0.01% 0.01% 0.02% 0.02% 0.03% 0.03% 0.04% 0.04% 0.05% 0.15% 0.01% 0.02% 0.04% 0.05% 0.07% 0.08% 0.10% 0.11% 0.13% 0.14% 0.25% 0.01% 0.04% 0.06% 0.09% 0.11% 0.14% 0.16% 0.19% 0.21% 0.24% 0.35% 0.02% 0.05% 0.09% 0.12% 0.16% 0.19% 0.23% 0.26% 0.30% 0.33% 0.45% 0.02% 0.07% 0.11% 0.16% 0.20% 0.25% 0.29% 0.34% 0.38% 0.43% 0.55% 0.03% 0.08% 0.14% 0.19% 0.25% 0.30% 0.36% 0.41% 0.47% 0.52% 0.65% 0.03% 0.10% 0.16% 0.23% 0.29% 0.36% 0.42% 0.49% 0.55% 0.62% 0.85% 0.04% 0.13% 0.21% 0.30% 0.38% 0.47% 0.55% 0.64% 0.72% 0.81% 1.25% 0.06% 0.19% 0.31% 0.44% 0.56% 0.69% 0.81% 0.94% 1.06% 1.19% 1.75% 0.09% 0.26% 0.44% 0.61% 0.79% 0.96% 1.14% 1.31% 1.49% 1.66% 3.00% 0.15% 0.45% 0.75% 1.05% 1.35% 1.65% 1.95% 2.25% 2.55% 2.85% 6.00% 0.30% 0.90% 1.50% 2.10% 2.70% 3.30% 3.90% 4.50% 5.10% 5.70% 20.00% 1.00% 3.00% 5.00% 7.00% 9.00% 11.00% 13.00% 15.00% 17.00% 19.00% 50.00% 2.50% 7.50% 12.50% 17.50% 22.50% 27.50% 32.50% 37.50% 42.50% 47.50% 100.00% 5.00% 15.00% 25.00% 35.00% 45.00% 55.00% 65.00% 75.00% 85.00% 95.00%
  28. 28. CAPITAL ADEQUACY
  29. 29. Confidential & Privileged DocumentConfidential & Privileged Document Capital regulatory evolution
  30. 30. Confidential & Privileged DocumentConfidential & Privileged Document Relevant Risk vs. a “Flat Charge” - 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00 20.00 1 2 3 4 5 6 7 8 9 Facility A Facility B Facility C Facility D Facility E Facility F Facility G Facility H Facility I Flat Charge ROE = ROA / equity RAROC = ROA / economic capital
  31. 31. Confidential & Privileged DocumentConfidential & Privileged Document Economic versus Regulatory • Economic capital (EC) is the amount of risk capital that a bank estimates in order to remain solvent at a given confidence level and time horizon. • Regulatory capital (RC) reflects the amount of capital that a bank needs, given regulatory guidance and rules.
  32. 32. Confidential & Privileged DocumentConfidential & Privileged Document Look what shows up again
  33. 33. Confidential & Privileged DocumentConfidential & Privileged Document Economic capital distribution
  34. 34. Confidential & Privileged DocumentConfidential & Privileged Document $10,000,000 low risk loan Interest income 4.5% $450,000 Interest expense 3.0% $300,000 Administrative costs $60,000 Risk of loss $2,000 Taxes $35,000 Net profit $53,000 Capital allocation 3.0% $300,000 RAROC 18% Pricing influence $10,000,000 high risk loan Interest income 6.0% $600,000 Interest expense 3.0% $300,000 Administrative costs $60,000 Risk of loss $46,000 Taxes $78,000 Net profit $116,000 Capital allocation 12% $1,200,000 RAROC 10%
  35. 35. Questions?

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