Loan Pricing: How to Reduce and Manage Lending Risk in an Increasing Rate Environment

While we have never been in another economic cycle exactly like this one, the fundamentals of lending and borrowing for financial institutions remain the same. As always, FIs are interested in how to prepare for and respond to what’s coming while protecting their interests and jumping on emerging opportunities to increase revenue and profits.

In this blog, Ty Glenham, consultant at Profit Resources, Inc., discusses how to manage lending risk in an environment of rising interest rates, higher inflation, low unemployment, and steady consumer spending.

“For the past two years, rising interest rates and increased competition have led to some community banks becoming laxer in their standards in order to get the business,” Glenham said. “Perhaps the initial underwriting of their portfolio of loans wasn’t as strong as it could’ve been and now those loans are repricing. While we don’t want to completely avoid risk, we do want to be much better credit risk managers in response to the current business conditions.”

Through thoughtful strategic planning, incorporation of strong data analytics and process improvement recommendations, PRI helps clients determine what makes sense for their specific organizations. Leveraging the skills of its internal team, the following are some simple strategies an FI can deploy to manage its potential credit risk.

Balance portfolio concentrations.

As at other times in history, although for very different reasons, heavy commercial real estate concentrations in portfolios are cause for concern in the current environment. After the pandemic sent most people home to work remotely, there has not been a mass return to empty office space. What happens to the empty space? How will the debt load be transformed in the community banking sector and how quickly can they adjust?

Keeping in mind that there may be excess supply in commercial real estate buckets, thereby driving down the ability to collect rents and service the loan, there can also be opportunities for community banks.

“They may be looking at new potential customers as bigger banks offload CRE loans,” Glenham said. “However, they cannot relax underwriting standards to accommodate this new business. In fact, they must utilize all the data analytics and stress testing tools they have available to strengthen their positions.”

Return to fundamentals.

Times may have changed, but the fundamentals of lending have not. There are four questions FIs must consistently ask when establishing new loans.  

·         Why does the borrower need money?

·         How do we get repaid?

·         What are the risks to repayment?

·         How do we mitigate the risks?

“There’s a saying that cash flow repays the loan, not collateral,” Glenham said. “This is particularly important to remember in the current environment because rising interest rates affect the cash flow of a business, which in turn impacts the ability to pay back the loan.”  

Glenham says when reviewing loans from three years ago, it’s important to keep in mind that much has changed in three years. He advises tightening underwriting standards and continuing to closely monitor loans in the “watch” bucket. These are credits that are more sensitive to economic conditions and benefit from portfolio data analytics to form the basis for an effective action plan to help the business manage through the economic cycle.   

Review triggers that impact credit.

The McKinsey & Company article, Navigating Economic Uncertainty: New Guidance for Credit Risk Management, said that the current levels of risk appetite were set during an extended era of low interest rates and lessened volatility than exists today. But these conditions are unlikely to return soon.

“Indeed, the reasonable assumption is that the business cycle has shifted, and through-the-cycle portfolio behavior may significantly change. Banks therefore need to revisit through-the-cycle views of client performance in a higher rate environment, as well as verify that monitoring frameworks, triggers, and cascading mechanisms are still relevant and workable—from both a risk management and business growth perspective.” – McKinsey & Company

Some of the triggers that impact smaller credits at FIs include overdrafts in checking, delinquencies, increasing usage of lines of credit and management issues. In larger credits, failure to meet loan covenants, negative financial trends and decreasing collateral values are cause for a closer look. In the CRE market, triggers include tenant rent roll, construction cost overruns or project delays, inadequate or lapsed insurance coverage and market or collateral value changes.

Deeply analyze your relationships.

Glenham suggests that it is best practice for lenders to regularly review their business customers’ abilities to continue repaying their loans. Some lenders require regular on-site visits with customers. Larger loans and aggregate relationships should have thresholds established to review credit on a periodic basis. Diving deeper into updated financials will give a fuller picture than relying on documents from two or three years ago.

While a higher interest rate environment can mean more profit and opportunities, FIs must continue to manage risk appropriately to protect their long-term health and success.

Resources:

Navigating Economic Uncertainty: New Guidance for Credit Risk Management, McKinsey and Company

Loan Pricing: How to Increase Profitability/ROE in an Increasing Rate Environment (profitresources.com)

Profit Resources specializes in identifying profitability improvement areas for financial institutions through revenue growth, cost control, streamlining processes, and effective use of technology. Contact us to learn more about our personalized approach to propel growth and improve profitability.