Why Community Banks Should Implement a Loan Pricing Model

While going with your gut can work in some scenarios, it can put you at a disadvantage when it comes to loan pricing in the highly competitive community banking space. Community bankers pride themselves on operating by relationship and providing personal service to their customers, and implementing a loan pricing model takes nothing away from that. What it adds is a repeatable and sustainable approach to achieving profitability targets grounded in data. PRI Consultant Shawn King says a standardized loan pricing model allows financial institutions to see their portfolio more clearly in terms of profitability and how to improve it.

In the article Pricing Models – 4 Changes Banks Need to Make Now, SouthState compares not having a loan pricing model to trying to drive cross country without a map. Although you may get where you’re going eventually, the route will likely be inefficient and by not recording the journey, you lose your chance to improve upon it the next time you travel.

In contrast, having a loan pricing model takes the guesswork out of setting rates. Including profitability targets helps lenders analyze profitability on the fly, and it ensures better consistency across the organization, King said. The model points out when lenders are focusing more on growing their portfolios than on driving profitability, which can lead to better long-term decision making. Deviating too far and too often from the modeled rates with preferred pricing can eat into the profitability of large customers a bite at a time until they’re no longer profitable at all, but it’s hard to identify the trend without a model or a tool to show it.

“Making loans is central to your bank’s operations, and lending has a compounding effect on profitability. Not only do you have to live with each pricing decision for an average of four years, but you often leverage that decision eight to twelve times. Inaccurate pricing is suboptimal in the best of times and catastrophic under the worst. If you don’t have a loan pricing model that handles cost and risk – you should. It is the single biggest thing you can do to improve profitability.” – SouthState Correspondent 

King shares tips for using loan pricing models effectively.

• Start somewhere. Using cost-plus pricing can be a good starting point to implementing a more data-driven approach to analyzing profitability.
• Accomplish institutional goals. For example, if your organization would like to get a bigger piece of C&I loans, you can use the model to price them very competitively, thereby ensuring that your strategic goals are built into and consistently implemented across the bank.
• Set risk-based pricing. Most loan pricing models allow the bank to set the risk factors and control the risk profile of their portfolio.
• Ensure lending practices are fairer and more consistent. Loan pricing models allow for rationale of rates across the board to customers rather than relying on the gut feelings of individual lenders. 
• Maintain and update the models regularly. The industry climate is constantly changing, and institutions must adapt and remain nimble. 

To the last point, King says upkeep of the pricing model is essential. Base rates should be reviewed either monthly or quarterly to ensure they remain competitive and in market. A full review of the model including profitability targets and risk factors should be performed at least annually.

“I have seen models fail because they weren’t reviewed regularly,” King said. “If something significant happens such as a change in interest rates or market demand, the model should be updated to reflect that. To keep the model relevant, institutions should have a process for keeping an eye on it and performing regular testing of the risk assumptions.”

The use of loan pricing models in community banking takes the guesswork out of setting rates and enhances the customer relationship by increasing consistency, fairness and responsiveness. It gives lenders across the bank access to standardized pricing policies that are set according to market conditions and bank priorities at their fingertips. And ensuring the long-term profitability of the financial institution ensures it will continue to exist to serve the community for years to come. 

Resources:

Loan-pricing models: What to consider for loan origination software – Abrigo

Pricing Models – 4 Changes Banks Need to Make Now – SouthState Correspondent 

Loan Pricing Model: Key Considerations for Lenders – DefiSolutions

PRI 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.