Developing and implementing commercial loan pricing models.

Many banks are re-evaluating their commercial loan pricing models to ensure that they are accurately pricing loans in relation to increased competition from other banks and nonbanks. The authors were responsible for developing and implementing such a model at Citizens Financial Group, a $18 billion multi-bank holding company. The following is a list of various issues that financial institutions must evaluate in this process.

Why Do We Need a New Pricing Model, Anyway?

Intricate evaluation of the profitability of individual loans and relationships is more cost-efficient today, thanks to advances in technology. It's fortunate that cost-efficiency is attainable, because the need to evaluate the risk-reward relationship is more critical to bankers than ever. Multiple-pricing alternatives and cross-sold relationships mean that bankers cannot just look at a single loan. Instead, they frequently must use the loss-leader marketing philosophy to meet competition.

The entry of unregulated competitors and borrowers' willingness to haggle over the last five basis points indicate that managing interest-rate sensitivity, overall return, and risk-reward has to be considered at the line level, not just on a macro-basis. So banks must provide lenders with tools to quickly and efficiently determine the spreads necessary on loans of various structure, tenor, and pricing level. Whether it's a customer the bank has supported for 40 years or one that the bank would like to add to its portfolio, the customer expects a quick response to alternate pricing quotes.

Who Should Own the Model?

The pricing analysis incorporates aspects of commercial lending, finance, credit, accounting, asset liability committee (ALCO), and risk management. The input of all the parties must be obtained, even though some issues will require compromises. The model, however, must have one owner to ensure proper documentation, training, applications, and future development. Often, the function with the proper technical resources and portfolio orientation to manage this process will be risk management. Care must be taken, however, to ensure that the model is viewed as our model instead of that model. It is especially important that the commercial lending department accept ownership of the model, because the loan officers and analysts will be the people most immediately impacted by its use.

Who Should Calculate Pricing Return?

Some institutions may wish to centralize the loan pricing function and perform pricing analyses for lenders on a request basis. This structure has the benefit of discouraging "gaming" of the model and ensures consistency and accuracy in applying the desired methodology. However, unless this area is adequately staffed and available at all hours (since that is when bankers work now), it will not provide adequate response time for lenders. This structure also could convey the concept that management does not trust line staff to manage this aspect of their relationships. By allowing lenders to immediately access …