presented by John Robertson and co-presented by Christie Behrens of Allegiance Bank Borrowers have enjoyed the benefits of a low interest rate environment but with rates beginning to creep up, a financial institution must price effectively by valuing the whole relationship to grow. You can be ahead of your competition by understanding the anatomy of a loan before and after you close.

1. ANATOMY OF A PROFITABLE
LOAN: BEFORE AND AFTER
John Robertson

2. Confidential & Privileged Document
Financial
Institution
Platform
Opportunities
Pricing and
Profitability
Credit and
closing -
capturing the
data
Credit
Monitoring &
ALLL
Asset &
Liability
Management
Business
Analytics
Full lending performance cycle

3. Confidential & Privileged Document
The power of pricing
• An increase of 2.5% in loan interest income
equals a gain of more than 7% in net income
• $1 in added pretax income = almost $3 in added
earnings
• A 2.5% decrease in operating expenses would
increase net income by 2.5%
• Pricing is almost three times as powerful as
expense reduction in potential impact on
earnings

4. Confidential & Privileged Document
Why has the interest in pricing amplified?
• Strategic reasons
– Margin compression
– Relationship management
– Risk management
– Performance measurement
– Return on shareholders equity
– Business and marketing strategy

5. Margins continue to narrow…forever
7.13
6.27
5.53
5.17
4.86
4.51
4.22 4.17 4.12 4.13
3.05
2.41
1.72
1.26
0.93
0.7 0.53 0.45 0.42 0.42
4.11
3.85 3.78 3.89 3.9 3.79 3.67 3.69 3.68 3.69
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
UBPR Peer Group Average - ALLL Banks
Int Inc (TE) to Avg Earn Assets Int Expense to Avg Earn Assets
Net Int Inc-TE to Avg Earn Assets

6. Confidential & Privileged Document
The importance of pricing
• Provides consistency
• Provides a scale
• Provides risk-adjusted view
• Enhances lender knowledge
• Enables profit-based reporting
• It’s indifferent

7. Confidential & Privileged Document
Truths about pricing
• Regulations will heighten competitive pressures
• CECL will dictate how much risk to consider
• Know the return you’re getting – back of the
napkin isn’t good enough
• Additional production can have
not only a positive influence, but also a negative
effect on the whole portfolio

8. Confidential & Privileged Document
What fuels the return results
• Interest rate
• Cost of funds/cost of deposits (FTP)
• Non-interest income
• Non-interest expense
• Risk expense
• Spreads
– Gross margin
– Net interest margin
– Net income

9. • Interest rates
• Non-interest
income
• Cost of funds
• Non interest
expense
• Risk premium
• Net income
• ROA
• ROE
Calculating a return - single loan
Totals Average assets %
O/S balance 100,000.00
Interest rate (V 100) 4.25%
Interest income 4,250.00 4.25%
Non-interest income 1,000.00 1.00%
Gross revenue 5,250.00 5.25%
Cost of funds 1,330.00 1.33%
Non-interest expenses 1,932.00 1.93%
Risk expense 0.3000% 300.00 0.30%
Total expenses 3,562.00 3.56%
Profit before tax 1,688.00 1.69%
Federal tax (34.0%) 573.97 0.57%
State tax (2.0%) 33.76 0.03%
Total tax 607.68 0.61%
Profit after tax 1,080.32 1.08%
ROA 1.08%
Average assets 100,00.00
ROE (8.0000) 14.14
ROA target 1.50
Additional fees 576.00
Additional basis points 57.60
Proposed Loan
Profitability
Detail Report
Loan: Proposed
Type: Commercial
LOC
Grade: Average

10. Confidential & Privileged Document
Critical measures
• Return on Assets (ROA)
– Net income / average asset
• Return on Equity (ROE)
– ROA / equity
• Risk Adjusted Return
on Capital (RAROC)
– RAROC = ROA / economic capital

11. Financial
Institution
Platform
Opportunities
Pricing and
Profitability
Credit and
closing -
capturing the
data
Credit
Monitoring
CECL & ALLL
Business
Analytics
Capture the data

12. Financial
Institution
Platform
Opportunities
Pricing and
Profitability
Credit and
closing -
capturing the
data
Credit
Monitoring
CECL & ALLL
Business
Analytics
Monitor the performance

13. Confidential & Privileged Document
Macro and micro monitor the portfolio
• Exception monitoring
• Portfolio overview
• Flags/triggers
• Proactive management

14. Confidential & Privileged Document
What do we monitor?
No Change
Good quality
Poor quality
Origination
Charge
off
Deterioration
Salvage?
Workout?

15. Confidential & Privileged Document
Financial
Institution
Platform
Opportunities
Pricing and
Profitability
Credit and
closing -
capturing the
data
Credit
Monitoring
CECL & ALLL
Business
Analytics
Risk exposure

16. Confidential & Privileged Document
Protect the stakeholder - regulators
• CECL and the ALLL
• Capital adequacy

17. Confidential & Privileged Document
Current Expected Credit Loss (CECL)
• Replace the incurred loss with a predictive loss approach
• CECL would require banks to use
– Historical information
– Consider current conditions
– Use reasonable and supportable
forecasts to estimate expected
shortfalls over the life of a loan
– Create a consistent
measurement approach
for all financial assets

18. Confidential & Privileged Document
Probability of default methodology
• Probability of default (PD)
– Borrower rating as to their ability to pay
• Loss given default (LGD)
– Facility rating differentiates risk associated with
different loans (and types of loans) to the same
borrower
• Exposure at default (EAD)
• Expected losses ($) = PD(%) * LGD(%) * EAD($)

19. Dual risk rating – facility/borrower
Becomes 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%

20. Capital regulatory evolution

21. 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

22. Capital deployment/economic capital allocations
 The primary value of economic capital is its application to decision making
and overall risk management
 Encapsulates a more comprehensive pricing system that covers
expected losses
 Broadens the evaluation of the adequacy of capital in relation to the
bank's overall risk profile
 Develops risk-adjusted performance measures that provide for better
evaluation of returns and the volatility of returns
 Enhances risk management efforts by providing a common indicator for
risk

23. Economic capital distributions

24. Pricing influence
Interest Income 4.50% $450,000 Interest Income 6.00% $600,000
- Interest Expense 3.00% $300,000 - Interest Expense 3.00% $300,000
- Administrative Costs $60,000 - Administrative Costs $60,000
- Risk of Loss $2,000 - Risk of Loss $46,000
- Taxes $35,000 - Taxes $78,000
Net Profit $53,000 Net Profit $116,000
Capital Allocation 3% $300,000 Capital Allocation 12% $1,200,000
Return On Equity 18% Return on Equity 10%
$10,000,000 High Risk Loan$10,000,000 Low Risk Loan

25. Financial
Institution
Platform
Opportunities
Pricing and
Profitability
Credit and
closing -
capturing the
data
Credit
Monitoring
CECL & ALLL
Business
Analytics
Analyze the performance

26. Confidential & Privileged Document
Business analytics
• Trending analysis
• Profitability analysis
• Funding analysis
• Strengths and weaknesses
• Strategic direction

27. Confidential & Privileged Document
Using analytics can mitigate the risk
– Balance-sheet restructuring
• Capital quality
• Balance-sheet management
• Reduced long-term funding costs
– Business-model adjustments
• Product design/mix
• Customer mix
• Risk transfer
• Geographical mix
• Cost and pricing

28. Financial
Institution
Performance
Opportunities
Pricing and
Profitability
Credit and
closing -
capturing the
data
Credit
Monitoring
CECL & ALLL
Business
Analytics
Full lending performance cycle

29. • Price effectively and adapt over time
• Monitor/understand your portfolio
• Use business analytics to set strategy
• Employ a methodology for monitoring
yesterday, today, and tomorrow
Knowledge is power!

30. KNOWLEDGE IS POWER!
Presenter Contact Info
John.Robertson@bakerhill.com