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Baker Hill Prosper 2017 - Anatomy of a Profitable Loan: Before and After You Close It

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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.

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Baker Hill Prosper 2017 - Anatomy of a Profitable Loan: Before and After You Close It

  1. 1. ANATOMY OF A PROFITABLE LOAN: BEFORE AND AFTER John Robertson
  2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 11. Financial Institution Platform Opportunities Pricing and Profitability Credit and closing - capturing the data Credit Monitoring CECL & ALLL Business Analytics Capture the data
  12. 12. Financial Institution Platform Opportunities Pricing and Profitability Credit and closing - capturing the data Credit Monitoring CECL & ALLL Business Analytics Monitor the performance
  13. 13. Confidential & Privileged Document Macro and micro monitor the portfolio • Exception monitoring • Portfolio overview • Flags/triggers • Proactive management
  14. 14. Confidential & Privileged Document What do we monitor? No Change Good quality Poor quality Origination Charge off Deterioration Salvage? Workout?
  15. 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. 16. Confidential & Privileged Document Protect the stakeholder - regulators • CECL and the ALLL • Capital adequacy
  17. 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. 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. 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. 20. Capital regulatory evolution
  21. 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. 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. 23. Economic capital distributions
  24. 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. 25. Financial Institution Platform Opportunities Pricing and Profitability Credit and closing - capturing the data Credit Monitoring CECL & ALLL Business Analytics Analyze the performance
  26. 26. Confidential & Privileged Document Business analytics • Trending analysis • Profitability analysis • Funding analysis • Strengths and weaknesses • Strategic direction
  27. 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. 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. 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. 30. KNOWLEDGE IS POWER! Presenter Contact Info John.Robertson@bakerhill.com

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