In a competitive environment, just giving the customer a good rate may not be enough. Financial institutions must value the complete relationship in order to understand how valuable that customer truly is.

1. RELATIONSHIP PRICING
Fran Brashares, Marquette Bank
John Robertson

2. KEY COMPONENTS IN LOAN AND
RELATIONSHIP PROFITABILITY

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How can you not make money in banking?
• Current commercial loan rates range from 3.00% to 7.00%
depending upon the perceived risk
• Cost of Funds/Cost of Deposits is much less
• Purely a matter of managing the arbitrage

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But you have to be really smart
• Simplest form
– Collectively all the income producing assets generate income through
interest rate charged based upon the perceived risk
– Liabilities provide the funds to generate the assets at a cost
– Employees pursue both the assets and liabilities at a cost
– Investors provide the where-with-all to obtain both with an expected
return in mind
– So unless you don’t charge enough, risk too much, or pay too much,
net, net, a bank should make money

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What fuels the returns? - critical attributes
• Interest Rates
• Cost of Funds/Cost of Deposits
• Non Interest Income/Expense
• Spreads
– Gross Margin
– Net Interest Margin
– Net Income

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Key measures
• Gross Margin/Revenues
– Interest Income plus Fees, less Cost of Funds
• Net Interest Margin (NIM)
– Interest Income less Cost of Funds
• Net Income (pre-tax)
– Includes Interest Income plus Fees less Cost of Funds less Non-interest
Expense less Risk Expense
• Net Profit After Tax

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Critical indicators
• Return on Assets (ROA)
• Return on Equity (ROE)
• Risk Adjusted Return on
Capital (RAROC)

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The importance of critical indicators
• Consistency in comparing business loan returns
• Provide a scale to use in managing customer relationships
• Provides risk-adjusted view of loan and relationship returns
• Enhances lender knowledge and ability to consider
loan structure tradeoffs
• Enables risk-adjusted and profit-based reporting

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Return on Assets (ROA)
• An indicator of how profitable a loan is relative to its total
outstanding balance.
• How efficient management is at using its assets to generate
earnings
• ROA = Net Profit After Tax/Average Asset

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Return on Equity (ROE)
• The amount of net income returned as a percentage of
shareholders equity
• How much profit a loan generates with the money
shareholders have invested.
• ROE = ROA/Equity

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Risk-Adjusted Return on Capital (RAROC)
• Framework for analyzing risk-adjusted financial performance
and providing a consistent view of profitability across
businesses.
• Economic capital is a function of market risk, credit risk, and
operational risk
• RAROC = ROA/Economic Capital
• RAROC = ROA/Value at Risk (aka VaR)

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ROE versus RAROC
• The primary value of economic capital is in its application
towards decision making and overall risk management
– Broadens the evaluation of the adequacy of capital in relation to the
bank's overall risk profile
– Develops risk-adjusted performance measures that provides for better
evaluation of returns and the volatility of returns
– Enhances risk management efforts by providing a common indicator
for risk

13. DEPOSITS HAVE VALUE TOO

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Funds Transfer Pricing (FTP)

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FTP should be consistently applied
• Balance sheet and liquidity management
– FTP assumptions should be closely synchronized with A/L modeling
assumptions; in turn, both should be consistent with investment and
Treasury funding decisions
• Performance measurement
– Results should allocate accurate funds charges and credits to the
entire balance sheet
• Product pricing
– When a new product is to be offered, its interest rate characteristics
should be fully understood to derive an appropriate FTP rate and thus
have the information necessary for profit/volume tradeoff analysis.

16. RELATIONSHIP PROFITABILITY

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Reasons banks use relationship profitability
• Margin compression – earnings pressure
• Relationship management – ranking
• Risk management – up front
• Performance measurement – a profit aspect
• Return on shareholders equity – economic profits
• Measurement consistency – equally unfair to all
• Business and marketing strategy – compliance

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Example – single loan pricing results
Revenues
Interest $7,875
Fees $0
______
Gross revenues $7,875
Expenses
Cost of funds $2,250
Deposit credits $0
Administration $2,513
Loss reserve $375
Other expenses $0
______
Total expenses $5,138
Profit before tax $2,737
Taxes $958
______
Profit after taxes $1,779
ROA 1.19%
Average assets $150,000
One Product:
One line
$250,000 LOC
60% utilized
At prime plus 1%
No fees

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Example – relationship profitability results
Revenues
Interest $7,875
Fees $420
Gross revenues $8,295
Expenses
Cost of funds $2,250
Deposit credits ($2,200)
Administration $4,163
Loss reserve $375
Other expenses $0
______
Total expenses $4,588
Profit before tax $3,707
Taxes $1,297
______
Profit after taxes $2,410
ROA 1.61%
Average assets $150,000
Two Products:
One line + one deposit
$250,000 LOC
60% utilized
At prime plus 1%
No fees
Variable rate FTP at 1.5%
Commercial DDA
$55,000 average balance
Collected less 10% reserve
Average FTP at 4%

20. PROTECT THE STAKEHOLDER
Capital adequacy is crucial

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Tools of the trade
• CECL
• Dual risk rating
• Application of economic capital

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CECL - Where it’s been
• GAAP required using an “incurred loss” methodology
• Delayed recognition until it is probable a loss has been
incurred
• GAAP restricted recording credit losses but not yet meet the
“probable” threshold

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Challenges
• Clarity around acceptable interpretation of the CECL model
externally and internally
• Level of coordination between finance, credit, risk, IT, and
others to execute the implementation
• Availability of data
• Capability to design, build, and test new models with limited
internal resources
• Capability to plan and execute a program of this size in
parallel with other current initiatives

24. DUAL RISK RATING
PD and LGD

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Dual risk rating
• Examiners review internal ratings of loans to determine the
adequacy of credit risk administration
• Definitions of credit grades should be detailed and clearly
delineate risk levels between grades
• Loan grades are becoming more granular

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Prominent factors used when determining dual risk ratings
• Probability of default (PD)
– Expected credit losses associated with
default during a defined time period
• Loss given default (LGD)
– An estimate of loss given default
• Exposure at default (EAD)
– Measure of estimated exposure at default
• Expected losses ($) = PD(%) * LGD(%) * EAD($)

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Dual risk rating – facility/borrower 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%

28. CAPITAL ADEQUACY

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Capital regulatory evolution

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Relevant Risk vs. a “Flat Charge”
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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

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Economic versus Regulatory
• Economic capital (EC) is the amount of risk capital that a bank
estimates in order to remain solvent at a given confidence
level and time horizon.
• Regulatory capital (RC) reflects the amount of capital that a
bank needs, given regulatory guidance and rules.

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Look what shows up again

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Economic capital distribution

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$10,000,000 low risk loan
Interest income 4.5% $450,000
Interest expense 3.0% $300,000
Administrative costs $60,000
Risk of loss $2,000
Taxes $35,000
Net profit $53,000
Capital allocation 3.0% $300,000
RAROC 18%
Pricing influence
$10,000,000 high risk loan
Interest income 6.0% $600,000
Interest expense 3.0% $300,000
Administrative costs $60,000
Risk of loss $46,000
Taxes $78,000
Net profit $116,000
Capital allocation 12% $1,200,000
RAROC 10%

35. Questions?