If you’ve ever considered building your own loan pricing / profitability model, you should have a pretty good idea about what’s involved. There are many factors, but the bulk of the profit is driven by credit risk and interest rate risk. To address credit risk, a bank needs to set aside a loan loss reserve (provision) large enough to cover the Expected Loss (EL), and hold enough capital to protect against the Unexpected Loss (UL). Mitchell wrote a great article about the effects of capital and provision on loan pricing… definitely worth a look whether you decide to buy or build. I won’t go into the details of interest rate risk, but encourage you to take a look at Mitchell’s article on choosing the appropriate cost of funds for your loan pricing model for a few nuggets of wisdom that you might not have considered.
Over the years, we’ve found that getting the math right, and doing it in a way that drives the right behaviors within the bank can be incredibly challenging – particularly for community banks. We believe that loan pricing is one of the most important things that banks do, and encourage you to to consider a trusted and proven risk-based loan pricing solution like PrecisionLender.
Some light reading… During our 25+ years of consulting with banks on loan pricing, we’ve built quite a library of resources. This week, I’d like to share a few books you might find helpful in your quest to either build a loan pricing model from scratch, or buy a loan pricing solution appropriate for your bank.
Know of a great book that we missed? Please let us know and we’ll gladly add it (and probably read it too).