asdfIf 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).

Bank Valuation and Value-Based Management: Deposit and Loan Pricing, Performance Evaluation, and Risk ManagementBank Valuation and Value-Based Management: Deposit and Loan Pricing, Performance Evaluation, and Risk Management

by Jean Dermine
This is a great book as it spends a substantial amount of time focusing on loan and deposit pricing and the principles of performance management within the bank. It also provides a great deal of background on Basel and the differences between regulatory capital and economic capital.

Credit Risk Modeling using Excel and VBACredit Risk Modeling using Excel and VBA

by Gunter Loffler and Peter N. Posch
If you are a “credit nerd” and want more than just theory and discussion and instead want to understand how put the math to work, this is for you. It provides some good discussion, but then gets down into real-world analysis in Excel.

Risk Management, Volume 1: A Modern PerspectiveRisk Management, Volume 1: A Modern Perspective

by Michael Ong
This is the standard textbook for a lot of Financial Risk Management (FRM) training courses. It is definitely comprehensive in scope, but does not goes as deep into the details as the Loffler & Posch book above. it is a great reference, but you will likely want more detail and examples to put it into practice.

Internal Credit Risk Models: Capital Allocation and Performance MeasurementInternal Credit Risk Models: Capital Allocation and Performance Measurement

by Michael Ong
This is another great reference from Michael Ong. This is much more focused on credit risk (as the name implies) so it is much more relevant to bank loan and deposit pricing and profitability modeling.

The Standard & Poor's Guide to Measuring and Managing Credit RiskThe Standard & Poor’s Guide to Measuring and Managing Credit Risk

by Arnaud De Servigny and Olivier Renault
Another great reference on credit migration analysis, probabilities of default (PD) and loss given default (LGD). This one will get deep on the math but still worth the effort and very handy to have on the shelf.

Principles of Corporate FinancePrinciples of Corporate Finance

by Richard A. Brealey and Stuart C. Myers
This is the standard textbook for most MBA-level Corporate Finance courses.  It is not banking focused at all, but provides a solid foundation for such things as spot rates, forward rates, liquidity, etc.