LET THE MARKET MANAGE OR MANAGE THE MARKET?

If there is one thing that saps the ROE of an independent bank, it is the origination of loans below $500,000. While good for diversification, small loans have nearly the same acquisition and maintenance cost as their larger brethren. It takes the same time to court the customer, same time to process credit and the same effort in documentation. A study we conducted last year revealed that the average independent bank loan officer spent almost 60% of their time with activities related to the pure administration of customers. Given that the average acquisition cost is approximately $15k per loan, banks need to drive more than $75k from the relationship in order to cover credit risk, relationship administration and overhead. A review of our relationship profitability database shows that 46% of these relationships fall below a 15% risk adjusted ROE and some are even negative. Since smaller loans are the bread and butter of many independent banks, lenders are left with the following tactics: 1) Increase pricing – Depending on the structure, pricing on small loans may need to be increased in order to compensate for the higher relative acquisition cost. Admittedly, increasing pricing by 20% or more is usually the least available option. 2) Streamline underwriting – In order to lower processing costs, banks that want to make smaller loans more profitable need to be prepared to reduce paperwork, simplify the loan approval process and utilize more credit scoring. Banks that do these things can cut direct and indirect expenses from an average of $15k, down to about $8k per loan. 3) More profitable structuring – Small loans need to have longer effective durations and less optionality than larger loans, in order to maintain the same profitability. Further, these loans need to be part of a deeper relationship. This means greater use of floors, prepayment penalties and covenants that increase (or decrease) pricing based on credit performance over time. In addition, banks should consider requiring mandatory deposits and longer maturities the smaller the loan. By using a pricing model similar to ours, banks can quantitatively see how these multiple factors can interact to create value. 4) Live with it – If banks are not willing to change pricing, underwriting procedures or structure, but still want to originate smaller loans, then they should understand the risk-adjusted ROE will suffer. For banks that are either forced to originate smaller loans, or choose to do so, it is important to make sure this is a conscience decision. For banks that find "small loans are all that they can originate," we challenge these banks to change their origination process to make the organization more profitable. Loans below $500k do not need to be a drag on profitability. In fact, if done right, banks can achieve risk adjusted returns of 20% or better with a bit more focus. As we say about all bank operations, management of resources and capital must be at the discretion of management, not the market.