Ahead of the curve: A banker’s podcast episode 2 – Loan pricing

Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

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Thomas Curley 0:16

All right -This is Ahead of the Curve: A Banker’s Podcast. Welcome to our next episode, I’m your host Thomas Curley and I am here with Rob Newberry who is a Senior Advisor with a Abrigo’s Advisory Services Team. He is also a faculty member of the Graduate School of Banking at the University of Wisconsin Madison. For the past ten years he’s been working with financial institution leaders and regulators to develop a suite of credit administration tools for community banks and credit unions. Prior to Abrigo, Rob spent 15 years at Wells Fargo holding very strategic and leadership roles in areas such as business intelligence and delivery innovation. And he is a proud graduate with his MBA from the University of Iowa.

Rob Newberry 1:00

Ya, Go Hawks!

Thomas Curley 1:02

So Rob welcome to the podcast.

Rob Newberry 1:05

Rob Newberry

Yeah, no problem. Thanks for having me, excited to get to talk today about what’s going on in the market.

Thomas Curley 1:10

Awesome! Yeah, well speaking of the market I know there’s been a lot of what do you want to say, uncertainty around some of the things that were going to happen at the beginning of 2022. And one of those big things were kind of a potential rising rate environment with some of the fed meetings coming up. You may want to walk us through maybe talk about some of that and what’s going on there with some of the expectations and things that might be up on the horizon.

Rob Newberry 1:34

Yeah, absolutely.  You know you’re right; we live in an interesting time right now with covid and stimulus money that’s out there and so one of the things that’s happening is we had some inflation. And anytime you have inflation the fed has a target number that they want to hit, which is around that 2% and we’re kind of trending it about that seven and a half percent and what’s a little different now than has been in the past is I think there’s a couple reasons inflation’s happening.

One is, I don’t want to overuse this term but we might have been a little overstimulated so we flooded the market with money, right? So now people have a lot of demand for products. At the same time covid created a lot of shortages either through computer chip shortages, there’s been disruptions in the distribution channel of how products get to consumers. Also, we had a shortage of supply which has caused inflation right? So, prices are all going up and so typically what the fed does is they’ll raise the interest rate to try to kind of subdue the demand. I think what the problem will be is because we have so much extra money in the market, it might take a little more rate increases than has been in the past because of that double edge sword that we’re working with right? A shortage in the supply chain and extra cash kind of sitting in the sidelines that could be put in the market. Those 2 combinations mean that we expect in 2022 several rate hikes probably by the fed to try to lower the inflation rate. So, like said interesting times, we really haven’t had a place I think in recent history where we’ve had both a shortage of supply and an excess demand. So. It’ll be interesting to see how many rate hikes it actually takes to kind of get inflation under control heading into 2022 as we kind of ease out of the pandemic and covid issues that are going across the country here.

Thomas Curley 3:40

Yeah, sure seems that things have been a little bit backwards recently from kind of conventional thinking. Two words you kind of mentioned them are kind of alluded to both of them but around you know margin compression and inflation, but do you want to maybe talk about those a bit more specifically and kind of what’s going on?

Rob Newberry 3:56

Yeah, and so when we talk about financial institutions there’s a couple things that we need to be concerned about. One is the cost of funds right and how institutions get money is you know we can borrow it from the fed, we can get it from customers right and then we use their funds and lend it to other folks. And so, what’s happening in today’s environment, if you had an account today and we’re only paying you let’s say 10 basis points, but all of a sudden, the fed raises rates twice what do you think is going to happen to the expectations of that customer right? They’re going to expect more return because they know the interest rates are going up in the in the industry. At the same time, we also have already lent money out at a certain rate and so what typically happens in a cycle like this is you do get compression or margin constraint where we’ve already lent money out at 4% but now our cost of funds are steadily creeping up and depending, and we’ll talk about ceilings and floors here in a minute Thomas, but it does create some compression on our net interest margin spread. And we’ve seen that if you look at financial institutions returns since covid started, we’ve seen a little compression in net interest margin and what I would say their overall profitability over the last couple of years for sure.

Thomas Curley 5:20

And gotcha that makes sense. What I find interesting just, you know, I’m relatively newer to kind of the banking industry, but typically a rising rate environment is something that’s a little bit, you know, cheered upon when it comes to institutions. But I know when we were talking before this prepping, you know there’s definitely some challenges that a rising rate environment presents that, you know, maybe those haven’t been through before maybe don’t remember, or maybe have just chosen to forget.

Rob Newberry 5:43

Yeah, you know one of the things is bankers always kind of think that in a raising rate environment they’ll be able to charge more for interest rate, higher loan rates and they’ll make more money. But at the end of the day, really, we kind of make money by managing that margin or that net interest margin spread. So, if the cost of funds that you have to pay your customers or borrower from the government is 2% and you’re offering 4% loans you still have that, you know ,2% margin. Well, if your cost of funds goes up to 4%, if you offer 6%, you’re still only making 2%, right? And so, I think a lot of bankers get tripped up on thinking well I’ll be able to charge more interest and I won’t pay as much for my cost of funds and the problem we’ll have is when financial institutions aren’t as liquid because they’ve lent all their money out. In order to get more funds, they have to pay more up just like inflation for a consumer. It’s kind of like inflation for a bank, right? Now we have to pay more for the money we need to lend out and so even though banks a lot of times think they’ll make more money in a raising rate environment; it really gets into how well they’re managing that net interest margin spread. Whether they’re on the loan side or on the cost of funds of what they’re paying their depositors.

Thomas Curley 7:03

And I know a big, I guess, advantage or a way that folks can kind of manage that spread is through, you know, loan pricing models and some software. What are your thoughts on, kind of, utilizing a tool like that to maybe help with something like that?

Rob Newberry 7:17

Yeah, you know we talk about it. There’s a few concepts when we talk about managing loan pricing from a, once again at the end of the day it all kind of comes down to managing that spread and so one of the bigger factors is understanding that input cost right? What do you have to pay for those cost of funds? Loan pricing models are great in a couple ways. One is if you have the right assumptions in your model, you can actually understand and protect that net interest margin and make sure that you’re charging enough for your loan rates to protect that margin.

Now usually in a beginning of an interest rate cycle where rates start to go up, you have laggers right? Where someone’s been living under a rock and they don’t understand that rates are going up so they still are offering 4% and my institution wants to offer four and a half percent. Where do you think, the customers are going to flock right? To the person that maybe has had their head in the sand for six months and doesn’t know what’s going on and so they can impact the market in a couple ways. One is you get that that interest margin compression and with the loan pricing model what it helps institutions do is understand is that a good deal for me to chase at instead of getting the loan? Or should I pass on that deal in wait and get a better opportunity with the customer that meets my expectations for my net interest margin requirements, so that I can protect the financial institution’s net interest margin and eventually ROA and ROE for that financial institution. So yeah, so there’s a couple ways that helps. One is once again, understanding what the lag is in the market and what you’re going to increase your rates based on how the fed increases the rates and two, when you look at competitive pressures through a loan pricing model, so if a competitor down the street is pricing at 4 and you think you should price at 5 you could actually see how much money you would be sacrificing to match that rate and understand is that something that you want to do or not. Without a pricing model a lot of times Thomas what customers end up doing or financial institutions is they just match that competitor and they don’t realize how much money they they’re losing by doing that match comparison.

Thomas Curley 9:30

Yeah, no I think that definitely, obviously, you’ve hit a lot on profitability there and trying to protect what you what you have right now and obviously just matching a competitor without really thinking about some of the other you know items that go into that. You know, are there any other examples or best practice you would say on how to maybe go about protecting kind of the current profitability that some of these financial institutions have right now?

Rob Newberry 9:52

Yeah, there’s a couple things you can look at. One of the things would be, one of the normal practices in a flat rate environment is a lot of financial institutions put in floors which would be what I would say is they’re going to say I’m going to give you prime plus 2% but the minimum that the rate will go down to is I have to at least charge you 4%. Well, the problem you have is in a raising rate environment one side of the equations going up while the other stays steady at that 4%, so your cost of funds will steadily rise and create profitability or margin compression on the financial institution side on that front. And so, from a profitability perspective in a raising rate environment, you want to be careful of your floors for a couple reasons. One is depending on how fast rates go up, will it trigger if you’re using a variable loan product enough where you can reset your rates to capture what the increased cost of doing that loan is so that you can protect that net interest margin. So, if you have a bunch of floors in, you’ll probably want to reassess maybe some of your loan pricing policies to say hey is that floor high enough? Or do I want to remove the floor and have a better a bigger spread on what the prime rate is to almost get to the floor so that when prime goes up it follows it a little closer to protect your net interest margin. So that would be something as we look into going into a raising rate environment. You’re going to want to consider.

On the other side of the equation right, that’s kind of the loan side, on the deposit side of the equation you have to understand how much of the interest rate you’re going to and how fast you’re going to pass it through to your customers. So just like on loans, there’s a lag when fed raises the rates a quarter and you’re only paying your customer ten basis points are you going to pay them 35 basis points now that the fed raised at 25 basis points? Or are you only going to pay them 25 and how long is it going to take you to raise what you’re paying your customer on their deposit account. So that’s the other thing when we talk about policies and a raising rate environments very important to understand those strategies on how to maintain your customers. You don’t want them to leave because, Thomas, your financial institution’s paying the full 35 basis points and I only want to pay 20, the savvy customers are going to go to your bank and say hey I can make a lot more money if I leave my money at Thomas’s bank then I can at Robs. And so, you really have to be careful not to lose a bunch of your liquidity or have we call it surge balance, right? Where sophisticated individuals might move their funds where they can make the most money versus people that maybe are a little asleep at the wheel and they don’t understand that they can make 25 basis points down the street so they just leave their funds at your institution.

Thomas Curley 12:48

Gotcha that makes sense and I guess that brings up I know one of the questions we talked about before was, you know, should you charge more for customers given this time that there’s kind of different factors happening on both ends of the spectrum.

Rob Newberry 13:01

Yeah, you know, it gets interesting and, you know, I don’t want to kind of breach the fair lending rules. We’ll talk a little about commercial first and so you know depending on the risk of that deal right, you should you want to match the risk with the reward as a financial institution. So, if you know that the customer is a little more risky and there’s a little more probability that he might not pay you back, you’re going to want to charge a little more money to make sure that you can break even on that deal, right? If you have a really solid customer, you probably don’t raise the rates as much as if you have someone that’s average or a little shaky coming out of covid. So, Thomas you would adjust your rates a little on the commercial side based on that. Same on the consumer side, right? A lot of folks are familiar with FICO scores and payment history and some of those things. A lot of times you’ll see whether it’s an auto loan, a home mortgage depending on the FICO score you might get a little better rate. It all gets into that credit risk component when we talk about profitability and loan pricing right? Is hey, because there’s more risk, I have to charge you a little more money for the folks that don’t make don’t pay me back to cover those losses. And so, you will see a little of that as we go into a raising rate environment and so it’s just like deposits, even if rates go up a whole quarter, if I’m a really good customer I probably don’t pay a whole quarter more. I probably only have to pay 15 or 20 basis points more because otherwise I’ll go down the street and get a better rate from another financial institution.

Thomas Curley 14:39

So yeah, competition is definitely not going anywhere so you got to be careful there on both ends. So, I think we’ve hit on a bunch of you know topics on hey here are some things that I have been doing that’s been keeping me profitable and we’ve also kind of touched on some of the challenges of a rising rate environment. But maybe what are some best practices or ways that you see the institutions can really take advantage of this rising rate, like is there something that they can tweak a little bit that really propels them kind of into this new environment.

Rob Newberry 15:08

Yeah, you know there’s a couple things you can do. One is product innovation, a little of it. You know much like banks and credit unions are worried about raising rates of environments as far as what it’ll do to their financial position. As a customer, I also know rates are going up so I probably want a product that maybe you don’t want to offer me right? And so, as a customer I want a fix term product right now because if rates continue to go up, I want to pay a lower interest rate and a lot of times bank are the exact opposite. In a raising rate environment what does a financial institution want to give you? They want to give you a variable product, right? Because they want that protection if rates continue to go up that they can charge you more money and so it’s coming up with some of these new maybe fixed product features that give a little protection to the customer but still give the financial institution a little upside. And you can get a bunch of market share, right? So most people are afraid of raising rates that they might lose market share, but it’s a great actually time to gain market share if you do the right things as far as if I want to grow my deposit base for a certain target market, do I pay actually a little more on basis points up front now and lock them into a longer term CD or something where maybe I can get some money now and pay a little up at the beginning but save money on the back end if rates go up. And so, there’s a bunch of different strategies both on the funding side of the balance sheet as well as the lending side of the balance sheet that you can do in a raising rate environment like that Thomas. But a lot of it gets into those product features and I would challenge financial institutions is take a walk a mile in the shoe of your customer and understand what they want because you know if they don’t want it it’s gonna be harder to get that net interest margin spread that you’re looking for because they, you know, says the old supply and demand curve right? They have a demand for a fixed product and you’re supplying them the variable product. They don’t want that so you can’t sell as much as of that if that makes sense.

Thomas Curley 17:12

And also, always brings to mind your favorite illustration of the various salts. So, from if anyone has joined any of your webinars in the past with us…

Rob Newberry 17:22

Yeah, absolutely yeah. When you get down to it, it’s all supply and demand Thomas and that’s what’s interesting too about the inflation and why I think we’re going to have to have multiple rate increases here in the near future is just because it’s hitting both sides of that equation. On pent up demand because I have money and you know, my son’s a great example. He wanted a new, I don’t know we’ll call it an Xbox and there’s only limited amount so he’s willing to get on a list and pay more money upfront to make sure he gets one because he’s worried that there might not be any for another eighteen months. But he wants to make sure he has one, right? And that’s kind of like the thing that’s going on in the market now is if you really want a new car, you’re willing to pay up. Well, what happens is there are people that wanted to buy a new car can’t afford it now are gonna buy a used car, now all the use car prices also go up. And so, you kind of see how that inflation’s impacting the market in general on that front.

Thomas Curley 18:19

So, you’re right I was actually going to say that the car market has been crazy. I’ve just seen some articles about used cars and I can’t remember that percentage, you know, increase in the overall prices but compared to, you know, two years ago that same car might actually be instead of depreciating asset it might actually be making people money all of a sudden which is definitely a strange thought.

Rob Newberry 18:38

Ah, yeah, it is but you know what happens is they still have to pay more for the next car. So, it’s kind of like the housing market, right? Housing market’s up, but if you make an extra 10% selling your house, you actually had to pay another 10% for the house you just bought. So, for them it is kind of a wash. But yeah, is that mindset that you have to struggle sometimes on. Yep.

Thomas Curley 18:58

I know for sure. Well I know we’re coming close on time here and so what I wanted to do was just kind of if folks maybe weren’t able to listen to the entire podcast or maybe they zoned out for a hot second, you know, what would be maybe your two or three big takeaways Rob for kind of knowing the rising rates are coming, knowing that profitability will always be something that financial institutions are striving for. What would be maybe your two cents’ there.

Rob Newberry 19:24

Yeah, I would say, kind of, leverage some of the software you might already have. Loan pricing models are a great way to protect your net interest margin. Remember, you’re not making money on what the cost of funds are coming from the government. You’re making it on that net interest margin spread. An in order to protect that spread you might have to have some new product features to provide enhancements or features in your products that your customers actually are willing to pay up for to protect that margin. And once again, take a mile walk in the shoes of your customer so you understand what they really want. And you know it’s not necessarily a bad time, it’s opportunity really for financial institutions to actually increase market share if they approach it the right way and still maintain their profitability or their margin that they have right now.

Thomas Curley 20:19

Well said and I think that those are some great tips for our listeners here. Well, we’re right at twenty minutes here so I just want to thank you so much for joining Rob. I think always good just to talk a little bit on loan pricing and also given when this episode will probably pop out here, we might actually get some clarity on some of the rising rates for sure as well.

Rob Newberry 20:39

Yeah, well thanks Thomas for having me. I’m always glad to come and pop on here and have some interesting conversations with you.

Thomas Curley 20:44

All right – we definitely appreciate it. For those that are new listeners or maybe haven’t subscribed yet. you can find this podcast and future episodes on Abrigo.com or you can find it on your favorite podcast app or platform, just search Ahead of the Curve: A Banker’s Podcast. And you can hit subscribe or whatever they choose to call that button on the podcast platform that you use. Thanks so much for listening and we will be back again with you soon.

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