February 2019

Michael Oravetz, Associate, ALM Strategy Group

Last year was a profitable one for most financial institutions. Despite increased volatility and global concerns, depository performance reached post-crisis highs as shown in Figure 1. Today, many institutions are looking for ways to maintain and grow profitability. In times of uncertainty, we suggest going back to basics with these core lending principles: asset pricing discipline, marginal return analysis, and leverage strategies.

Figure 1

Core Lending Principles

Pricing Discipline to Combat Margin Compression

Pricing discipline should always be at the forefront of an institution’s lending decisions. For institutions facing concentration risk concerns, or operating an originate-to-sell model, the harsh realities of poor pricing can negatively impact earnings.

Net interest margins (NIMs) and profitability have expanded over the last decade as lending has surged and deposit pricing has lagged. This leaves many depositories susceptible to repricing risk in their primary lending categories: auto loans and residential mortgages. To combat margin compression as funding costs rise, benchmark pricing can be evaluated through an economic return on equity (ROE) lens and pricing (i.e., yield) can be adjusted as changes in market-based sources arise.

Marginal Return Analysis to Balance Volume & Profitability

High performing institutions work hard to foster and maintain relationships, especially those who capitalize on cross-selling opportunities. However, profitable assets must be added to the balance sheet to increase the value of an institution. This means executive management should be measuring the value of relationships and finding a balance between volume and profitability – best accomplished through marginal return analysis.

Efficient allocations of capital should be evaluated on the margin. As shown in Figure 2, this involves gauging the perceived risk-adjusted performance of any two (or more) assets. After adjusting for marginal operating, credit, and funding costs, only those assets that meet the institution’s hurdle rate (commonly thought to be WACC, or weighted average cost of capital) should be added to the balance sheet.

Figure 2

Deploying Leverage to Fund Profitable Assets

If loan demand remains strong and deposit growth dwindles, funding profitable assets can become burdensome. That’s why many institutions have chosen to wholesale fund on the margin and leverage.

Leverage strategies should be evaluated within the broader context of existing balance sheet risk and capitalization. An example wholesale leverage transaction can be seen in Figure 3. Many institutions have utilized this type of transaction to supplement organic loan growth. Wholesale or non-core funding, if appropriate for an institution’s risk profile, can be an effective way to maintain a robust lending program and manage reduced margins.

Figure 3


Overall, financial institution performance remained strong in 2018. However, maintaining discipline within lending programs can help prevent complacency. This “back-to-basics” approach will help depositories in 2019 and beyond. Pricing discipline and marginal return analysis are a must, and leverage can be used when appropriate as part of capital planning and management.

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