The first rule of policy analysis is that policies have both intended and unintended consequences. This is no more true than in the commercial banking space, as good intentions can sometimes produce negative results. In this article, we examine the importance of lenders having a well-designed and profitable loan pricing strategy as part of fair lending compliance.
It is surprising how many commercial banks have difficulty explaining how they determine the interest rates they charge on loans. Design and management of an appropriate pricing structure is the subject of a future post. Here we focus on the benefits of profit-based pricing and the potential costs of not having an appropriate loan pricing system.
Proper loan pricing must take into account a number of factors, with one of the most important being risk. Due to fair lending pressure, some lenders have opted for static pricing with little or no adjustments made for risk. Although on the surface this may appear to be the safest alternative to minimize fair lending risk, it actually has the potential for very negative effects.
For example, if loan pricing is static with little or no adjustments for risk, one rate must be applied to all loans equally. An average rate must be established, and then all loans, regardless of differences in risk, priced accordingly. This means that the institution is over-pricing its best customers and under-pricing its worst customers from a risk standpoint. The graph below illustrates this by plotting probability of default based on credit score.
As shown, the loss curve indicates default is much higher for lower credit scores and much lower for higher scores. This results in over-pricing of low risk customers and under pricing of high risk customers. This scenario then creates conditions for additional problems.
First, customers with strong credit profiles may be unwilling to pay the higher rates if they are able to obtain lower rates with another institution. This then places the bank in a situation in which they must make exceptions to rate policy or lose customers. In most instances, institutions will likely do the former. This means a static rate structure can increase the frequency of pricing exceptions thereby elevating fair lending risk.
A second consequence of a poor loan pricing system is an institution may be reluctant (or unable from an asset quality standpoint) to make loans to customers that have weaker credit. Loans with weak credit profiles are not only more likely to default but also to become delinquent over the life of the loan. This increases costs due to servicing efforts that may be necessary relative to stronger credits. An institution may avoid such loans or make fewer of them if they are not pricing for the additional risk.
A third consequence is that the weaker credits may be to LMI customers or customers situated in census tracts which are LMI or minority-majority. Over time, this can result in CRA and/or redlining concerns by eroding lending penetration to critical segments and geographies. Simply, the institution may be unintentionally limiting extension of credit.
In summary, implementing a static, “one-size fits all” loan pricing structure may appear to be prudent, but it holds the potential for adverse unintended consequences – consequences that may not become evident until it is too late to correct them. A profit and risk driven methodology, on the other hand, creates an appropriate loan pricing structure which is robust from a safety and soundness standpoint, produces more loan volume, fewer exceptions, and is in keeping with CRA obligations.
One final caveat—risk and profit based pricing requires effective management. Unless consistency can be maintained, all the benefits described above will be offset by introducing significant fair lending risk. The approach, therefore, should be twofold:
- Have an appropriate strategy.
- Use effective implementation and management.