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Should I set my products' ROE targets equal to my bank's target?

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You can set a Target ROE for each of your products in the Administration section. While it's possible to set your ROE to be the same for all products to match your bank's overall Target ROE, we recommend instead tailoring your Target ROE on a per-product basis. Since loans generally subsidize other profit or loss centers that aren't meeting your overall target, individual products' targets should be set higher than your overall target to compensate. 

The table below shows various profit and loss centers for an example bank, which has $1 billion in assets and $124 million of capital. There is a catch-all category of Admin, which holds excess capital and certain fee based businesses. For this bank, the excess capital amounts to about 25% of the total capital. No capital is allocated to cash.

 
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The next table shows income and expense allocations and projected net income (loss) for each category. The bank's marginal tax rate of 37.1% is used to determine net income, with small adjustments for tax exempt securities and municipal loans.
 
 
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The final table shows the ROE by Profit (Loss) Center.
 
 
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This table shows some valuable information:
  • Almost half of the capital is associated with non-loan related centers, which have a low net income and ROE. In contrast, the loan center ROE is 13.78%. If the overall target of 10% was applied to the loans as well, the bank's overall ROE would decline from about 8% to 5.3%. In order to hit an overall 10% target, the loan portfolio's target would need to be close to 17.5%.
  • The bank has excess capital. Growing loans with their higher ROE will be beneficial to the bank. For example, if $56.4 million of internal cash management funds were converted from deposits at the Federal Reserve to CRE loans with the same characteristics of the existing loans, assuming no other changes, the bank’s overall ROE would increase to 9.17%. These new loans would have an ROE of 14.66% compared to the negative 12.24% as an internal deposit. Almost $5 million of capital would be moved to the Loan Center from the Admin Center. However, if the new loans are targeted at 10%, the total increase in overall ROE would only be about 1% - approximately 20 basis points less than what could be achieved by using the current ROE for CRE loans. Moving funds to commercial loans is helpful, but if the overall goal is to be at 10%, new loans need to have a target above the overall bank goal.
  • Higher market interest rates will likely have a positive impact on the Deposit and Internal Cash Management centers, and a negative impact on the Investment Portfolio; however, a moderate rise in rates is not likely to meet the bank’s overall 10% target without adding commercial loans with individual targets above the bank’s goal.
  • The commercial loans were fully allocated bank costs in this analysis, except for general overhead non-interest expense. For many of our clients, the amounts allocated for origination and servicing expense may not equal the fully allocated costs, so a higher ROE is required to account for the gap.
 
Every bank will have different results and assumptions will vary by financial institution. But they will all have a number of Profit and Loss Centers that will produce ROEs below the overall bank target. In order to reach the bank’s goal, the commercial loan centers need to produce superior ROEs. Setting individual targets for each product will help increase the bankwide ROE and meet the overall goal.
 
For more information on setting Target ROEs, visit Setting the Target ROE. For more information on how the math works behind the scenes in PrecisionLender, visit How Does the Math Work?
 
 
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