When you price an Opportunity, PrecisionLender may suggest reducing maturity to reach your ROE target. This article explains why shortening the maturity increases ROE.
Reduced credit risk and interest rate risk
A shorter loan lessens both your credit risk and your interest rate risk on fixed and adjustable rate loans, and that translates into:
- higher net income (the numerator in the ROE calculation); and
- less capital (the denominator in the ROE calculation).
Together, these two effects drive ROE higher.
In short, a shorter maturity means lower credit risk over the life of the loan and may mean less interest rate risk if your loan has a fixed or adjustable interest rate. In combination, these two effects favorably impact net income and capital allocations, which will translate to a higher ROE.
Assuming that your bank varies its capital by duration, annual loss and capital are higher for longer durations, which generally results in a lower ROE. Annual loss and capital must be higher for longer durations because over time, the risk of adverse credit migration increases. This is true even with your best credits, since although they may stay at their current risk rating, if they do experience movement, it can only be downward in direction. For more on risk ratings, see our article on Setting Up Risk Ratings. All other things being equal, such as rate, risk grade, quality of collateral, and loan structure, loans with a shorter term will have a better return than those of longer term loans since there is less risk.
Interest rate risk
It’s difficult to know where interest rates will be in the future, and even more difficult the farther into the future you look. This is interest rate risk: the risk that the fixed or adjustable rate loan that you’ve written locks in an interest rate that in some future time is unprofitable. Shortening duration can help with this, since it shifts some of that interest rate risk to the borrower. This translates into a better ROE on a 54 month note, for example, over a 60 month note, everything else held constant.
Let's consider two loans that are identical in every way, except that the first loan matures in 60 months, and the second matures in 54 months. Interest expense for the 54-month loan is lower, because reducing the loan's maturity has moved down the cost of funds curve, applying the 54-month rate (rather than the 60-month rate) to the average outstanding balance less average equity. To view the interest expense associated with your Opportunity in PrecisionLender, you'll need to expand the Opportunity's Financial Statements. Click on the Financial Statements tab on the right side of the Opportunity screen, and you'll see the amount of interest expense to the right of the Interest Expense field.
The loan loss reserve and the average equity are also lower for the 54-month loan than the 60-month loan. You can view the loan loss reserve and the average equity for your Opportunity in the Financial Statements, next to the Loan Loss Reserves and Average Equity fields.
Cost of funds
You can use the Funding Curve graph in PrecisionLender to see that 54 month money is less expensive than 60 month money. To view a graph showing the cost of funds associated with the Funding Curve for your Opportunity, click on Assumptions on the upper right side of the Opportunity screen and then click the Funding Curve tab. You can use the table in the Funding Curve tab or hover over the points on the Funding Curve graph to see the specific cost of funds for different durations.