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Setting The Target ROE

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In PrecisionLender the Target ROE is one of the main ways to guide lenders.  Technically speaking, PrecisionLender, calculates a risk adjusted return on risk adjusted capital (RAROC), however, for simplicity we refer to it as ROE.  It should be noted that these are meant to be targets, not the minimum acceptable ROE.

In this article we will cover:

 

Things To Consider When Setting Target ROEs

  • Portfolio Needs & Objectives
    • Ultimately, the Target ROEs should reflect the strategic needs, objectives and priorities of the bank’s portfolio and balance sheet. Aligning the Target ROEs in PrecisionLender with these larger strategic objectives ensures that PrecisionLender will help steer the portfolio construction in the direction management wants it to go.  This creates an important link between portfolio strategy and the pricing strategy.
    • Considerations that should be taken into account when establishing the initial Target ROEs:
      • Current year budget for projected loan growth
      • Net interest margin
      • Loan yields
      • Product mix
      • Product concentration
      • Market segment growth goals
    • Often times trade-offs must be made between maximizing loan growth vs. maximizing profitability vs. managing risk. Finding the right balance between the different objectives is very important.
      • A preference to maximize loan growth will generally result in lower overall target ROEs.
      • A preference to maximize profitability will generally result in higher target ROEs.
      • A preference to maximize risk mitigation will generally push towards variable rate loans with shorter terms to better rated credits.
    • For example: If you are budgeting loan interest income averaging 4% during the course of the year:
      • Setting a ROE target too low can result in an implied loan yield that will not permit reaching this level.
      • A target ROE set at 5%, might imply that new fixed rate Commercial Real Estate (CRE) loans can be originated at a 2.75% rate, which might make achieving the overall 4% interest income level impossible.
      • Conversely, consideration must be given when a 30% target ROE results in a 6% interest rate on similar type loans. This may be the rate needed to reach the overall 4% interest income budget goals, but obtaining such a rate may be impossible in the current competitive environment, or it might imply only lending to subprime borrowers and taking on more credit risk, or extending the maturity of loans out farther on the yield curve and taking on more interest rate risk.
    • Portfolio concentration levels are also an important factor. If the institution has concentration risk in a particular loan product type that should influence the target ROE. 
      • For example: Assume the institution has too much concentration in CRE – Non Owner Occupied.
      • As a result, the institution has less of an appetite to add more of that product/ loan type to the portfolio. Consequently, the target ROE for this product should be higher (all other things held constant) to reflect the fact that there is less appetite to do those types of loans unless they can generate a premium return. 
      • By elevating the target ROE, the institution will become less price competitive and will thereby slow the rate of acquisition of that product into the portfolio.
      • On the other hand, if the institution would like to add more C&I loans to the portfolio that preference may suggest that the target ROEs on those C&I products should be lower so the institution can more aggressively add that type of loan exposure to the portfolio.
    • On a go-forward basis, the institution should implement a process to regularly review the target ROEs in PL in the light of the portfolio strategy and goals and make adjustments as necessary. The target ROEs are not intended to remain static, but rather should be actively managed by management.
  • Competitive Landscape
    • Lending is a highly competitive business and has only become more intensely competitive over the last few years. This competition acts as a natural constraint on loan pricing.  While it is presumed that each institution wants to be competitive in their markets, at the margin it is important to consider where “in the pack” you want to be.  The competitors in the market create a price range for different types of loans and structures. 
    • Competition can vary by loan type and/or geographic marketplace among other things.
    • For example: Large urban markets where there are more banks present tend to be more competitive, whereas more rural markets may be less competitive on a relative basis.  All of these factors can impact how target ROEs are set.

 

The Process for Setting Target ROEs

It is important to establish a baseline ROE based on how the institution has been pricing in the recent past (typically defined as the last couple of quarters) in light of current market conditions and current lending practices.

The procedure to perform this is as follows:

  • Gather necessary information on recently closed loans that have been originated or that are currently in active negotiations.
    • The more recent the better as it is important to calibrate against current market conditions. 
    • It may also be useful to include recent loans that were lost to competition as these can be good indicators of current competitive pricing dynamic. 
  • Select loans from this sample that are down the fairway of the types of deals you typically do to calibrate the target ROEs against a sample that is representative of the standard types of deals you do regularly.
    • Try to collect information on a minimum of 20 loans.
      • Try to collect at least 5 loans per product type.
    • Generally, use loans originated or priced within the last six months.
      • If rates are rapidly changing, restrict the selection to the last three months.
    • Avoid really small loans.
      • Use a minimum of size between $150,000 and $300,000 depending on the size of the bank. 
    • Avoid really large loans. 
    • Avoid deals with unusual terms and structure.
    • Do not include in the input any existing loan or deposit relationships that are outstanding prior to the origination or expected origination of the input loan the borrower may have with the institution.
  • Assign input of the loan information to a small group including the PrecisionLender administrator and one or two “alpha” lenders.
  • Once all of the sample loans have been entered, contact the PrecisionLender Client Success Manager and/or the assigned Consultant to review the targets for each loan type.
  • The average actual ROE of the different loan products, based on the samples reviewed, will help establish a current baseline ROE target.

 

Setting The Target ROE

Navigate to the Products Pane of the Administration Section, and click on the name of the product that you wish to set the target for.

products pane in administration section

Click "Edit" in the top left hand corner.

porduct screen with the edit button highlighted

Clicking into the Base Target ROE field allows you to set the Base Target ROE.

base target roe field on product edit screen

If you would like to add Repricing Duration Adjustments, click "Add". For each row you can set the adjustment to the Base Target ROE as well as the duration that adjustment is valid for.

target roe adjustments on product edit screen

Adjustments to Target ROE can also be made based on the Risk Rating, which can be found by scrolling down or clicking "Risk Ratings" at the top of the page.

risk rating target roe adjustment on the product edit screen

Adjustments to Target ROE can also be made based on the Prepayment Option, which can be found by scrolling down or clicking "Prepayment Options" at the top of the page.

prepayment target roe adjustment on the product edit screen

When you are done, click "Save" to keep the changes you have made. You can now click "Close" to return to the Administration Section.

product edit screen with the save button highlighted

 

Login to PrecisionLender and click on the Administration button in the lower left hand corner.

Click Products

Click on the product you would like to set the Target ROE for, or click "New" to create a new product.  For this tutorial we will select Commercial Real Estate - Investment

Click Edit

Click on the Target ROE field

Here you can set the Base Target ROE.

If you would like to Add Repricing Duration Adjustments, Click the Add button.

For each row you can set the adjustment to the Base Target ROE as well as the duration that adjustment is valid for.  

Adjustments to Target ROE can also be made based on the Risk Rating.

And, Adjustments to Target ROE can be made based on the  The Prepayment Option.

When you are done, click Save to keep the changes you have made.

Click close to return to the Administration Section.

Repricing Duration

  • The repricing duration of a floating rate loan is 1 month.
  • The repricing duration of a fixed rate loan is the maturity.  
  • The repricing duration of an adjustable rate loan is the Initial Fixed Period.

Consumer Loan Products

  • For those using Rate Sheets for consumer products, the process is similar to the above, however, it is best to first develop the appropriate rate sheet.
  • Adjustments to the overall target for duration or risk can be made while creating or editing the rate sheet.

Deposit Products

  • Many of the clients leave these levels at 0%, with the view that deposits are a wanted addition to the loan. 

 

 

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