Rising interest rates can increase funding costs for commercial banks, which can impact their profitability. Loan pricing strategies such as adjusting loan rates, tightening lending standards, or adjusting loan terms can help banks maintain profitability in a rising interest rate environment.
Variable interest rates can be advantageous for commercial loans in a rising interest rate environment, as they allow the bank to adjust the loan rate as interest rates rise or fall. However, fixed interest rates may be more attractive to borrowers for longer-term loans, and can provide greater certainty and stability for both the borrower and lender.
Determining the optimal loan pricing strategy for a commercial bank will depend on a number of factors, including the bank's funding costs, risk appetite, and competitive landscape. Banks should consider their own cost of funds and the cost of capital, as well as factors such as credit risk, market demand, and customer retention.
Longer-term fixed-rate loans can be subject to interest rate risk in a rising interest rate environment, as the bank may be locked into a lower interest rate for an extended period of time. To manage this risk, banks may consider offering adjustable rate loans, implementing risk management strategies, or diversifying their loan portfolio.
Mitch Woods: Welcome to today's episode of Lending Made Easy. Today I'm joined again by Brian Peckinpaugh and David Catalano. And we're gonna be talking about navigating commercial loan pricing with rising interest rates. So in 2022, the Fed's been aggressive with raising rates. In fact, they raised their rates seven times throughout the year.
And with the rising rates, the demand for loans is softened and you know, inflation has crept up and deposits have decreased and it leaves a lot of bankers trying to figure out how to grow profitability and households and balances and, and what could be a pretty chaotic environment. And so, Brian, I'll start with you today.
My, my question to kick things off is what are some common pitfalls that bankers should avoid in the current rate environment when it comes to commercial loan pricing strategy?
Bryan Peckinpaugh: Yeah, that's a great question, Mitch. You know, I think we're gonna find a lot of , a lot of things they need to avoid, be cognizant of, be aware of, just cuz it's, it's very different than the market we've operated in for, you know, the past, you know, one to two decades where, you know, cost of funds have been so low that. I, I didn't have to worry quite so much about, uh, how I priced the loan and, and what the overall profitability or expected profitability was gonna be for those loans. We were, we were just looking to get 'em done and, you know, get those relationships on the books. So I think it's gonna be going back and, and just revisiting.
That strategy, kind of getting back to basics, if you will, of evaluating the entirety of relationships and what the value of those commercial clients are to the financial institution. So I think it's a great opportunity to, to revisit those loan pricing and profitability solutions so that you, you can have some automated systems bring all your data into one place and use that to intelligently price the loans, right?
Not, not necessarily just compete on price, but, but compete on the entirety of what you offer and making sure that it's gonna be a, a good, solid, profitable loan for. For the bank or credit union.
David Catalano: Yeah, I would agree with you Brian. There's gotta be a way to allow the, the relationship managers to understand the value of a deposit and have a deposit value contribution and get to a relationship pricing mechanism where you can understand the value of that relationship.
Because as we all know, the banks that we deal with, commercial banks, uh, whether they're at the community level, the regional level are making the majority of their money from these commercial relationships and the relationships are complex and have lots of different components to them, and understanding the value of each component and how they in aggregate allow us to reach our goals as bankers is really what we need to do at the very, at the very tip of that spear.
You know, and there are some things to watch out for besides, um, understanding the value of that deposit in a, in a way that reflects reality, understanding the current credit environment that you're in, which, you know, it's interesting that this environment now is forcing us to look out as, as opposed to backwards.
The way CECL is is designed to make us look. Out instead of backwards. We really need to understand what's the, what are the ramifications of the current economic environment to the credit, the underlying credit of the businesses we're lending money to, and do we really understand that? Because we can see the, the tightening of credit, but we can also see the shrinking of the money supply.
We can see lots of layoffs in the technology sector in particular, but the changes in the, in the commercial real estate looking at large metro areas like New York City where half the commercial real estate's empty. So there's a lot of changing landscape out there and understanding what all that, how all that is impacting our individual loans and our portfolios and our communities in which we serve is gonna be important as we move into an idea or a relationship pricing model.
That allows us to be very competitive, hit our goals, but also value the total relationship because deposits are going away. You can see deposit degradation across the board and you know, people are fighting for deposits and one of the ways to get and retain is to price appropriately for those commercial customers that frankly have better things to do than switch banks.
Bryan Peckinpaugh: Right, right. It, it's all about getting sticky, right, Dave? Yeah. Where exactly you, you've gotta find the breadth and depth of products that, that allow you to maintain these relationships in these these trying times where, as you stated it, it's that entirety of the relationship. It's the deposits, it's the existing loan book I have with that commercial client.
It might be my treasury services. With the rate changes, I think we're gonna probably see people shopping their business more than ever before. Whether that's to to chase. Higher interest rates on my deposited money, whether that's reshaping loans I have on the books, as you mentioned there, there's gonna be some churn in the CRE market for sure going into 23.
And you know, people that have those. Loans on the books that maybe are for projects that are going sideways, that are for, uh, underperforming loans or just to shop interest rates, that that's gonna drive, I think, evaluation of those overall relationships. Instead of just individual product relationships that, that you may have seen over the last few years.
Right? So it's not, it's not gonna anymore be who, who can give me the best rate on this loan from all the banks on the block? I may have to look at my entire relationship given the the current state of the economy and, and where interest rates are across the board. So I think having that view of the totality of the relationship, not just current, but what you could bring into the bank as part of making a deal is, is just more critical now than, than it has been in in a long time.
David Catalano: Yeah, exactly. Giving your relationships, your relationship managers a lever to pull, that's not the interest rate on the commercial loan is gonna be a good thing for them. Meaning if they want a lower rate on that loan, what other things can they ask for to get on the quid pro quo side from that, from that commercial customer?
And if they're flushed with cash, why? Why would they care where they park it? You know, as long as there's a a somewhat competitive rate out there, and the whole package is what's making sense. You know, the, the other thing, we talk about this all the time, but the other thing is, is a fast Yes. Or a fast No, in particular.
Mm-hmm. A fast No is critically important. So pre-flighting deals very, very quickly, and then getting them closed. , you know, where we have commercial customers closing their deals in 35, 40 days. You know, you need to get those deals closed fast. And the one way to do that is to help your RMs, your relationship managers understand well, what, what goes into the pricing?
What makes me competitive? And it's not just the commercial loan price, but it's the other products that we have with this relationship. The other, and in particular the deposits. Because deposits obviously are more valuable today given the rate environment that we're in and given the lack, uh, or the, what I would call scarcity of the deposits today. Mm-hmm.
Bryan Peckinpaugh: You hit on a key thing there, David. That's, and that's that lever concept. You know, it, it's not just pre-flighting deals, but you know, potentially pre-flighting options. Right here. Hey, here's what this would look like if you brought me a hundred thousand dollars in deposits as part of doing this deal.
Here's what it would look like if we went after, you know, this rate term structure versus this other rate term structure and reworking, you know, all of the loans on the books be being able to have some flexibility there to. You know, do some, some testing of potential offers and, and quickly to the potential borrower, uh, just helps all that much more, right?
Less time that I'm having to go back and, and get approvals. Right. Run multiple scenarios. Only after the client says, Hey, that's not gonna work. You know, again, it's all about that, that Yes, fast. No, that, that you were talking about to, to make sure I'm, I'm driving the best customer service I possibly can, cuz that that's gonna continue to win the day as as we move forward in the market.
David Catalano: Yeah. And the other things to consider are the optionality of each, both deposit and loan product that the client has. If they're pledging more cash, uh, is there a penalty? If they remove that cash, can they actually remove it? If they're taking out this loan and it's a five year term or a 10 year term, is there a prepayment penalty so that you can retain some margin before they try and refi with you or refi with someone else. So, and those are subjects that you historically likely didn't have to talk too much about, given the environment. You didn't worry about refi risk when your cost of money was zero or close to it, . But now the, now your cost of money is a lot higher, therefore the loan rates are a lot higher.
We look at loan rates from Q1 of 2022 to Q4 of 2022. C&I yields went from 372 to 577 so it's a 202 basis point clip on just overall C&I Industrywide, right? So the C&I loans move faster than the deposits themselves. So you might have a fat margin today, but in late 2024. Early 2025, this environment should be different.
Uh, will you retain that? Mm-hmm. . So we need to be thinking about all the different optionalities that your clients have, as well as the credit risk that their individual business, uh, could be impacted by.
Bryan Peckinpaugh: Yeah I think, there's one thing we could almost definitively say, David, is they won't be able to maintain those margins cuz the, the cost of funds are just going to, I think, continue to go up right?
Whether the with the Fed at raising the interest rates, that cost of money is gonna be higher. That's gonna lead to all of the banks repricing their depository products, which just means you're gonna have to offer a higher depository products to compete with the bank down the street, which means your existing clients are gonna start shopping that deposit business to, you know, whoever's offering, you know, the, the current 5% on a CD right? And it's, it's just gonna drive up your costs. And, uh, if you don't have that visibility into it through automated or systemic channels, meaning, you know, kind of forcing it into the process to say, are, are we pricing this appropriately given all the factors we're feeding into our engine? You're gonna struggle to maintain the margins you need to, to successfully run this business, especially when it's just getting more and more competitive, right? Less deals on the street means it's harder to win each one.
Mitch Woods: Bryan, I think you bring up a a good point there too, right? In today's environment, a lot of people haven't, haven't had to really compete before because there've been a lot of loans out there to win. Now all of a sudden that competition's pretty heated, and I feel like a lot of people are going and they're looking and, and seeing what's my competitor doing?
What rates are they offering, and how do I match that? When in reality that's, that's not a strategy, that's a, that's a reaction. So where do you start? If you're a banker out there today that hasn't been in this environment before, where it, it is hyper-competitive. Where do you start to develop that strategy for effective commercial loan pricing and taking into account the entire commercial relationship?
Bryan Peckinpaugh: You know, I think the, the, the first step is a good, deep understanding of your business, you know, really, uh, looking into the relation between your, your deposit relationships, your lending relationships, and then your other, right? Whether that's treasury or, or whatever el else, these fall in your organization.
And then starting to understand those correlations between the data. Uh, so the first step is always look. Look internally, look at what you have, look at what's successful, what does good look like for me? So that you can start to identify what should you go more after, more of, and maybe what should I stop going after given the markets I serve, or the product mixes that I have?
You know? And then it just again, gets back to basics. Uh, I think it, to a certain degree, we've gotten away from it because we had the luxury of a booming economy and and lots of deals to chase. Uh, so I think we just have to be more selective here. Uh, and again, just take all of those factors into account and make sure you're just pricing appropriately, not just pricing based on, you know, what the bank down the street's, pricing.
David Catalano: Yeah, that's a good point. My, my response to Mitch's question would be I would start looking at the vendor landscape as to who provides pricing tools. Find out how they operate, talk to them, see if they have advisory services. You may engage consulting firms that provide advisory services. Um, But a lot of times the vendors that have a pricing module will have people on the staff that are subject matter experts that can help you dig into your data, help you understand the strategies to pursue, and then once you're in it and you're using this as a uh, really core offering. You can modify this as you, as you move forward, but if you think about going from loan pricing to relationship pricing, that's a cultural change. Mm-hmm. and everyone needs to get really comfortable with that because they're, you're gonna use funds transfer pricing to, to understand the value of those deposits.
And people are gonna probably, you know, quibble about, well, should we really be applying that much to that versus this and, you know, there's no free lunch so. You gotta get through that. You gotta, as a culture, understand what's the value of deposit, uh, what's the value of a relationship, understand what all of that is, and then you need a tool.
So that your people can work with your customers and educate your customers on how this works because they, if they understand, Hey, if I give 'em a little more deposit, I'll lower my loan rate. And then you might have a loan or loan rate focused person and he might offer 'em up just as long as he knows what the, if he knows what the levers are, he can help you
Uh, cause there's things that are important to him. They're, you know, less important to you and vice versa. Right? So I, you know, I think it's important to get some expertise on board, and I wouldn't assume you have it unless you've got somebody who comes from another organization that's lived this and, and really applied relationship pricing to commercial lending, um, already.
Bryan Peckinpaugh: Yeah, I, I, great, great call out David. It definitely, you know, look to the market, see, see what solutions, you know, align with your, you know, internal philosophy on how to price these things. I would also say wherever possible, you, you want that to be embedded or at least integrated into your loan origination system so that you're not having things happen outside of systems, right? Relying on somebody to go and enter a deal separately into your pricing platform and then copying that back appropriately, right? You wanna force it into the processes as much as you can.
David Catalano: Yeah, that's that, that's a very good point. You wanna understand what, what solutions does this pricing tool integrate with?
Don't assume it'll integrate with anything because that's a bad assumption. And, and, and if, think about it this way, with enough time and money, anything will integrate to anything. , but you don't have all the time you need and you don't have all the money to do that. So you can quickly and easily figure that out on the front end.
Start with the systems you have, evaluate whether or not they are the right system to get to where you get you to where you want to be. They may already have an integrated pricing tool. If they don't, then you can start looking at the pricing tools and where do they integrate, who do they integrate with and does that work for me?
And if it doesn't, then you open that up and look outward. A, a good pricing tool combined with a loan origination solution, especially a digital solution that accomplishes end-to-end processing. Uh, we'll have a higher ROI uh, for your organization. So don't be afraid to look at those. They, when implemented properly and, uh, used, they have a, a phenomenal ROI cuz they scale and help you grow without adding people.
You know, it's just a, a, a, a consideration you should definitely think about in the current environment.
Mitch Woods: Absolutely. Thanks David. I. I think today a great conversation, obviously, and a takeaway from me, right, is getting back to basics, understanding what levers are out there and how those impact the value of each relationship for a commercial customer, for, for the bank.
I think some great things for, for any banker to to think about today on how to really navigate today's interest rate environment that's super competitive when it comes to pricing their loans. So thanks to everybody out there listening to today's episode of Lending Made Easy.