The Value of Loan Pricing
Try Our Marginal Loan Yield Pricing Tool
Membership at the FHLBNY comes with a variety of products and tools that can allow your institution to achieve optimal loan pricing, thus mitigating the increasingly challenging lending environment. In using our tool, you can compare your loan against alternative investments of similar duration, adjust the price for credit risk and servicing costs, and determine the “All-in” cost of funding the loan with FHLBNY advances. You can also analyze and simulate various scenarios using our advances to attain excellent pricing, all while factoring in your institution’s asset or liability sensitivity. Furthermore, this tool can help account for competitor pricing.
Overview of How to Price a Loan
Continue reading to learn how to compare investments and understand more about how loan pricing tools are able to produce optimal results to help you maximize profit.
Summary of How to Price a Loan
Compare the prospective loan to 2-3 alternative investments of similar duration to determine the base price of the loan.
Adjust the loan price to account for credit risk and loan servicing.
Analyze varying funding sources to determine the most profitable approach to funding the loan.
Achieve operational ease by using pledged mortgages to collateralize the Interest Rate Swap transaction – keeping highly liquid marketable securities unencumbered.
Parallel the loan price against that of your competition and determine how much upward or downward pricing you can make to achieve maximum profitability.
Perform one final overall assessment of the loan price factoring in alternative investments of similar duration, credit risk, interest rate risk, funding sources and competition.
Principles of Loan Pricing
By focusing on maximizing risk and cost adjusted revenue at the margin, optimal loan pricing can be achieved.
Optimal loan pricing allows for maximization of profit.
In order to achieve optimal loan pricing, institutions must price the actual present value of cash flows on a risk adjusted basis by using Macaulay Duration.
Members can determine the base price of the loan by comparing it to comparable alternative investments, then adjusting for credit risk and loan servicing.
FHLBNY advances are an integral part of the process as they are an affordable funding source.
Loan pricing should be flexible to account for competition.
Loan Pricing Further Explained
Growing and maintaining the right level of Net Income is achieved by maximizing risk and cost-adjusted revenue at the margin.
This is realized by accumulating assets until revenue is no longer accrued, i.e. when the marginal cost of producing revenue exceeds the marginal revenue produced.
Many institutions place their focus on Net Interest Margin without fully considering the cost and risks associated with incremental revenue production. This practice is flawed in certain operating environments, notably a flattened yield curve.
Institutions can mitigate these fundamental flaws by calculating the present value of future cash flows from new loans, aka Macaulay Duration analysis. Macaulay Duration calculates the interest rate risk of a loan and is defined as the percentage change in the loan’s price relative to a 1% change in market rates.
Macaulay Duration Explained
Macaulay Duration is the weighted average term to maturity of the cash flows from a fixed income investment (ex. bond, loan, etc.) It is determined by dividing the present value of the cash flow by price:
t = respective time period
C = periodic coupon payment
y = periodic yield
n = total number of periods
M = maturity value
Current Loan Price = present value of cash flows
*This can be further broken down by recalling that the Current Loan Price, i.e. Present Value of Cash Flows is: (PV) = C * [(1 – (1+i)^-n)/i]
C = the cash flow each period
i = the interest rate
n = number of payments
Contact your Relationship Manager to set up a “shoe-box” review and or attend one of our ALM strategy sessions with industry experts. Read more at our Education Programs page.
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The content provided in these disclosures is presented as a courtesy to be used only for informational purposes and is not represented to be error free. The FHLBNY makes no representations or warranties of any kind with respect to the content contained herein, such representations and warranties being expressly disclaimed. The FHLBNY is not a financial or investment advisor.
Moreover, the FHLBNY does not represent or warrant that the content of these disclosures is accurate, complete or current for any specific or particular purpose or application. It is not intended to provide nor should anyone consider that it provides legal, accounting, tax or other advice. Such advice should only be rendered in reference to the particular facts and circumstances appropriate to each situation. The FHLBNY encourages you to contact appropriate professional(s) and consultant(s) to assess your specific needs and circumstances and to render such advice accordingly. In addition, the FHLBNY is not endorsing or recommending the use of the means or methods contained in or through these disclosures for any special or particular purpose.
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