Most financial institutions continue to function in a siloed fashion when it comes to pricing and profitability. With the introduction of CECL, a financial institution's pricing will be immediately influenced by this new standard. Discover what that impact might be.

1. Rob Foreman – Senior Business Analyst
John Robertson – Business Process Architect
Pricing and How CECL Affects It

2. How can you not make money in banking?
• Current commercial loan rates range from 5.00% to 8.00%
depending upon the perceived risk
• Cost of Funds/Cost of Deposits is much less
• Purely a matter of managing the arbitrage

3. But you have to be really smart
• Simplest form
– Collectively all the income producing assets generate income through interest rates charged
based upon the perceived risk
– Liabilities provide the funds to generate the assets at a cost
– Employees pursue both the assets and liabilities at a cost
– Investors provide the where-with-all to obtain both with an expected return in mind
– So unless you don’t charge enough, risk too much, or pay too much, net, net, a bank should
make money

4. What fuels the returns? - critical attributes
• Interest Rates
• Cost of Funds/Cost of Deposits
• Non Interest Income/Expense
• Spreads
– Gross Margin
– Net Interest Margin
– Net Income

5. Key measures
• Gross Margin/Revenues
– Interest Income plus Fees, less Cost of Funds
• Net Interest Margin (NIM)
– Interest Income less Cost of Funds
• Net Income (pre-tax)
– Includes Interest Income plus Fees less Cost of Funds less Non-interest Expense less Risk
Expense
• Net Profit After Tax

6. Critical indicators
• Return on Assets (ROA)
• Return on Equity (ROE)
• Risk Adjusted Return on
Capital (RAROC)

7. The importance of critical indicators
• Consistency in comparing business loan returns
• Provides a scale to use in managing customer relationships
• Provides risk-adjusted view of loan and relationship returns
• Enhances lender knowledge and ability to consider
loan structure tradeoffs
• Enables risk-adjusted and profit-based reporting

8. Return on Assets (ROA)
• An indicator of how profitable a loan is relative to its total
outstanding balance.
• How efficient management is at using its assets to generate
earnings
• ROA = Net Profit After Tax/Average Asset

9. Return on Equity (ROE)
• The amount of net income returned as a percentage of
shareholders equity
• How much profit a loan generates with the money shareholders
have invested.
• ROE = ROA/Equity

10. Risk-Adjusted Return on Capital (RAROC)
• Framework for analyzing risk-adjusted financial performance
and providing a consistent view of profitability across businesses.
• Economic capital is a function of market risk, credit risk, and
operational risk
• RAROC = ROA/Economic Capital
• RAROC = ROA/Value at Risk (aka VaR)

11. ROE versus RAROC
• The primary value of economic capital used in determining
RAROC is in its application towards decision making and overall
risk management
– Broadens the evaluation of the adequacy of capital in relation to the bank's overall risk profile
– Develops risk-adjusted performance measures that provides for better evaluation of returns and
the volatility of returns
– Enhances risk management efforts by providing a common indicator for risk

12. Dual Risk Rating
PD and LGD

13. Dual risk rating
• Examiners review internal ratings of loans to determine the
adequacy of credit risk administration
• Definitions of credit grades should be detailed and clearly
delineate risk levels between grades
• Loan grades are becoming more granular

14. Prominent factors used when determining dual risk ratings
• Probability of default (PD)
– Expected credit losses associated with
default during a defined time period
• Loss given default (LGD)
– An estimate of loss given default
• Exposure at default (EAD)
– Measure of estimated exposure at default
• Expected losses ($) = PD(%) * LGD(%) * EAD($)

15. Dual risk rating – facility/borrower expected loss (EL)
Facility – Increasing loss given default
5% 15% 25% 35% 45% 55% 65% 75% 85% 95%
Obligor–Increasingprobabilityofdefault 0.01% 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.01% 0.01% 0.01%
0.05% 0.00% 0.01% 0.01% 0.02% 0.02% 0.03% 0.03% 0.04% 0.04% 0.05%
0.15% 0.01% 0.02% 0.04% 0.05% 0.07% 0.08% 0.10% 0.11% 0.13% 0.14%
0.25% 0.01% 0.04% 0.06% 0.09% 0.11% 0.14% 0.16% 0.19% 0.21% 0.24%
0.35% 0.02% 0.05% 0.09% 0.12% 0.16% 0.19% 0.23% 0.26% 0.30% 0.33%
0.45% 0.02% 0.07% 0.11% 0.16% 0.20% 0.25% 0.29% 0.34% 0.38% 0.43%
0.55% 0.03% 0.08% 0.14% 0.19% 0.25% 0.30% 0.36% 0.41% 0.47% 0.52%
0.65% 0.03% 0.10% 0.16% 0.23% 0.29% 0.36% 0.42% 0.49% 0.55% 0.62%
0.85% 0.04% 0.13% 0.21% 0.30% 0.38% 0.47% 0.55% 0.64% 0.72% 0.81%
1.25% 0.06% 0.19% 0.31% 0.44% 0.56% 0.69% 0.81% 0.94% 1.06% 1.19%
1.75% 0.09% 0.26% 0.44% 0.61% 0.79% 0.96% 1.14% 1.31% 1.49% 1.66%
3.00% 0.15% 0.45% 0.75% 1.05% 1.35% 1.65% 1.95% 2.25% 2.55% 2.85%
6.00% 0.30% 0.90% 1.50% 2.10% 2.70% 3.30% 3.90% 4.50% 5.10% 5.70%
20.00% 1.00% 3.00% 5.00% 7.00% 9.00% 11.00% 13.00% 15.00% 17.00% 19.00%
50.00% 2.50% 7.50% 12.50% 17.50% 22.50% 27.50% 32.50% 37.50% 42.50% 47.50%
100.00% 5.00% 15.00% 25.00% 35.00% 45.00% 55.00% 65.00% 75.00% 85.00% 95.00%

16. Capital
Adequacy

17. Capital regulatory evolution

18. Economic versus Regulatory
• Economic capital (EC) is the amount of risk capital that a bank
estimates in order to remain solvent at a given confidence level
and time horizon.
• Regulatory capital (RC) reflects the amount of capital that a
bank needs, given regulatory guidance and rules.

19. Relevant Risk vs. a “Flat Charge”
-
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
18.00
20.00
1 2 3 4 5 6 7 8 9
Facility A
Facility B
Facility C
Facility D
Facility E
Facility F
Facility G
Facility H
Facility I
Flat Charge
ROE = ROA / equity
RAROC = ROA / economic capital

20. How do you come up with Economic Capital?
Commerci
al
exposures
Economic
capital factor
%
LGD × N – (LGD × PD)
1 + (M – 2.5) × b
= ×
N-1(PD) + √ R × N-1(CL)
√ 1 – R 1 – 1.5 × b
Retail
exposures
Economic
capital factor
%
LGD × N – (LGD × PD)=
N-1(PD) + √ R × N-1(CL)
√ 1 – R
Once each parameter is filled out for each desired loan segmentation
bucket, the economic capital factor can be calculated:

21. Economic capital distribution

22. Pricing influence
$10,000,000 low risk loan
Interest income 4.5% $450,000
Interest expense 3.0% $300,000
Administrative costs $60,000
Risk of loss $2,000
Taxes $35,000
Net profit $53,000
Capital allocation 3.0% $300,000
RAROC 18%
$10,000,000 high risk loan
Interest income 6.0% $600,000
Interest expense 3.0% $300,000
Administrative costs $60,000
Risk of loss $46,000
Taxes $78,000
Net profit $116,000
Capital allocation 12% $1,200,000
RAROC 10%

23. Deposits have
value too

24. Funds Transfer Pricing (FTP)
Clients
Asset
generators
Mismatch
unit
Liability
generators Clients
Funds transfer
pricing charge
Funds transfer
pricing charge
Equity
capital
• Loans
• Securities
• Cash
• Fixed assets
• Intangibles
• Deposits
• Wholesale
funds
• Preferred
shares
Interest rate
paid
Funds Funds Funds Funds
Interest rate
paid
Interest rate earned on
capital
Equity credit rate
ECR1 ECR1

25. FTP should be consistently applied
• Balance sheet and liquidity management
– FTP assumptions should be closely synchronized with A/L modeling assumptions.
• Performance measurement
– Results should allocate accurate funds charges and credits to the entire balance sheet
• Product pricing
– When a new product is to be offered, its interest rate characteristics should be fully understood
to derive an appropriate FTP rate and thus have the information necessary for profit/volume
tradeoff analysis.

26. Relationship
Profitability

27. Reasons banks use relationship profitability
• Margin compression – earnings pressure
• Relationship management – ranking
• Risk management – up front
• Performance measurement – from a profit aspect
• Return on shareholders equity – economic profits
• Measurement consistency – equally unfair to all
• Business and marketing strategy

33. CECL Impact
on Profitability

34. CECL - where it’s been
• GAAP required using an “incurred loss” methodology
• Delayed recognition until it is probable a loss has been incurred
• GAAP restricted recording expected credit losses that did not
yet meet the “probable” threshold
• With CECL banks have to account for the credit loss at the
instrument level at the time of origination over the life of the
loan.

35. Challenges
• Clarity around acceptable interpretation of the CECL model
externally and internally
• Level of coordination between finance, credit, risk, IT, and others
to execute the implementation
• Availability of data
• Capability to design, build, and test new models with limited
internal resources
• Capability to plan and execute a program of this size in parallel
with other current initiatives

36. Example – single loan pricing results
Revenues
Interest $7,875
Fees $0
______
Gross revenues $7,875
Expenses
Cost of funds $2,250
Deposit credits $0
Administration $2,513
Expected loss $375
Other expenses $0
______
Total expenses $5,138
Profit before tax $2,737
Taxes $958
______
Profit after taxes $1,779
ROA 1.19%
Average assets $150,000
One Product:
$250,000 LOC
60% utilized
At prime plus 1%
No fees
ROA Goal 1.50%

37. Example – single loan pricing results
Revenues
Interest $7,875
Fees $0
______
Gross revenues $7,875
Expenses
Cost of funds $2,250
Deposit credits $0
Administration $2,513
Expected loss $750
Other expenses $0
______
Total expenses $5,513
Profit before tax $2,262
Taxes $850
______
Profit after taxes $1,412
ROA 0.94%
Average assets $150,000
One Product:
$250,000 LOC
60% utilized
At prime plus 1%
No fees
ROA Goal 1.50%

38. Individual Product Results

39. Influence & Strategy
• A flexible and dynamic CECL solution could help you improve
profitable loan growth….
– Evaluate your loan pooling
– Use multiple loss methods across your portfolio
– Run parallel methods to develop the appropriate strategy for each of your pools.
– Form a CECL team that will encourage collaboration between the Credit and Finance teams

40. Detailed Pool Delineation & Methods

41. Portfolio Results

42. CECL Considerations
• One size does not fit all when it comes to CECL.
– Run parallel model/methods
• Better collaboration in the ECL/reserve process could drive more
accurate reserves without sacrificing profits.
• Knowledge is power- understanding your ECL upfront allows you
to better price for the risk

43. Conclusion
• Understanding the components that influence profitability
• CECL will make the user more aware of the risks
• This knowledge enables the user to lend more effectively to the
benefit of the FI.

44. Questions?

45. Thank you!
Rob.foreman@bakerhill.com
John.Robertson@bakerhill.com