Essential Concepts in Pricing Loans

Relationship profitability is an important metric within most pricing models.  While it is important to understand the profitability impact of individual new loans, it is crucial to understand how the pricing decision on a new credit will impact the profitability of the entire customer relationship.  These relationships often include deposit accounts.

Analysis of time deposits is straightforward because they have a stated maturity term.  The credit for funding rate, or funds transfer pricing rate, is based on the term of the CD and the origination or last renewal date.  The credit for funding on these types of accounts is assigned in the exact same way the cost of funding is assigned to loans.

Non-maturity accounts pose a separate issue.  Because they do not have a stated maturity term, the assignment of a credit for funding rate isn’t as straightforward.  The results of a deposit decay study normally provide the key average life assumption needed to properly assign the credit for funding.  Once the average life is known, it can be weighted with the repricing term of the account (0.0 years) to define the credit for funding, or funds transfer pricing term.

Below is an example of the funds transfer pricing terms assigned to non-maturity accounts based on a 50-50 weighting of average life and repricing term.

At this point, the FTP term is compared to the appropriate funding curve on a blended average basis.  For example, instead of matching the Savings account to the current 4-year rate on the funding curve, it would be assigned a credit for funding rate based on the average 4-year funding rate over the last 4 years.  These blended rates may be further adjusted by comparing the rate of the longest-lived product to the credit for funding rate on capital.

Given the increase in market rates over the last 18 months, especially at the short end of the curve, now is the time to update the credit for funding rates on non-maturity accounts within your pricing models.

According to the data in the charts below, the credit for funding rate should be increased between 40bps and 120 bps depending on the product type, funding curve, and average life assumption.