Announcing an Amazing New Way to Analyze Profitability

Product-Based Profitability - λ Model
Today, community banks and credit unions often ask: Which loan products are profitable?

Many profitability models are backward-looking, used only for a "reward mechanism." By way of contrast, the λ Profitability Model is a decision-support system that enables credit, lending, ALCO, risk management and financial reporting departments to work together coherently. The model includes CECL, expected and unexpected credit losses, interest rate risk, and non-interest income/expense allocation. The model is also consistent with capital market pricing for transactional activities.  

This product-based profitability approach can be used for strategic and tactical decisions

Challenge
Changing regulatory and market forces have adversely impacted profitability, causing community banks and credit unions to ask the following questions:

  • Which products are profitable?
  • Are we pricing at optimal rates?
  • Is it beneficial to match competitors' rates?
  • How should overhead expenses be allocated?
  • What is the best way to match funding costs to measure profitability?
 
The THC λ lambda approach enables banks to optimize lending/investment decisions to enhance ROE, adjusting for risk, and expense allocation. Consistent with the capital market and general ledger.

The λ Lambda Model was developed in response to the urgent needs of community banks and credit unions today. First, the introduction of CECL, a dynamic measure of credit risk. CECL should be viewed as an opportunity to manage the balance sheet rather than a regulatory burden. Second, backward-looking profitability models, used only for a "reward mechanism". Profitability should be forward-looking, consistent with capital market pricing and based on detailed characteristics of loans and deposits while considering customer behavior.  Third, profitability models should be dynamic and used as a decision-support system to enable management to enhance bank performance.

The λ Lambda Model can address the needs of multiple departments:

Lending
  • optimally set loan offer rates and review the tradeoff against the volume and design of products such as the caps/floors of Adjustable Rate Mortgages;
  • set the minimum offer rate for each loan type and relate the profitability of loan acquisition/origination to the profits reported in the financial statements;
  • Identify optimal acquisition or sale opportunities to manage CECL and other balance sheet performance metrics.
Credit Management
  • determine the reserve of risk premiums to avoid overstating profitability of products with higher credit risks
  • ensure CECL is used as a business solution for loan pricing and balance sheet analysis in ALCO
Strategic Planning
  • incorporate activity-based costing to determine loan profitability based on the marginal cost and the average cost curve
  • identify the relative profitability of loan products to determine an optimal growth plan
  • ensure consistency between assumed product profitability to that of the income statement, allowing for accurate implementation of profitability strategies based on tactical actions, such as loan rate setting
  • Identify the relative profitability of balance sheet products for optimal resource allocation
 
 
The Lambda λ Model
 The λ Lambda Model extends from other profitability models in multiple ways to enable management to use the Model for decision-making. In particular, the advantages of the λ Lambda Model are:
 
  • A CECL and PD/LGD model to price the expected and unexpected loss (Risk Premium) as components of product ROE and RAROC
  • Real-time offer prices to ensure the credit model and profitability analysis is consistent with capital market reality; the CECL value is not derived solely from historical data or macroeconomic model forecasts, but also by the capital market consensus.
  • Risk-Adjusted Return on Capital (RAROC) is derived from the credit risk premium (estimated unexpected credit loss); risk premiums are reported only for management and not included in ROE.
  • Related to the Loan Rate Sheet; the product-based profitability is consistent with the institution's overall ROE when applied to the base-case input values.  The model can identify the relative profitability of each product, based on the institution's Chart of Accounts 

Conclusions

Consider a new approach to product and banking profitability, called the λ Lambda Model. This model combines ALCO, credit analysis (CECL), lending, management, and financial reporting in a single consistent framework. The model can be used for strategic and tactical decisions to enhance profitability.

 
 Are you curious about what the THC λ Lambda Report could do for your institution?  Reach out to us at 269-275-3720 or email us at support@thomasho.com
 
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References
Current Expected Credit Loss (CECL): THC Model  
Thomas Ho Company research
What is the THC λ Lambda Report? Thomas Ho Company research
THC Lending Profitability Model Thomas Ho Company research
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