Corporate banking has undergone a significant metamorphosis of late as profitability has come under pressure across the board, especially since the last economic downturn.

Large corporate loans are believed to be unprofitable on a stand-alone basis. By contrast, the middle market is dominated by smaller private companies that still provide good profit opportunities on stand-alone lending.

But to take advantage of this profit opportunity before it, too, yields to competition, savvy lenders require a new generation of credit pricing and structuring tools.

Building a successful business strategy for middle-market lending that combines loan pricing and structuring tools, one must consider three primary "drivers" affecting risk and profitability measurement-convergence, pricing inefficiency, and enhanced distribution capabilities.

Convergence, a major driver of change throughout financial markets, is forcing disparate markets, institutions, and analytic approaches toward each other at a rapid pace. For example, investment banks are now making term loans to middle-market customers.

Once-marginal trading markets, such as those for commercial loans, are becoming more liquid and credit derivatives are rapidly advancing. Complicated capital markets analytic techniques for valuing derivatives- such as option pricing-have pushed down to middle-market credit risk assessment.

As for the second driver, a number of loan pricing studies-including Peat Marwick's analysis of two middle market portfolios-show a disturbingly low correlation between risk and return. Low-risk loans tend to be somewhat overpriced relative to the credit risk, and higher-risk loans tend to be underpriced.

By most accounts, pricing for credit risk tends to be highly inefficient in middle market portfolios and even across different relationship managers within a single bank.

Finally, there is the growing need to expand the distribution channels for managing credit risk exposures and balance sheets.

As capital markets activities within commercial banks expand, the trading and securitization activities related to middle-market lending will surely become an integral part of the business strategy.

These alternative distribution channels will provide both a method for managing and packaging credit risk exposure and an alternative fee-based source of revenue.

In trying to determine how best to address these primary drivers of change in middle market, one central theme stands out: Leading commercial lenders need better ways to value, price and structure middle market commercial loans, to identify relative economic value.

One of the dominant features of commercial loans that is typically not taken advantage of by banks is the value of embedded loan structures. By "structure," we mean everything from grid pricing to embedded prepayment options to covenants.

Each component of structure can interact with the expected cash flows for the loan in a complicated manner, providing value either to the borrower or the lender. Establishing the value of each structural component-and taking advantage of it-requires combining credit risk measurement and option valuation into a single approach.

This is yet another place where convergence comes into play. Using derivatives methodology to value embedded options is an approach that can be combined with ratings migration analysis. Together these methodologies can provide a theoretically sound and implementable way of undertaking loan price structure analysis to create economic value.

Let's look at a few examples of how this analysis might help savvy lenders use loan-structure analysis to their advantage. Most floating-rate term loans offer prepayment without penalty during the loan's term.

If the borrower's relative risk declines due to a risk rating improvement, then he will probably prepay the loan and seek less expensive funding. But Peat Markwick's analysis shows that if the original loan incorporated higher up-front fees with less spread while keeping the overall price more or less constant, the loan appears cheap to the borrower for longer, decreasing the incentive to prepay.

Analyzing prepayment options in conjunction with shifting fees and spreads can actually capture much of the option value back from the borrower, keeping a profitable loan on the books longer. The Peat Marwick analysis of an average size middle-market portfolio implies that the aggregate value of the prepayment option in the portfolio is about $25 million to $30 million-an amount essentially given away.

Shifting the price structure toward more up-front fee use over a renewal cycle could capture 25% to 50% of this value back for the lender.

As another example, consider that much of the profitability in middle- market portfolios derives from higher-margin, prime-based lending.

Intelligent, creditworthy borrowers and aggressive competitors are pushing in the middle market for more loans based on the London interbank offered rate, directly eroding profitability. Yet Libor-based loans tend to have more elaborate structures like grid pricing, which is prevalent in the syndicated-loan market, but not generally used in the middle market.

Adding a grid pricing structure to newly originated Libor-based loans makes a lot of sense for middle-market lenders as the grid helps keep profitable loans from prepaying and automatically facilitates higher pricing as credit risk increases. If you are going to give up the more profitable prime-based loans, you might as well take advantage of more elaborate loan structures.

The middle market for commercial lending is still a cornerstone for most commercial banks and as long as loan pricing remains relatively inefficient, there are significant arbitrage opportunities for leading lenders who can value the trade-off between price and structure.

Lenders that develop a business strategy which leverages leading-edge transaction valuation tools can gain a significant advantage over competitors who can't value these trade-offs.

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