More Loan Evaluations Using Return on Capital

A handful of banks are combing through their corporate clients' financial and economic data to ensure that proposed loans are worth making under increasingly stringent capital requirements.

This new way of evaluating loans is causing bankers to rethink their past lending decisions and perhaps decline to make a loan in which the projected earnings are not sufficient compensation for the commitment of risk-adjusted capital.

"It is important to be able to understand the business, to drill down to see where profitability is coming from and where the capital is utilized," said Daniel Pocrnich, a vice president at Norwest Corp. The computer systems to carry out the needed calculations have only been available recently, he said.

Systems Lacking

While the Fed laid out its capital requirements three years ago - total risk-adjusted capital must equal 7.25% of assets this year and will increase to 8% in 1993 - the vast majority of banks do not have the accounting practices or the computer systems to figure out the risk-adjusted value of a credit portfolio, let alone an individual loan.

The bankers who have adopted this new approach to evaluating commercial loans say a risk-adjusted return on capital - where riskier assets require higher levels of capital - provides an important view into whether a loan is worth making. This view gives a more accurate reading of the value or the cost of a loan than the more traditional return on assets, say bankers.

Norwest, along with Bank of Boston, is among the few banks who have adopted this new approach to evaluating whether a loan is worth making.

So far, the new view is making a difference at Norwest. "For some credits, the perception of profitability is different than the reality," said Mr. Pocrnich. "This analytic tool doesn't give any deference to the name of a borrower."

At Norwest, a calculation of the return on capital for a commercial credit is included in every discussion of loans to companies with at least $20 million in annual sales. Like any such tool, the calculation gives a consistent approach to evaluating credits. Norwest, which started calculating return on capital in the past few months, has found that some loans already made don't cut it on this scale. Those are being looked at again.

To calculate the risk-adjusted capital for a loan, a bank needs a customer data base that details clients' financial status and the profitability of that customer to the bank. A bank also must be able to calculate the real cost of money needed to make a loan, a calculation called funds-transfer pricing.

Some use computer systems and customer information files to automatically make those calculations; others rely on more manual methods.

"If the government is requiring capital against credits, bankers must know if a loan will earn enough so that they can increase their capital," said Anthony Gaas, chairman of Micro/Resources Inc., a Corte Madiera, Calif., software company that markets a loan profitability system to banks.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.