The spate of recent regulatory and legislative actions has fundamentally altered the earnings dynamics of banking.
While many details will not be known until the issuance of regulations, it is clear that Dodd-Frank and the Basel III initiative will require — either implicitly or explicitly — insured depositories to increase their level of capital.
It is also clear that activities that used to generate fee-based revenue have been either prohibited or significantly curtailed and that banks will have to bear additional fees and costs associated with the new compliance requirements.
In order to generate an adequate return on the higher level of capital as well as to offset the negative impact on profitability, it is imperative for management to maximize the revenue from the interest margin.
The creation of the Consumer Financial Protection Bureau means that differentiated pricing on consumer loans will be subject to greater regulatory scrutiny. While the ambit of the CFPB does not extend to commercial lending, it is possible that transactions falling within its purview might be extended to include financial transactions involving small-businesses customers with less than $1 million in sales.
To avoid fines and mitigate reputation risk, lenders who want to calibrate their pricing commensurate with the borrower's risk should have standards in place to demonstrate objectively why customer A was charged a higher rate than customer B.
A two-factor loan-risk-rating framework (also commonly referred to as a dual risk-rating framework) can help to improve risk-adjusted returns on capital as well as provide an objective basis for justifying pricing differentiated by risk. It includes risk ratings for both the borrower and the facility.
Explicitly capturing both elements provides management with a better sense of the true risk in their loan portfolio. This can serve as a basis for risk-based pricing and more accurate allocation of capital. The single-factor risk-rating methodology is not robust enough to serve as a true measure of credit risk.
The two-factor rating framework should reflect the institution's credit policies, credit culture, and risk management objectives. To be truly effective, the factors to consider when assigning risk to a borrower must be explicit and objective.
In addition to meeting regulatory expectations, this will help to reduce uncertainty between the lenders and credit personnel about what constitutes a specific grade. Factors to consider will differ by type of lending. The facility rating should account for the type of collateral, the degree of control exercised over the collateral, and the loan-to-value ratio.
For lenders, the future will be characterized by higher capital requirements and greater regulatory scrutiny. To ensure accurate allocation of capital based and to pass regulatory muster, a two-factor loan-rating framework can serve as a foundation upon which to build risk-based pricing strategies, improved accuracy in provisioning and more robust analysis and reporting capabilities.
