In this article, we cover:
- Understanding Federal Reserve policy direction
- How rising interest rates impact business loan pricing
- How inflation impacts the profitability of recent and pending business loans
- Risk-based pricing to maintain demand in uncertain economic conditions
With interest rates on the rise, many banks are now beginning to pivot towards a different kind of lending strategy than the one that has characterized the last 15 years since the Great Recession. With this change in the landscape comes a whole host of questions that banks need to consider. Especially, how to price loan products for small businesses so as not to crush demand (which is strong due to recession) but also adequately account for the risk that may be entering the economy due to a weaker economic environment.
Upcoming Federal Reserve Policy in 2022
With inflation rates in the United States greater than 7% in every month in the first half of 2022, the Federal Reserve is far off from its 2% inflation target. The Federal Reserve views a 2% inflation rate as healthy for the economy.
Jerome Powell, the head of the Federal Reserve, is in charge of leading the strategy of Fed interest rate hikes. Raising the federal funds rate is the primary tool the Federal Reserve has to slow down inflation without creating a recession. In recent months, the Fed has bumped up the funds rate by between 50 and 75 basis points at each of its periodic board meetings. This follows over a decade of historically low interest rates set by the Fed, so it marks a major change in policy that bankers need to pay close attention to.
Because the Federal Reserve is deeply committed to reducing inflation to its 2% target rate, it will likely continue to raise interest rates in the immediate to short term or until inflation begins to cool.
How Federal Reserve policy impacts bank profits
Rising interest rates and banking profits are intertwined and can have both a positive and negative impact. To give you a sense of how Interest-rate changes affect the profitability of banking, consider the following:
- If the recent increase in inflation were to prove persistent, this would be positive for bank profits as they can establish loans to small businesses at higher interest rates and collect more in monthly interest payments.
- The high inflation numbers that are compelling the Federal Reserve to take action and increase rates, also puts upward pressure on banks’ expenses, particularly wages of bank employees.
Banks must maneuver and balance their strategy to account for these two inflationary impacts. Focusing on maintaining net interest margin in the face of a changed monetary landscape is one of the challenges that banking executives are now spending much of their time debating and planning for.
According to The Office of the Comptroller of the Currency (OCC), an independent bureau of the U.S. Department of the Treasury that charters, regulates, and supervises all national banks, despite inflation being both a positive and negative for banks, the expectation is that the overall impact of higher inflation on GDP and bank profits would be positive and could extend into 2023. If GDP growth slows down as the Federal Reserve policy to increase interest rates to rein in inflation takes effect, bank profits could slow as well. So caution is advisable here as the situation is sorting itself out.
How rising interest rates impact business loan pricing
When the Federal Reserve raises interest rates, it raises the interest rates on small business loans and slows demand. Low interest rates stimulate demand with a lower cost of funds for businesses and incentivize them to pursue their goals which typically means taking out a loan to grow or expand or acquire. We have seen this play out in recent years and as early as the beginning of 2022 when interest rates were hovering around 0%.
The Federal Reserve faces a very difficult balancing act when raising interest rates. The goal is to reduce inflation but not cause a recession. The Fed needs to raise interest rates aggressively to bring down inflation, but if they raise rates too much, and businesses are faced with higher rates, they might decide not to expand which in turn causes a contraction of their business and the economy at large. If a recession does occur, then the business loans that are outstanding on a bank’s balance sheet could face higher default rates because of reduced business profits and a potential rise in business failures.
How inflation impacts the profitability of recent and pending business loans
We’ve discussed how rising interest rates and banking profits are intertwined. Let’s review another example of how inflation can negatively impact banks. There is a gap between when a bank locks in an interest rate on a loan and when that loan closes. The interest rate for that loan might have been locked in anywhere from 30 to 120 days before closing (to provide a general sense of timing). Take for example the first half of 2022 when interest rates started at near 0% and then by June the Federal Reserve had enacted four consecutive rate hikes over a few months taking the benchmark borrowing federal funds rate up to a range of 2.25%-2.5%.
If a bank locked in an interest rate on a loan for a small business at near zero percent right before the Fed started hiking rates, they could have missed out on a more profitable loan.
From the bank's perspective, the upward movement in interest rates hurts the profitability of recent and pending loans because the customer has locked in lower interest rates than what is being charged at the time of the loan origination date.
There’s also the risk of default for individual loans that are pending with businesses which may be facing significant negative effects of a potential recession. Bankers must keep an eye on the performance of the existing balance sheet before they decide to advance with growing the loan book even more. So what is an effective strategy for doing this? Let’s take a look at a risk-based lending model that bankers can use to particular effect during a recession.
Risk-based pricing to maintain demand in uncertain economic conditions
A rising interest-rate environment puts pressure on lenders to find optimal prices. Lenders need to implement pricing optimization to ensure they have a strong and healthy loan portfolio. How should lenders make pricing decisions on loan products for small businesses so as not to crush demand but also adequately account for the risk that may be entering the economy due to a weaker economic environment? Lenders need to change their current pricing methodology so they do not impact the elasticity of loan demand.
Let’s take a closer look into risk-based lending as a loan pricing model.
What is Risk-Based Lending?
One tactic banks can use in uncertain market conditions as a loan pricing model is risk-based pricing or risk-based lending. At a high level, risk-based pricing is a form of risk management when lenders offer different interest rates or different loan terms to different types of consumers based on the estimated risk of whether or not the consumer will fail to pay back their loan. Risk-based pricing models considers myriad factors to determine the loan amount and the borrower’s credit risk that go above and beyond simply a credit score.
A risk-based lending strategy allows traditional financial institutions like large banks, commercial banks, small banks, credit unions, community banks, etc to offer lower interest rates to lower-risk borrowers while offering higher interest rates to higher-risk borrowers that consider an appropriate risk premium. In other words, this pricing approach creates more competitive pricing for the individual borrower.
By expanding the loan criteria to include higher-risk borrowers via risk-based lending, banks can create additional demand from a customer pool that they might have previously stayed away from while maintaining healthy demand from preferred customers.
A byproduct of risk-based lending is it creates more customer relationships as your market share increases. A larger customer base typically means more opportunities for future up-selling.
Senior leaders at a bank will first need to adjust and expand their ideal customer profile. By pursuing a risk-based lending strategy, banks can expand their growth potential. By pursuing risk-based loan pricing strategies, banks can adjust their lending criteria in an attempt to achieve higher profit margins to de-risk taking on borrowers with a riskier credit profile. The goal is that profit gains largely offset losses.
Conceptually risk-based pricing is easy to understand. However, its complexities lie in the nuances of execution and continuously adjusting the strategy based on data coming in from issued loans. For example, no successful lending strategy can be implemented without input, consultation, and buy-in from the underwriting department.
Lenders can better assign fair and appropriate loan interest rates when equipped with borrowers’ business information, credit history, and industry benchmarks for points of comparison. The goal is that interest rates can effectively meet the credit needs of the borrower which means a risked-based pricing strategy requires a lot more customer data.
Risks of a risk-based pricing strategy
A general disclaimer when creating new lending practices is to consult your legal department. As one of the most highly-regulated industries, financial services need to comply with any equal credit opportunities and compliance requirements in their local or national market, base pricing strategies on algorithms that have consistent and fair data, and monitoring systems to avoid losing profitability due to large overhead costs, such as underwriting and collection.
Determining Credit Risk for Business Borrowers
There are many factors to determine the credit risk for business borrowers. Typically a lender would rely on a credit score; whether that’s the business's credit score or the business owner's credit score, how long the business has been open, revenue, and more all play a factor in whether the borrower is considered high risk or low risk.
However, risk-based lending relies heavily on data to limit risk and maximize profits. Modern lenders are equipping their credit risk teams with software that can provide instant intelligence and financial insight to make superior lending decisions that do not rely on a team of humans to manually hunt down data. The more manual processes and procedures you have, the higher your operating costs become which can reduce the effectiveness of this strategy.
Having a software solution in place can take your business lending operation to a whole new level of confidence and transparency, thanks to tools that provide credit analysis including cash flow monitoring and transaction-level analysis.
With a software infrastructure in place, your credit risk analysis team can have access to features like
- Automated cash flow analysis of a business which allows you to make credit decisions more intelligently and faster
- Work between multiple document types and across different data sources
- Reduce risk by identifying patterns and calculating risk metrics on each credit file
With a credit-analysis tool, your bankers can drill into a precise level of detail on every credit decision, behavior patterns such as signs of business expansion to risk-driving transactions, and ongoing debt obligations.
Creating a scalable, profitable, risk-based lending business needs technology in place to help make smart, real-time decisions. The right technology can create a competitive advantage and even lower your funding costs.
For additional information, learn more about Biz2X’s Advanced Credit & Risk Analytics Tools.
Finding a lending platform
Biz2X is the platform chosen for business lending at banks and financial institutions around the world. Lenders choose our platform because they want to transform their lending practices digitally. Our approach is different because we know business lending. Biz2X is built on the insights and expertise that came from a decade-plus of Biz2Credit’s lending experience. That’s why the platform works so well for lenders of all sizes.
We invite you to bring any questions you may have to Biz2X. Reach out to schedule a demo, drop us an email, or reach out to a platform specialist on our team to learn how Biz2X can boost your bank’s business lending IQ and help you make shrewder lending decisions more quickly and efficiently than you’ve ever made them in the past.