im18 - Chapter 18 Customer Profitability Analysis and Loan...

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Chapter 18 Customer Profitability Analysis and Loan Pricing Chapter Objectives 1. Describe the elements in customer profitability analysis. 2. Examine the various sources of bank revenues and expenses associated with a customer account. 3. Provide an application of customer profitability analysis to a commercial account. 4. Demonstrate how to use the account analysis framework to help make loan pricing decisions. 5. Examine the importance of fixed-rate versus floating rat loans, and the choice of different base rates. 6. Apply customer profitability analysis to installment loans. Key Concepts 1. Customer profitability analysis compares revenues from a customer account relationship with expenses, including a target return to bank stockholders. 2. An account is profitable if revenues exceed expenses, but the difference must exceed the target profit before the account meets the bank's minimum acceptable return criteria. 3. When a customer has a loan, the primary sources of revenue are loan interest, fees, and investment income from balances. The primary expenses are load administration, risk (charge-offs), and the cost of funds. 4. A bank can transfer interest rate risk to borrowers by pricing loans on a floating rate basis. 5. Profitabiliity analysis is especially valuable for customers with multiple account relationships, including loans, deposits, and other services. Banks should attempt to assess the actual cost of providing services for all types of relationships and should view the revenues jointly so that the entire account relationship is profitable. 5. Consumer loan profitability analysis typically establishes break-even relationships so that expected revenues at least equal expected expenses. The output is the minimum size loan a bank should make, or the minimum rate that should be charged for each size and maturity loan. Teaching Suggestions Chapter 18 directly compares account revenues with expenses plus the bank's target profit. The most difficult aspect of the chapter is the terminology. Work through the basic examples to demonstrate how banks measure the cost of funds, cost of deposit account, and target profit, how banks account for credit risk, and how banks measure the interest income from investing customer deposit balances. Note the connection and similarities between the analysis in this chapter and what students learn in traditional corporate finance classes regarding measuring the marginal (weighted average) cost of capital. Spend some time discussing loan pricing. A bank must know its cost of funds. Where appropriate, refer to Chapter 4 and the discussion of internal funds transfer pricing models. The same framework for an individual loan transaction is used for the revenue and expense estimation process for a customer account. Discuss also the propensity of some banks to price loans tied to their own bank’s base rate. Have students assess the advantages and disadvantages of a such pricing
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im18 - Chapter 18 Customer Profitability Analysis and Loan...

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