Where Asset Liability Management and Transactions Meet
Loan Pricing Profitability
key words: loan pricing, rates, RAROC, profitability measure, fund transfer pricing, approaches
THC Asset-Liability Management (ALM) Insight
Loan pricing is important to community banks and credit unions, as it can impact customer relationships,
change loan volume and margin, and also impacts the balance sheet risk exposures. Because multiple factors
affect loan pricing, the process in determining a loan price can be complex.
For example, ALCO and loan officers are often motivated differently in loan pricing. The loan officers tend to
be pressured by the customer’s needs, while the ALCO tends to be pressured by risk management. The loan
pricing process should consider the needs of all stakeholders. In the end, both are unified in efforts to
increase risk-adjusted margin.
This article describes a systematic methodology in pricing loans ensuring direct costs are covered and indirect
and overhead costs are properly allocated. This enables ALCO and loan officers to make informed decisions
in product offerings and secondary market transactions. Ultimately, the underlying profitability driver are
assumed and pricing objectives are met.
In particular, do ALCO and loan officers alike know which products provide the highest value? How much (if
any) rate concession can the loan officer offer to borrowers given the loan policy, secondary market pricing
and risk analysis? Can ALCO adjust the rate cap to meet the borrower’s needs without changing the loan offer
This article explains. In particular, this article describes the Dynamic Cash Flow method in measuring
profitability on loan pricing across a broad range of loan types. The relative profitability measure enables the
ALCO and loan officers to jointly decide:
the appropriate loan rate in negotiating with a customer in certain occasions;
most profitable loan products given the loan market competitive rates, combining the market
intelligence from the loan officers and ALCO balance sheet strategies;
the growth potential of certain profitable loan products as the loan market supply and demand are
the bank’s risk-adjusted return on capital (RAROC) against the loans in the secondary market to
expand profitable opportunities.
Figure 1 below depicts the RAROC profitability of loan pricing based on a bank’s loan offer rates and a sample
of secondary market loan rates. These results are relative measures of profitability of loans benchmarked
against the secondary market offer prices. While the RAROC has adjusted for the expected credit loss rates
of the loans, the profitability has not adjusted for the credit risk premium. The risk premium has to be