Tailored loan pricing is the key to unlocking banking profitability

Since 2008, banks have primarily boosted profitability by increasing loan volume. However, given today’s changing economic landscape characterized by compressed margins, potential charge-offs, a challenging deposit environment, and reduced consumer cash reserves, banks must reconsider their strategies to stay profitable.

One strategy that needs work is loan pricing. Many banks employ outdated strategies when pricing loans, regardless of whether their customers are big commercial clients, individual consumers, or small and medium-sized businesses (SMBs). But to truly drive profitability, bankers should adopt a more nuanced approach, tailoring their pricing methods to the specific needs and characteristics of each customer segment, aligning pricing to their balance sheet strategy and considering the regulatory landscape that governs them.

Here are some considerations banks should look at when setting the pricing for commercial, consumer and SMB loans:

Commercial clients

Price to achieve your balance sheet strategy. Banks should pinpoint what they want their balance sheet and income statement to look like, identify their target clients, and execute these objectives with discipline. Intentionality in client acquisition and pricing is key. For instance, if a bank is overconcentrated in commercial real estate (CRE), it should avoid onboarding new clients in that sector or price them higher. Conversely, in sectors they aim to enter, banks should consider lowering pricing, leveraging extra margins from less desirable areas.

Define your business model. Although many banks claim to be relational, their culture, incentives, and management practices reveal they are transactional in nature. Being solely transactional worked when deposits were cheap, losses were minimal, and growing loan volumes was the key to success, but this strategy doesn’t work today. Strengthening relationships with clients ensures bankers are seen as trusted advisors, further improving the client experience and driving growth.

Build a full-cycle pricing model. Transactional banks focus on pricing relationships at the point of sale: Closing the deal, getting it on the books and moving on to the next one. This approach is a missed opportunity. Effective pricing requires a full-cycle process, from client acquisition through expansion, relationship management, renewal, and onboarding. Banks should also proactively identify clients in their portfolio who need pricing adjustments before renewal, and coach the entire banking team on the new pricing model to ensure alignment and effectiveness.

Consider risk. Assessing risk is a distinct function handled by the bank’s credit group. Once the risk associated with each client relationship is understood, banks should price accordingly and adjust as necessary throughout the relationship to ensure they are not assuming additional risk without appropriate compensation.

Consumer clients

Understand regulations. Consumer lending is a highly regulated sector, governed by three distinct laws: the Equal Credit Opportunity Act (ECOA)/Regulation B and the Fair Housing Act, which prohibit any form of discrimination, as well as the Truth in Lending Act, which ensures consumers are informed about credit terms and costs through required disclosures. Banks entering the consumer lending sector must have a thorough understanding of these regulations.

Build a pricing process. An effective process involves creating consumer product scorecards based on attributes like FICO score, debt-to-income, and loan-to-value ratio, and assessing the risk associated with each scorecard. Once this is complete, banks should establish rates for each scorecard category and price accounts accordingly, making sure they continuously monitor and adjust pricing if necessary.

SMBs

Consider size. The pricing strategy for SMBs varies based on their size. For businesses with less than $500,000 in assets the approach should align with consumer pricing, as the credit metrics used to underwrite small SMB loans are often based on the business owner’s personal financial, and so, fair lending practices could apply. For larger SMBs, the strategy should be similar to commercial accounts.

In today’s challenging economic environment, banks must embrace more sophisticated, tailored approaches to loan pricing. By aligning pricing methods with the specific needs, risks and the regulatory frameworks of different customer segments, banks can better position themselves for sustainable profitability and growth.

Mac Thompson is the founder and CEO at White Clay.