ABA Stonier Graduate School of Banking Traditional Capstone Strategic Project

Loan Pricing Model For XYZ Bank

XYZ Bank Boise, Idaho

Table of Contents

Executive Summary.3 Introduction and Background..5 Strategy and Implementation.15 Develop a source for determining cost of funds15 Determine equity allocation...18 Develop a source for determining a tax rate..18 Develop a source for determining loan loss provision...19 Determine sources for target ROA and ROE.21 Develop sections for the detail of the loan including fees collected and costs..21 Address related loans and their potential impact on pricing..23 Develop a model for the determination of and effect of investable balances and other related services and products....25 Develop a source for loan administration costs.26 Develop a computer application to compiling and calculate the results of combining the information.27 Implementation of the model.....29 Financial Impact.30 Non-Financial Impact33 Conclusion.36 Bibliography..37 Exhibit A---Loan Pricing Model-Prime Based Loans.....i

Executive Summary
XYZ Bank is a family-owned Idaho community bank established in the early1900s. Management includes a former Idaho politician, his son, and grandsons as well-as a group of experienced managers and lenders. The Bank has 285 employees, 113 of which are officers, and numerous retail branches throughout southern Idaho. 2007 resulted in record size, as the Bank became the largest Idaho community bank as measured in deposits, and record dollar earnings were recorded. Net interest income was in the 88th percentile, net operating income was in the 56th percentile, and the efficiency ratio was in the 52nd percentile relative to peers in 2007.Competition in the market has been using pricing models. In recent months, minimum pricing guidelines have been established by management with variation by credit quality, term, index used, and general industry type. A pricing model for individual loans has not been used.

Cost of funds sources were considered including Federal Reserve district cost of funds, Federal home loan bank indexes, and the Banks average cost of funds. The chosen source is the Bank actual average cost of funds by repricing timeframes: daily, one-year, three-year, and five-year. Equity allocation; tax implications; costs for loan loss provisions; determinations of Return on Equity and Return on Assets; the effect of loan amount, fees, floors and ceilings, payment structure, maturity, and advance structure on pricing; related loans; investable compensating balances and other products and services; loan administration costs; developing a computer application, and strategy for implementation of the model are all discussed and developed resulting in a formula that is included as the Exhibit A addendum to this document.

No investment in addition to what XYZ Bank would normally expend relative to pricing has been or will be necessary. Therefore, the return will be significant relative to cost. The ability to explain and justify modestly higher pricing is estimated to increase income by $425,000 annually. Determining adequate return is estimated to result in an additional $252,000 annually in new business that otherwise would be lost to other banks due to pricing.

The non-financial impact is essentially being able to better understand and communicate internally and externally with customers.

The model is recommended to be implemented as early as possible. Implemented as a guideline with flexibility to, on an exception basis, price below the model calculation, no downside is anticipated and significant additional profits and better communication will be realized.

Introduction and Background

In the Early 1900s, Fred Smith, a southeast Idaho entrepreneur, and a group of Idaho pioneers opened the first XYZ Bank in Boise, Idaho, with a $25,000 investment. The bank had this single-bank office for over 50 years. XYZ Bank is one of the few Idaho banks having survived floods, drought, The Great Depression, and acquisition attempts. Nearly thirty years ago, ABC Bank, a modestly larger sister bank located in another Idaho town and having some common shareholders, attempted to purchase XYZ Bank. Edward Smith, Jr., a great grandson of Fred and loan officer for another Idaho bank at the time, organized a capital campaign, which was able to raise adequate funds to purchase the stock from the shareholders promoting the sale. Edward Smith Jr., Chief Executive Officer today, came to work for XYZ Bank just following this event.

Ownership of XYZ Bank is privately held. The largest single shareholder of XYZ Bank of roughly 12% is actually the employees as a group in the XYZ Bank employee stock ownership plan. Remaining stock is owned and/or controlled by Fred Smiths descendants and family friends, many of whom were those helping in the capitalization at the time of the acquisition attempt. The employee stock ownership plan has in excess of $1 million in cash ready to purchase any shareholder stock shares that become available. Only in the last two years have opportunities been provided to the employees to receive actual stock shares in their employee stock ownership plan shares instead of just accumulating cash for some unknown day in the future when stock shares are available for the purchase. This employee stock ownership plan is 100% employer funded.

Management of XYZ Bank includes Smith family members Edward Smith, Jr. (Chief Executive Officer), Edward Smith (President), and Edward Smith III (Executive Vice President of the Boise area branches). Other non-family executives include the Chief Financial Officer and Chief Credit Officer. Edward Jr. has other relatives that work for XYZ Bank, including a son, Michael, who manages the largest branch by physical size. Edward Smith has only in the last year become less active in day-to-day operations of the organization. He, a former State of Idaho politician, was hired in 1986 by his son, Edward Jr., following 35 years of devoted community service including the service he provided to the State of Idaho. Prior to health-related issues occurring a year ago, Edward was active in loan committee, management, and marketing. He has resumed involvement in loan committee and has maintained activity as a leader of the bank board. Edward Jr. continues to be the operational leader of the bank with significant roles played by each of the other bank executives. The Chairman of the Board for XYZ Bank has been in the role for over 50 years, certainly one of the longest sitting banking board chairs in the nation. Longevity in its existence and in management and leadership contributes to the strength, integrity, viability, and success of XYZ Bank. The XYZ Bank Report to the Community states the following. What started as an enthusiastic business venture has become a five-generation family tradition. Today you will find three generations of the Smith family involved with the daily bank operations and the board of directors. We really are family owned, family managed, family

oriented. 1

Frontline operations and customer-contact personnel report to operations supervisors, branch managers, and department managers. Branch managers have a matrix reporting scenario. They report to an operations senior vice president relative to marketing, operations, and personnel functions. Yet, they report to a senior loan manager relative to lending and directly to senior management in areas such as budgeting. Department managers mainly report to senior management for all areas of accountability. XYZ Bank employs approximately 285 employees, 113 of which are officers. Management feels that Fred Smith lived by the principles of integrity, charity, friendliness, compassion, and hard work and that current XYZ Bank directors, officers, and other employees emulate these principles.

XYZ Bank expanded to a second location in Boise in 1979, and the headquarters were moved to this West Idaho location where it remains today. Since then, XYZ Bank has expanded, doubling in size roughly every five years. Currently, XYZ Bank has footings of over $800 million and has twenty branch offices and additional stand-alone real estate offices and commercial leading offices, all located in south Idaho in major towns and cities from the east to west side of the state. Offices are located in all southern regions

________________________________________________________________________ 1. XYZ Bank, Report to the Community, (2008): 3.

of the state. Boise is the site of many offices. Other major communities are the homes of the additional offices.

The following financial results were reported by the Chief Executive Officer of XYZ Bank, Edward Smith Jr., in the 2007 XYZ Bank Annual Report. The numeric tables are followed by a written analysis.

December 31 (in $000 except for share data) Assets Cash, Due Form and Fed Funds Securities Loans Installment Real Estate Commercial Agricultural Total Loans Less Loan Loss Reserve Premises Other Real Estate Owned Other Assets Total Assets Liabilities Non-Interest Bearing Deposits Interest Bearing Deposits Total Deposits Securities Sold to Repurchase Borrowings Long-Term Subordinated Debentures Other Liabilities Total Liabilities Capital Capital & Surplus Undivided Profits Unrealized Gain (Loss)-available for sale securities Total Capital Total Liabilities & Capital Book Value Per Share based on 517,275 shares

2003 38,064 46,551 35,390 138,576 49,169 67,555 290,690 (2,233) 9,796 130 6,027 389,025

2004 14,056 51,682 31,657 189,463 61,246 89,046 371,412 (4,276) 12,073 81 7,581 452,609

2005 34,945 64,128 30,523 225,209 71,773 93,679 421,184 (4,769) 20,423 387 9,470 545,768

2006 30,754 74,900 25,731 307,987 82,202 107,304 523,224 (6,010) 26,634 112 10,632 660,246

2007 31,878 96,087 24,594 369,235 94,443 111,432 599,704 (7,329) 31,224 112 12,623 764,299

78,260 265,859 344,119 12,847 0 6,186 1,852 365,004

84,691 293,202 377,893 21,460 15,300 9,279 2,333 426,265

121,602 361,629 483,231 14,069 5,000 9,279 3,100 514,679

116,573 447,847 564,420 19,042 19,800 14,434 3,858 621,554

123,252 516,749 640,001 37,965 19,000 16,496 4,360 717,822

16,701 5,679 641 23,021 388,025 $44.81

16,701 9,376 267 26,344 452,609 $51.28

22,201 9,214 (326) 31,089 545,768 $60.52

22,052 16,902 (262) 38,692 660,246 $74.80

22,686 23,519 272 46,477 764,299 $89.85

December 31 (in $000 except for dividends) Interest Income Interest Expense Net Interest Margin Loan Loss Provision Gain (Loss) on Provisions

2003 21,532 5,450 16,082 1,836 (61)

2004 25,709 6,278 19,431 1,500 2

2005 33,719 9,819 23,900 1,409 0

2006 46,190 16,991 29,199 1,540 13

2007 55,606 23,813 31,793 1,920 9

Non-Interest Income Salaries and Benefits Occupancy Expense All Other Expenses Total Non-Interest Expense Income Before Taxes Income Taxes Net Income DIVIDENDS DECLARED RETURN ON AVERAGE EQUITY RETURN ON AVERAGE ASSETS

6,217 9,553 1,375 5,132 16,060 4,342 1,406 2,936 174,658 13.50% 0.86%

5,277 9,914 1,833 5,605 17,352 5,858 1,977 3,881 184,932 15.83% 0.94%

5,519 11,449 2,038 5,925 19,412 8,598 3,065 5,533 195,206 19.26% 1.12%

6,147 13,144 2,423 6,869 22,436 11,383 4,117 7,266 210,617 21.17% 1.21%

7,083 14,989 2,879 7,433 25,301 11,664 4,186 7,478 227,601 17.81% 1.04%

December 31 (in $000 except for share data) COMMON STOCK DATA Income per common share Dividends paid per share Book value at December 31 INCOME ($) Net interest income Provision for loan losses Non-interest income Non-interest expense Income taxes Net income AVERAGE BALANCE SHEET ($) Investment securities Total loans Allowance for loan losses Earnings assets Total assets Total borrowings Interest bearing deposits Total deposits Repurchase agreements Shareholders' equity END OF PERIOD BALANCE SHEET ($) Investment securities Total loans Allowance for loan losses Earnings assets Total assets Total borrowings Interest bearing deposits

2003 5.72 0.34 44.81

2004 7.56 0.36 51.28

2005 10.77 0.38 60.52

2006 14.05 0.41 74.80

2007 14.46 0.44 89.85

16,082 1,836 6,156 16,060 1,406 2,936

19,431 1,500 5,279 17,352 1,977 3,881

23,900 1,409 5,519 19,412 3,065 5,533

29,199 1,540 6,160 22,436 4,117 7,266

31,793 1,920 7,092 25,301 4,186 7,478

43,201 267,943 (3,187) 316,545 342,611 2,737 233,222 295,690 13,458 21,750

51,954 327,888 (3,885) 384,278 414,381 7,861 278,987 356,161 15,813 24,514

51,660 399,320 (4,904) 460,582 495,264 9,129 333,943 428,579 14,829 28,724

71,447 475,680 (5,714) 551,339 601,208 26,825 398,288 507,850 14,516 34,320

84,425 569,035 (7,085) 656,464 716,167 9,784 506,023 620,175 21,877 41,981

46,551 290,690 (3,233) 347,014 388,025 0 265,895

51,682 371,412 (4,276) 424,311 452,609 15,300 293,202

64,128 421,184 (4,769) 487,891 545,768 5,000 361,629

74,900 523,224 (6,010) 598,688 660,246 19,800 447,847

96,087 599,704 (7,329) 696,815 764,299 19,000 516,749

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Total deposits Repurchase agreements Shareholders' equity SELECTED RATIOS (%) Return on average assets Return on average equity Allowance for loan losses to loans at 12/31 Net loans charged off to average loans Non-performing loans to loans at 12/31

344,119 6,186 23,021

377,893 9,279 26,344

483,231 9,279 31,089

564,420 14,434 38,692

640,001 16,496 46,477

0.86 13.50 1.11 0.45 0.78

0.94 15.83 1.15 0.12 0.37

1.12 19.26 1.13 0.22 0.33

1.21 21.17 1.15 0.05 0.14

1.04 17.81 1.22 0.11 0.53

XYZ Bancorp had record net income from operations in 2007 of $7.5 million. This represented a 2.9% increase from 2006 net income of $7.3 million. (Management) is (pleased with its) performance achievements in 2007 considering the economic upheaval created bysub-prime mortgage(s)and slowdown of the housing market. The return on average shareholder equity (ROE) was17.81%. Return on average assets (ROA) ended the year at 1.04%. Income per share increased 2.93% to $14.46 per share compared to $14.05 per share in 2006. Book value of common stock increased 20.12% or $15.05 per share to $89.85 compared to 2006 levels of $74.80 per share.

The Bancorp was able to refinance the original $6,000,000 in (Trust Preferred Security) TPS that was completed in 2002, priced at 3.40% over the 3-Month Libor. The new TPS issue was priced at 1.50% over the 3-Month Libor, allowing XYZ Bancorp to increase the new issue to $8,000,000. Due to the lower rate (decrease of 1.90%), XYZ Bancorp was able to maintain the same interest cost to(allow) for continued growth.

Total assets increased to $764 milliondeposits grew(to) $640 million

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XYZ Bank became the largest community bank in Idaho.

Loan demand wasstrongend(ing) the year at $600 million, up 14.62%...Credit quality declined slightly in 2007. Non-performing loans increased to .53%...

(Management is) optimistic that housing will turn around in the second half of 2008 when the housing inventory is reduced and prices stabilize. The aggressive interest rate reductions by the Federal Reserve will also improve the outlook for 2008. 2

Using the Uniform Bank Performance Reports (UBPR) provided on the Federal Deposit Insurance Corporations (FDIC) website, the following measures provide context to the annual report summary presented above. Net interest income was at the 88th percentile and net operating income was at the 56th percentile relative to peers. The efficiency ratio of 62.02 is at the 52nd percentile relative to peers.3 XYZ Bank enjoys strong interest income revenues yet experiences high expenses relative to peers. The expenses can be in part attributed to the expansion in recent years.

________________________________________________________________________ 2. XYZ Bank, Annual Report 2007, (2008): 4-5, 11-13. 3. Federal Deposit Insurance Corporation Website, UBPR Report, XYZ Bank, Boise, Idaho: 1.

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The overall strategy of XYZ Bank is described in its byline, Idahos Best Community Bank. The strategy is to provide an entirety of the most used banking services using the customers choice of personalized, traditional delivery methods and/or todays technological delivery methods. Technology use is not necessarily industry leading but certainly in line with industry standards. Traditional delivery includes custom-hired bankers who enjoy meeting the public and are highly skilled in each ones area of expertise. The cost of this approach is reflected in XYZ Banks ranking in the top quartile of personnel expense and nearly the same in occupancy expense relative to peers. This approach, however, has also resulted in being in the top quartile of net interest margin relative to peers and the top of Idaho community banks in return on equity in the first half of 2008.

For perspective XYZ Bank this year became the largest Idaho community bank in deposits. Regional banks are much larger in deposits and loans. XYZ Bank is from this perspective near the middle in bank size. Competition for deposits is highest in each market area of the bank, due in part to national conditions. The number of banks relative to the size of each market and number of non-bank depository institutions such as credit unions also contribute to the competitive environment. Loans have been no different in the intense competition. This has changed dramatically in the last month due to the banking economy and U.S economy in general.

The task at hand is to develop a loan pricing model as an informational tool to support pricing decisions for commercial loans of all types. At some future point, the information

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provided may be expanded to include consumer lending, including in-house real estate lending. The scope of this project will be limited to commercial lending, including commercial real estate and specialized commercial lending such as financing in the agriculture industry.

Competition has generally used pricing models as a tool to arrive at a starting point to price loans and to understand the profitability of pricing a particular loan at a particular price. In some instances, it is estimated that the competition has been inflexible in dropping below the minimum required pricing produced in these models. However, the market seems to drive pricing far beneath what a pricing model should support. From these competitive experiences in the market, pricing models are generally used for understanding a loans profitability relative to the value of an entire relationship.

Until the last few months, loan pricing at XYZ Bank has had no central structure. Variable prime rate based loans today have new pricing guidelines. Executive Management has implemented term loan pricing using the Treasury Constant Maturities index as a base rate. The rate over the one, three, or five-year base rate is laddered based on loan risk rating, the relative risk assigned to a loan. Pricing is set so that, the higher the risk, the higher the assigned rate over the index. These rates over the base rate are the bank managements opinion of market but are arbitrary as no analysis was completed to determine costs associated with loans of different quality and required rates of return at a targeted rate. In summary, loan officers have historically been required to use personal experience and perceptions to estimate an appropriate market-

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driven rate. New pricing has been set. If a rate is lower and therefore an exception, it is considered by an approving authority for estimated adequacy for the type, size, risk rating, and overall relationship tied to the proposed loan. This lack of information, consistency, and analysis has lead to the need to develop a loan pricing model.

Strategy/Implementation---Develop a Loan Pricing Model

Develop a source for determining cost of funds The cost of funds to be used in the loan pricing model was chosen among choices discussed with Executive Management of XYZ Bank. The potential choices were as follows. (1) 12th Federal Reserve District Cost of Funds. While this index has regional relevance to the banking community and is easily accessible, the relevance to XYZ Bank is not as exact as other potential sources of funds. The net result of using a cost of funds source that is less exact. This potentially could lead to a resultant model rate that is overpriced, with the potential of losing a customer, or under-priced, with the potential of making an unprofitable loan. The purpose of the pricing model is a decision-making tool. The more detailed, within reason, and the more applicable specifically to XYZ Bank, the better the related loan decisions will be. As cost of funds sources more directly applicable to XYZ Bank are available, this source will not be used. (2) Federal Home Loan Bank Cost of Funds Rates Quotes. This index source has benefits over 12th Federal Reserve District Cost of Funds. XYZ Bank purchases

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funds from this source at times. In fact, one could justify using this source with the following logic. A new loan will need funding. The cost of additional funds at that moment would be the cost of funds that could be obtained by Federal Home Loan Bank at that same time. A benefit available with this funding source would be the ability to match maturity of the funding source with the repricing time periods (buckets) to be used for the potential loan. For example, a fully floating loan based on the Wall Street Journal Prime could have the shortest term (7-day) Federal Home Loan Bank quoted rate used as the cost of funds in the proposed model. The rate produced by the model could be deducted from the current Walls Street Journal Prime to determine the rate over (and likely in rare instances) the rate under prime. One, three, and five-year Federal Home Loan Bank quoted rates could be used as the cost of funds in the model for like repricing periods. For example, the quoted cost for the purchase of three-year funds used in the model calculation could be used for loan repricing every three years. The rate produced by the model could then be deducted from the proposed index rate, for example the 3-Year Treasury Constant Maturities Rate index, to determine the rate over said index. Although these rates represent a rate source that could logically be supported, the actual XYZ Bank cost of funds is different from Federal Home Loan Bank quoted rates. Although to a lesser extent, this point is the same made against the 12th Federal Reserve District Cost of Funds. (3) XYZ Bank Actual Average Cost of Funds. This source is readily available as were each of the other potential sources. The source is absolutely relevant at

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the point in time it is used, which supports use of this funding source over the other two. Using this average internal source as the cost of funds should have the effect of producing an average targeted return for XYZ Bank. As the prior two cost of funds sources are not relevant directly to XYZ Bank, the result would not necessarily be the targeted return. This is a current, or historical, cost and neither necessarily reflects what the unknown future actual cost of funds will be nor is the number adjusted in any way to project what anticipated cost of funds will be during the loan period. The use of variable rates partially offsets this issue. However without using cost of funds sources that build in a factor for repricing time periods, rates again may be overstated or understated. For this reason, this cost source is not the best. (4) XYZ Bank Actual Cost of Funds Using Four Repricing Periods: Current or Fully Floating, One-Year, Three-Year, and Five-Year. This cost of funds approach is recognized as the best for XYZ Bank. In this case, actual current cost of funds in each time category will be the source of cost of funds. This approach approximates, using funding sources and uses, the match in repricing maturities. Actual cost of funds, targeted return on equity, and the additional custom formula inputs will make calculated results as meaningful as possible. Bank executive management has ready access to this cost of funds approach by maturity. The net result of the above considerations is the fourth option, XYZ Bank Actual Cost of Funds Using Four Repricing Periods: Current or Fully Floating, One-Year, Three-Year, and Five-Year.

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Determine equity allocation Determining equity allocation in a real-world situation was overly simple. XYZ Banks comptroller suggested that a 10% capital level be used for XYZ Banks target equity, as 10% is the minimum allowable risk based capital portion allowable for well-capitalized banks. If the model used the current equity position of the Bank, the resulting rate calculation would more truly represent the potential earnings and return for the Bank. The Chief Financial Officer or Controller of XYZ Bank will be responsible to see that any changes in tax rates be made to the model if needed.

Notes: After discussion with the Comptroller, this section will be amended. The 10% would better be replaced with an actual capital measure. Risk based capital does not make sense in the context of capital for the purpose of deriving an interest rate with a certain target Return on Equity. An equity measure without adjustment for risk weighted assets and without an adjustment to equity for loan loss provisions will need to be chosen. The number used in the ROE calculation for the Bank is likely the best number

Develop a source for determining a tax rate The XYZ Bank tax rate is currently 39%, which will be used in the formula. The Chief Financial Officer or Controller of XYZ Bank will be responsible to see that any changes in tax rates be made to the model if needed.

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Develop a source for determining loan loss provision amounts This factor has a potentially significant impact on pricing. For example, the estimated average annual loan loss reserve allocation is 1.35% of the average gross loan balance for the year. If this estimated loan loss reserve is assessed by charging each loan this amount, the effect will be over allocation on short term loans and under allocation on term loans. This is shown by a set of calculations showing the effect of 1.35% of a loan amount. In the case of a one-year fully advanced loan, a 1.35% loan loss provision will necessitate increasing the rate charged to the customer by 1.35%. In the case of a 15year, fully amortizing loan, an example calculation resulted in requirement to increase an interest rate .1327% to recover the 1.35% over the 15-year period. To deal with the inequity associated with two loans of the same amount, a duration determination and inclusion of this duration necessarily will be included in the model formula.

Proposed loan average maturity in years (DL) divided by average XYZ Bank loan portfolio maturity in years (DP) times 1.35% of the loan amount (L) to determine the dollar amount of the provision (P) for profitability calculation purposes should, in theory, provide in the profitability pricing model for the necessary 1.35% to be provided for the year. This assumes in terms of loan quality and for average maturity in years that the loan portfolio will stay consistent. The pricing model has the ability to be adjusted should the average maturity in years or loan quality change in the future. This obviously will have no retroactive effect on loans already priced, but a change in the input or formula could be made to affect future decisions. (DL/DP) (L) (.0135) = P

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The provision calculation to this point is not intended to arrive at the effect of the provision on the profitability of each loan for the life of the loan; rather, it is intended as an equitable method of allocating the provisions effect on pricing considering the necessity of an annual loan loss provision equal to 1.35% of the annual average of the XYZ Bank loan portfolio.

One additional factor in the provision should be considered, which is the allocating the provisions effect on profitability stratified by credit quality. Assumptions again must be made including that new loans will almost exclusively be risk rated 1 though 4.2. Risk ratings 5 through 7 will not be part of the model, rather will be determined by management. A calculation to determine how the 1.35% should be adjusted based on credit quality is a separate schedule. The schedule will, however, not be used as the rates would have nearly a 12% spread, which would neither represent the loss potential nor be accepted in the market. The proposed calculation to determine the cost of loan loss reserve by risk rating is as follows.

(DL/DP) (L) (.0135) (.05) = P1 (DL/DP) (L) (.0135) (.75) = P2 (DL/DP) (L) (.0135) (.95) = P3.1 (DL/DP) (L) (.0135) (1.05) = P3.2 (DL/DP) (L) (.0135) (1.25) = P4.1 (DL/DP) (L) (.0135) (1.95) = P4.2

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Allocations for loan loss reserve as used by each branch to determine adequacy range from .05% for a Risk Rate 1 (CD secured) loan to 10% for a Risk Rate 4.2 (watch). The Banks controller disregards these allocations and uses loan-specific allocations for all impaired loans as the .05% to 10% allocations have no relationship between a beginning loan grade and actual losses. At present, the Bank does not have historical information to support charge-offs relative to loans by risk rating. The above allocation adjustments for risk ratings are estimated and certainly can and will be adjusted with additional supporting data as it is developed by the Bank.

Determine sources for target ROA and ROE and the flexibility of use of these targets The source of target ROA and ROE will be the Chief Financial Officer of XYZ Bank and, in her absence, the Banks Controller. At present, they have set an ROE of 20% and a return on average assets of 1.00%. The model will base the rate from a 20% return on equity. The interest rate and the return on assets will both be calculated by running the model. All customers will have the same targeted rate of return. The difference in risk rating or risk profile between loans or loan relationships is taken into consideration in the cost of allocating for loan loss reserves.

Develop sections for the detail of the loan including loan amount, fees (and their effect on pricing), effect of floors/ceilings, payment structure, maturity, advance structure

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Loan amount. The fixed and variable costs of pricing included in the formula should have the desired effect of increasing the pricing of smaller loans and diluting the fixed costs on larger loans. No specific additional costs will be added in the formula for loan size.

Fees. Fees will be included together with interest to arrive at a total projected revenue amount having much the same effect as fees would in an Annual Percentage Rate calculation.

Floors and ceilings. Ceilings on loans at XYZ Bank have not been realistically considered by the customers to benefit them. This is because approximately 8% over the start rate is not anticipated to be reached during the term of any loan. As there is no perceived benefit by the customer and the effect would only be to reduce the potential return for the Bank, as remote as is that possibility, the recommendation is to discontinue use of ceilings except where required by law.

Floors are used by the Bank. The Chief Financial Officer and Controller of the Bank have no market sources to determine the effect of floors in variable rate pricing. A floor should logically result in a lower rate over the index. However since no market sources are available to determine the effect of floors on pricing, the effect of floors on pricing will not be addressed. The interest rate produced by the net end calculation considering all factors may have to be achieved by a combination of the index plus rate over and an

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interest rate floor. How this will be accomplished is using the pricing information calculated in this analysis to assist the judgment of the lending and approving officers.

Payment structure and maturity. To begin, the formula will use the loan officers estimated average outstanding balance during the term of the loan. Actual historical averages may be used for renewal multiple advance open end lines of credit when projected future use is not expected to change. Otherwise, an interview with the customer relative to anticipated use will be necessary to estimate the average outstanding balances.

Advance structure. Multiple advance open end lines of credit will include an additional cost to cover the activity associated with advances and related documentation. See the loan administration section that is detailed below.

Address related loans and their potential impact on pricing Related loans were given consideration. The issues include the following. If a loan is underpriced and, therefore, not producing adequate return on equity, the effect on the pricing of the newly proposed loan should be adjusted to a higher rate to compensate for the income that should be generated from the existing loan. If a loan is overpriced relative and producing a higher than required return on equity, the pricing of the new loan could be lowered. With both or all loans considered together in pricing, the combined return would be targeted to produce adequate return on equity.

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The difficulty with factoring in existing loans is that the balances and future payoff dates are unknown. An attempt to estimate balances and future payoff is estimated to result in less accuracy than ignoring the issue altogether. For example, a highly profitable loan is considered in pricing the new loan. Shortly after the new loan is completed, competitive forces either result in the borrower refinancing the existing loan elsewhere or the negotiations with the Bank results in a decision to reduce the interest rate to retain the business. The issues could be addressed by incorporating a tiered interest rate into the loan agreements. In the case of this example, the rate would be set and then increased should the existing loan be paid. At present, this is not an acceptable process to implement for the bank.

The conclusion is that existing loans will not be considered in pricing of newly proposed loans. Each loan will be priced individually. Further, care will be taken not to include factors such as contractually required average balances in pricing for more than one related loan. The net effect over time should be ideally that each loan is priced to result in no less than the rate necessary to produce the desired rate of return.

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Develop the model for the determination of and effect of investable compensating deposit balances including a source for the effect of reserve requirements on deposits, rates paid, and operational costs. Also address the difference among contractually required balances, historical average balances, and projected balances. Address other income producing products such as overdraft and insufficient funds fees and off balance sheet deposits or services such as those held through the investment department and their effect on pricing. Compensating deposit balances are sometimes considered in loan pricing models. The reasons for dismissing any such consideration is that deposit products are usually priced at a rate equal to what otherwise could be attracted as a source of funds, transactional deposit costs are not included when considering the value of the deposit accounts, and the deposit balances are not generally contractually required to be maintained during the duration of the loan. The exception to be considered for this model, therefore, is noninterest bearing deposits, analyzed to net out balances necessary to offset reserve requirements and account transactions. The model will, therefore, only consider these contracted deposit balances, meaning that deposit balances will be used infrequently in the pricing model.

The calculation when used will be deducting the balance from the loan amount, average projected balance for revolving lines of credit, lowering the dollar costs to make the necessary return.

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At this time, a comprehensive relationship profit model is not used by XYZ Bank. As is mentioned above relative to deposits, each product and service is priced at a market competitive level. Profitability in excess of required returns for each individual product realistically does not exist and, if it did, could not be tracked. Tracking would be critical to avoid using the same excess profit multiple times to, for example, reduce a loan rate. For this reason, no other products or services will be factored into the model.

Develop a source for loan administration cost and how potentially this will vary by loan type The Chief Financial Officer and Controller for XYZ Bank will be the source of the allocated administrative costs involved in originating and servicing a loan. No current costs are available at this time. Approximately four years ago, the Bank completed a study of costs associated with originating a loan. For all types of commercial the following costs were determined: $250 for loans in the amount less than $300,000, $725 for loans $300,000 to $800,000 and $950 for loans $800,000 and over. These costs are outdated and are estimated to be low relative to todays costs. These numbers will be used until an update on the cost study is completed by administration.

In addition to the costs as outlined above, an additional administrative cost will be allocated for multiple advance, open-end lines of credit. The source of this additional amount will again be the Chief Financial Officer and/or Controller for XYZ Bank. Beginning costs will be an amount equal to the administrative costs shown above, or,

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more clearly stated, double the amount of the assessed costs for a multiple advance, open end line of credit.

Develop a computer application to compile and calculate the results of the combining of the information above. The result of the calculation will be a suggested minimum interest rate. A functioning use of the model is included in the Excel spreadsheet attached as Exhibit A. The model includes calculations as follows.

1. A loan amount (face note amount). 2. A loan amount, which is either the initial or face amount on a term loan or average anticipated balance on a multiple advance line of credit. 3. Scheduled beginning loan balance for each year, one through ten. Longer maturities will be entered as ten years as the pricing will be affected in so significant way be longer terms. 4. Maturity in years. 5. Overall bank portfolio average maturity in years. 6. Annual cumulative principal average balance divided by the number of years. 7. Investable, contracted compensating balances. These balances will need to be required by loan agreement and be free, meaning balances that are neither used to offset transaction and other operational costs nor are used as compensating balances for other loans.

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8. Cost of funds including the interest rate plus the calculation of dollar costs, which is the cumulative balance shown above less compensating balances times the interest rate. The recommended cost of funds rates are in four categories determined by XYZ Banks actual funding costs: daily variable (prime based), one-year, three-year, and five-year. 9. An allocated equity amount. 10. The tax rate including a one minus the tax rate calculation. 11. A loan loss provision amount using the formula as detailed above. 12. A non-use loan loss provision originally set at .25% of the estimated average difference between the face note amount and average balance for multiple advance lines of credit. 13. Targeted return on equity set at 20% at present. 14. Targeted return on assets is shown and may be used in some form in the future. Return on equity is the key factor in for this bank. 15. Loan origination fees (not including out-of-pocket fees that pass through to pay loan costs. Any non-reimbursed fees should be deducted from fees collected in this line item. 16. Administrative costs as outlined above. 17. Additional multiple advance line of credit costs as outlined above. 18. The formula adding cost of funds (adjusted for investable, contracted deposit balances), loan loss provision costs, non-use loan loss provision costs, administrative costs, and line of credit administrative costs less the loan fees collected.

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19. The formula using dollar loan amount (estimated average balance for multiple advance lines of credit) times the equity allocation times the required return on equity divided by one minus the tax rate. 20. The formula totaling the above cost and required dollar return. 21. The formula for the calculating the rate, which is dividing the total costs and required dollar return by total annual principal average balance.

The net result is a formula that includes the factors that realistically should be considered as part of pricing in a form that is flexible and easily modified.

The resulting loan pricing model will be implemented throughout the bank for the use of front line commercial lenders, credit administration, and management as a tool to help set loan pricing and assess existing loan pricing.

Implementation of the Model Rates at or higher than the model rate will require no further approval by loan officers and the approving authorities; rates lower will require the established exception approval. The model will be owned and maintained by the executive management of XYZ Bank. The fixed input will be protected leaving loan amounts, maturities, investable balances, loan loss provisions, loan fees, and administrative costs as the only fields to be entered by the loan officers. Changes in the fixed fields will be determined by executive management. No less frequently than a quarterly review of the model is recommended.

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A version of the model recommended in this presentation process will be recommended to be implemented in quarterly loan officer training. The components of the model will be addressed in detail, and lenders will be trained on proper use of the model. Implementation is estimated to be during the April or July quarterly loan officer training, contingent on final approval from the XYZ Bank Executive Committee.

Financial Impact
Investment No cash investment will be necessary to complete this project. The cost will be one related to time expended by existing bank personnel. As this has been a goal of the bank to develop this model, the time resources necessary will be allocated to complete the project.

Return on Investment Since the investment will be limited, the return for the small amount of time will be significant. No pro forma profit and loss statement will be developed as realistically it does not apply in this case. The financial impact to the bank, however, is considered and estimated below. This financial impact consists of supporting pricing to successfully contract new loans the bank otherwise may feel are under-priced, to avoid contracting loans that are under-priced, to increase the pricing on some loans, and to provide information to help a customer understand a rate that is higher than what the customer may think is appropriate.

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Back testing of a random sampling of six recently made lines of credit showed three calculations higher than the actual rate and three calculations lower than the actual rate. The highest calculated rate over the actual rate was .34% and the lowest calculated rate under the actual rate was .29%. The rates resulted in a surprisingly tight range between the actual and calculated rates. Interest rate floor have an effect on the current actual rates. As rates increase in the future, the floors will have a lesser impact.

This sampling was performed from one of the lowest yielding and higher quality loan portfolios in the Bank. As the model takes into consideration loan quality, the sampling is estimated to be representative of the Bank as a whole. The model should be and will be fine tuned over time as assumptions are modified into historical experience.

If half of the Banks loans are under-priced and half are overpriced, the model could be used to more fairly price loans due to costs and required returns. Further, the pricing model can be used to justify higher rates, only if marginally higher. Typically, XYZ Bank uses even .25% increments for rates over an index (prime for example). If justified due to a model, rates over the index could be provided in increments of .05% or even .01%. A rate, for example, of Wall Street Journal Prime plus 1.89% could be used instead of 1.75% if the rate could be justified. The customer may not see any difference between the two rates because they are perceived as essentially the same. However, the increased dollar interest over a years time on $1,000,000 would be $1,400. Unless a customer is unhappy with a rate, those customers with actual rates higher than the rate calculated by the pricing model could be maintained at the same rate. An alternative

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would be to adjust the pricing to near the calculated rate in order to keep the customer from leaving the Bank for a better offering.

In any case, the information will be used as a basis for loan pricing and, maybe more importantly, as a tool to make more informed pricing decisions. Pricing differences are unlikely to be .25% different over the entire bank loan portfolio. Because of the incremental pricing opportunities, one-half of that affecting one-half of the loans may be reasonable. On a portfolio of $644,000,000 in loans, this .125% estimated difference is additional income of $425,000.

Another factor of significance is the potential to successfully achieve business that historically has been lost due to pricing. An interview with six of XYZ Banks lenders revealed that $7,922,000 in loans was lost over the last year due to either exclusively or mainly pricing issues. This is approximately $1.3 million per loan officer. XYZ Bank has 65 commercial lenders. The high and low for the six officers sampled was $6,269,000, a newly hired officer that came from a very competitive bank, and $214,000, a most well-established officer in the region. If the average of the sample group was used for all 65 lending officers, the total estimated loans lost due to pricing in one year is $84,000,000. Using logic stemming from the idea that half of the loans in the Bank are priced higher that the model calculation, potentially $42,000,000 of these requests could have been approved with lower rates without negatively affecting the Banks ROE. Although the pricing model may calculate a lower rate, successfully attracting these loans will have much to do with how much lower XYZ Bank can go and still be a profitable

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venture. Even if just 20% of the $42,000,000 in loans lost due to pricing were successfully attracted to XYZ Bank, the profit (about one-half of total costs; see the formula) would be an additional $252,000.

Together the model as a tool and the potential new business available are $677,000 in additional annual revenues on essentially no investment. Adopting this model will be very profitable for XYZ Bank as the assumptions made above are verified as valid.

Non-Financial Impact
Introduction of the Model and Training XYZ Bank has approximately 65 individuals in the lending area that would use this pricing model to calculate interest rates on commercial loans. In addition, another ten individuals would review these models in a loan administration and loan review function. Training to implement the model is recommended to be performed in a quarterly loan officer training. The meetings already are established. The flexibility of the meeting and length of the meeting allow for training. Given this, no logistical issues are anticipated in introduction and training relative to the model. Accessibility and Documentation The four models ranging from fully floating prime based to a 5-year adjustable base rate will each be placed on the XYZ Bank intranet as bank templates. From this location, loan officers will access the models, modify the documents by entering information in the designated cells to arrive at a calculation of rate, and then save the document to a personal drive. The model will be part of the required documentation in loan approval

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and will then be part of the documentation included in the loan file. Given this, no logistical issues are anticipated in the accessibility and documentation relative to the model. Acceptance by Administration and Lenders Acceptance by administration is a key issue. In the discussions with executive management when considering this project, development of a pricing model was given the highest priority of importance. The Chief Financial Officer had been given responsibility to develop a model and present it for approval. The task has been completed in the form of this project and is highly likely to be accepted. Some minor modifications are expected as the model is approved and implemented. Although this is a cultural change in the organization, executive management has been willing to accept such changes as the benefit is understood. As the need for the pricing model was originated by executive management, the idea of a cultural change will be even less of an issue. To explore the organizations cultural and resistance to change issues, nine of the 24 senior branch and regional credit officers were interviewed. Nine of nine responded that they are accepting of the new process. Responses included, better than what we have now, needs to be something to help loan officers price loans, great idea to have something like this, good thing, huge tool, used a pricing model extensively at my previous job, like to use a pricing model, and has a place in our industry today. All expected flexibility in the used of the model, meaning exceptions at times when merited to price below the pricing model calculated rate. This flexibility is already in XYZ Bank current policies and is part of the recommendation accompanying this pricing model.

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Six of nine respondents were concerned about understanding the model and training. Four of nine expressed concern about whether deposit balances are to be considered in the calculation of loan rate. One was concerned that any model would have a difficult time being approved by executive management. The last three hurdles are addressed in the following paragraphs. Understanding the model and training will be provided for at implementation as presented above. Credit administrators, regional credit administrators, and credit review will be resources to answer questions and to provide assistance on an ongoing basis. Deposit balances are considered as part of the model. Lenders will need to be educated as to why interest bearing deposits and deposit balances needed to cover activity costs should not be included. The issue of contracted compensating balances will also need to be explained. The opportunity to provide this information will be during the initial training and subsequently from credit administrators, regional credit administrators, and credit review. Executive management has agreed to the idea to the point that obtaining a model for the XYZ Bank was given as an assignment to the Chief Financial Officer by the Chief Executive Officer. Results of the Model The non-financial impact will be important in addition to the financial impact. Through adoption of the model, customers will receive pricing based more on the real costs and a consistent required return of the loan to the bank. This consistency in return and equitable assessment of costs in the formula potentially benefit the customer. Information relative to the factors affecting interest rates will be available, allowing

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customers and bank officers a more clear understanding of why rates are set as they are. Management and approving authorities will have clearer information from which to make decisions and communicate decisions. This will result in a greater level of employee satisfaction for management and approving authorities as well as lending officers. The understanding of the factors contributing to interest rates will potentially allow customers to make changes to qualify themselves for a better rate. Measurement of the success of the model will be full implementation and ongoing use. The models use in the long-term is also the only way the model will be profitable for XYZ Bank.

Conclusion

The conclusion relative to the above analysis is that the proposed pricing model, with periodic ongoing modifications, be implemented by the management of XYZ Bank at the earliest possible time. The model will be as instrument to increase profit by justifying improved pricing, to increase loan volume, to communicate pricing with customers, and to communicate internally in matters of pricing. No potential problems or risks are inherent in using this model for information in decision making. Used as a tool as presented above, the model will create increased assets and profitability with no costs other than what is now expended in determining pricing.

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Bibliography

XYZ Bank, Report to the Community, (2008)

XYZ Bank, Annual Report 2007, (2008)

Federal Deposit Insurance Corporation Website, UBPR Report, XYZ Bank, Boise, Idaho

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