How to rationalize geographic loan pricing and structure variances for regional and national banks.

Commercial banks are responsible for determining appropriate risk premiums for commercial loans across varying geographies. This is an important task that requires careful consideration of the local economic conditions and the borrower’s creditworthiness. To determine an appropriate risk premium, banks must first understand the local economic conditions and the borrower’s creditworthiness.

The local economic conditions of the area in which the loan is being taken out should be evaluated. This includes the local unemployment rate, the average income of the area, and the local housing market. These factors can provide insight into the level of risk associated with the loan. If the area is economically depressed, the risk of default is higher and the risk premium and loan structure should be adjusted accordingly.

Using macroeconomic and county level economic data can enable the banker to determine the risk profile of the underlying area and then risk-based adjust the loan rate and structure. This exercise is not one-and-done, however. The process needs to be back-tested regularly and data updated to stay current on the economics of the local region and enable the bank to adjust accordingly. Loan pricing models need to incorporate geographic risk into the model. In a future post, I’ll discuss industry risk premiums for specialized lending.

Commercial banks can determine appropriate risk premiums for commercial loans across varying geographies by utilizing a variety of risk assessment methods. These methods include analyzing the local economic environment, assessing the creditworthiness of the borrower, and evaluating the collateral offered. When assessing the local economic environment, banks should consider factors such as the local unemployment rate, GDP growth, and the rate of inflation. These factors can provide insight into the overall economic health of the region, which can be used to determine the risk associated with the loan. For example, if the local economy is in a recession, the risk of default is likely to be higher, and the risk premium should be adjusted accordingly. The creditworthiness of the borrower is also an important factor in determining appropriate risk premiums and how the local geographic economy may amplify or dampen those risks.