Implementing activity-based costing (ABC) to measure commercial loan profitability

Journal of Bank Cost & Management Accounting, The, 2001 by Kocakulah, Mehmet C, Diekmann, Douglas

There are a number of factors, which drive the total cost of a loan. All of these factors were considered in building a model which could review the profitability of a sample of loans. The first and primary consideration is the cost of funds benchmark. For purposes of assumption in this report, the cost of funds was set at 6.00%. The cost of funds correlates to the total cost that a bank must pay in order to obtain funds for re-lending to commercial borrowers. There are a number of ways that a bank can obtain these funds; however, the most common methods are leveraging the level of deposits on hand at the bank, which corresponds to the cheapest source of funds, and also borrowing from the Federal Reserve Bank at the discount rate. Interest rate changes are not a cost driver in this instance because interest rates and the discount rate move in parallel fashion with one another. The differences between the traditional model and ABC model can also be seen in the traditional model providing assumptions for an overhead factor of 0.65% as well as the loan loss reserve of 1.0%. In the ABC system, neither of these areas should be assumed because the cost drivers account for the overhead activities and levy a premium on the cost of funds based on loan grade.

The other aspect of this analysis, which must be established as part of the benchmark for pricing a commercial loan, is the level of risk or loan grade that is assumed by the Bank. Standard bank practice is to place loans on a one-to-nine scale for risk with one being the lowest risk and nine being a total loss. Most loans fall within the three (satisfactory risk)to-five (moderate risk-watch) categories. Any loans classified as a six or greater would be considered a criticized asset by the bank and its examiners. In the case of a criticized asset, the bank will be less inclined to work with this borrower to maintain a borrowing relationship and will instead encourage the borrower to seek alternative financing sources. This can be seen in the sizable premium levied on credits graded five or worse; it also accounts for the absence of any premium in credits graded eight or nine because those credits are typically on non-accrual (no interest income is recognized) because of the high risk of loss. Also associated with all credits graded six or worse, the bank is required to reserve a large percentage of the loan for potential loss, dragging the earnings and profitability for a bank that has a large number of criticized assets. For purposes of this study, it is assumed that risks will be assessed interest rate premiums based on the following schedule:

The table above establishes the base for the ABC pricing model by using the cost of funds and a mark-up based on the level of risk in the loan transaction.

RESULTS OFTHE MODEL

The research over the last twelve months on the specific loans resulted in an ability to quantify the cost drivers identified previously. This information can then be used to determine the actual cost of a loan relationship considering all activities which are conducted in setting up a loan and servicing the loan and the customer. It should be noted that some activities, such as the cost of continued data processing or computer setup, were not considered in this study; this is because these types of fees would be outside of the scope of the commercial lending department's responsibilities and direct costs would be considered in an analysis of the overall Bancorp. From the research of the loans listed in Exhibit 2, it was determined that the cost drivers corresponded to the following activity-based costs under each of the scenarios listed: