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Home loan profitability optimisation in the financial industry
Product profitability needs to remain a competitive advantage to a bank's home loan product. Ever changing customer needs and even more demanding customers today enforce reasons to investigate the profitability of home loans. Other aspects to consider includes transfer pricing, ROA, cost to deliver product to market areas (marketing and distribution cost) and break-even period. Banks are facing immense challenges to achieve sustainable profitability. Historically low interest rates are compressing margins and forcing banks to enhance performance management capabilities (Convery, 2003:39). The presence of both fixed and variable costs make it very difficult to evaluate the real profitability of a product. In the banking environment the normal way of measuring profitability is to deduct the fixed cost and variable cost on average from the income generated through interest and non-interest income per home loan account. Home loan profitability is influenced by various factors like interest rates, origination fees, fixed cost, variable cost, bad debt, inflation rates, house prizes and income levels of the customer base. The mix of income levels per household in a geographic area influence the profitability of a home loan in that area. A customer that earns a high income is usually more demanding regarding the interest payable on the home loan, for example interest rates of mortgage bond rate (MBR) less 2 percent are demanded. Customers that earn a lower income normally pay interest as set by the bank according to an interest rate matrix that is used in relation to loan to value (LTV). "Banks' profit margin is increasingly under pressure due to higher interest rates. This necessarily means that banks will have to increase non-interest income." (Gavin Opperman, ME Home loans, 18 March 2007). The sources of home loan applications are originators (65%), channels (25%) and estate agents (10%). At Absa bank who is the leader in home loan finance with 33% market share the channels is represented by Retail Banking, Bank Brokers and Private Bank. By measuring home loan profitability on a branch level will give a bank the benefit of capitalizing on the strengths of the different product offerings, limiting weaknesses, create more opportunities internally and externally, whilst eliminating threats. The focus will be on operating income, operating expenses versus profitability and ROA (defined as return on net income after tax / balances). Corporate and Business banking, Small Business and Foreign Exchange will be excluded. The profitability model of a bank has been discussed. It is hoped that through this research the key elements have been identified to optimize product profitability for home loans. The variable interest rate home loan is the most common form of home loan. It is however very difficult to evaluate the real profitability of a home loan due to variable and fixed cost components that might differ from time to time. This apparently prevent banks from offering better home loan rates since the cost to income decreased due to higher variable cost. Banks use mortgage originators because it offers an additional marketing channel in a highly competitive home loan market. The National Credit Act rules dictate that customers have to declare all information pertaining to income and expenditure before a home loan can be approved. The competition further expand on client potential, acquisition costs, product attrition, market penetration and market segmentation as elements that influence the marketing mix problem. When used as a measurement of profitability reporting, contribution margin more clearly shows how cost behaviour impacts on profitability. In taking a contribution margin approach when reporting profitability focuses the user directly on fixed and variable cost behaviour. While fixed expenses stay the same as volume increases, fixed unit costs actually go down within the relevant volume tolerance range. The higher the loan value the higher the risk and expected losses in bad debt. Higher capital amounts lend to customers increase the unexpected losses. "Economic capital" is the capital banks set aside as a buffer against potential losses inherent in any business activity - mortgage lending. The purpose of the Home Loans Value model is to provide Home Loans business units with a tool to reach some of the most important objectives listed above. This model projects the economic value1 of new retail mortgage business and enables the business to make strategic and tactical decisions based on future profitability. The dependable variables used for analysis are average economic profit (EP) per account and return on assets (ROA) per account. The different independent variables are expected to have an influence on home loan profitability and if closer attention can be given to each of these aspects the profitability of home loans in the financial industry will be optimized. The independent variables are categorized in demographical variables, operational variables, financial variables and channel distribution. The cost components allocated to business generated by mortgage originators and estate agents are high and should impact the profitability of home loans generated through these channels. One of the ways to optimise home loan profitability is to have special sales drives that have the objective of increasing the home loan book and increase market share. Market analyses per area in the different provinces gives a better understanding of your customer base and enable better quality credit decisions to optimise profitability of home loans. The study showed an inverse relationship between ROA and EP due to credit impairments and overhead costs.