This is a financial modeling case requiring the candidate to calculate profitability metrics for two competing operational systems. The key insight is that despite a lower approval rate and higher per-application costs, the proposed system generates greater expected profit ($550,000 vs $485,000) due to significantly better loan quality (5% vs 10% bad loans). Success requires careful attention to mathematical structure and multi-step calculations involving approval rates, loan values, and earnings/losses per dollar.
Your client is a bank that is considering changing its loan-issuing operation to a new system. The bank’s original loan process has the following steps:
• A loan application is generated at a bank branch • The branch completes a first background check • If the applicant clears the first background check, it is sent to a central office for a second background check • The central office either approves or denies the loan
The bank is considering eliminating the first background check and relying only on the check at the central office. Because more scrutiny would be needed at the central office, the total background check cost for each application would increase from $100 to $110 per application. For the original system, about 50% of all applicants make it through the first background check, and then 90% of those make it through the second background check. For the proposed system, any “good loans” where the bank if re-paid, the bank makes $0.20 per dollar loaned. For any “bad loans” that are not re-paid, the bank loses $0.50 per dollar loaned.
They would like you to evaluate the pros and cons of each system and recommend how they should proceed.