15- loan pricing

8/20/2019 15- Loan Pricing

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Customer Proftability

Analysis and Loan Pricing



Risk-adjusted returns on loans

When deciding what rate to charge, loan oficers attempt

to orecast deault losses over the lie o the loan Strong competition or loans tends to increase the banks

under-pricing o loans The appropriate procedure is to identiy expected and

unexpected losses and incorporate both in determining

the appropriate risk charge. redit risk, in turn, can be divided into expected losses

and unexpected losses.

!xpected losses might be reasonably based on mean

historical loss rates.

"n contrast, unexpected losses should be measured by

computing the deviation o reali#ed losses rom the

historical mean.



The lending process and pricing

Relationship pricing: $ust consider all investment cash %ows in the loan

pricing decision.

Minimum spread: ompare the lending rate to the cost o unds plus a

pro&t margin.

Aerage cost ersus marginal cost: When market interest rates are changing, average cost

could clearly be incorrect. " a loan was match funded by issuing 's, the marginal

cost is clearly more appropriate. Per!ormance pricing:

hange the loan rate i the &rm(s riskiness changes.

Monitoring and loan reie": ompliance with loan agreement.



#i$ed rates ersus %oating rates

)loating-rate loans*

increase the rate sensitivity o bank assets, increase the+

reduce potential net interest losses rom rising interestrates

ecause most banks operate with negative unding +s

through one-year maturities, %oating-rate loans normallyreduce a bank(s interest rate risk.

+iven e/uivalent rates, most borrowers preer &xed-rateloans in which the bank assumes all interest rate risk.

anks re/uently ofer two types o inducements to

encourage %oating-rate pricing*0. )loating rates are initially set below &xed rates or

borrowers with a choice

1. bank may establish an interest rate cap on %oating-rateloans to limit the possible increase in periodic payments



The lending process

2oan pricing $arkups*

Index rate 3i.e., prime rate4 plus a markup o one ormore percentage points.

Cost of funds 3i.e., 56-day ' rate4 plus a markup.

These methods are simple but may not properly accountor loan risk, cost o unds, and operating expenses.

2oan pricing models* Return on net funds employed:

$arginal cost o capital 3unds4 7 ro&t goal 8 32oanincome - 2oan expense49:et bank unds employed

;ere the re/uired rate o return is marginal cost o capital3unds4 7 ro&t goal.



Methods &sed to Price 'usinessLoans

ost-lus ricing $odels rice 2eadership ricing $odels

elow rime $arket ricing 3$arkup

$odel4 2oans earing $aximum "nterest <ates

ustomer ro&tability nalysis



Cost-Plus Loan Pricing



Price Leadership Model



'elo"-Prime Market Pricing



Customer Proftability Analysis

ustomer pro&tability analysis is a decision toolused to evaluate the pro&tability o a customer

relationship

The analysis procedure compels banks to be

aware o the ull range o services purchased by

each customer and to generate meaningul cost

estimates or providing each service.

The applicability o customer pro&tability analysishas been /uestioned in recent years with the

move toward unbundling services.



Customer Proftability Analysis(CPA) !stimate Total <evenues )rom 2oans and =ther

Services

!stimate Total !xpenses )rom roviding :et2oanable )unds

!stimate :et 2oanable )unds

!stimate eore Tax <ate o <eturn y 'ividing<evenues 2ess !xpenses y :et 2oanable )unds



*$pense components

Credit +erices ost o unds 2oan administration

'eault risk expense

,oncredit serices



Credit serices

These costs include the interest cost o &nancing

the loan, loan administration costs, and riskexpense associated with potential deault.

ost o )unds…the cost of funds estimate may be a bank’s

weighted marginal cost of pooled debt or itsweighted marginal cost of capital at the time theloan was made.

2oan dministration…loan administration expense is the cost of a

loan’s credit analysis and execution. 'eault <isk !xpense

…the actual risk expense measure equals thehistorical default percentage for loans in that riskclass times the outstanding loan balance.



,on-credit serices

ggregate cost estimates or noncredit servicesare obtained by multiplying the unit cost o eachservice by the corresponding activity level.

!xample* it costs <s > to acilitate a wire transer and the

customer authori#es eight such transers, the totalperiodic wire transer expense to the bank is <s?@ orthat account.



Reenue components

anks generate three types o revenue

rom customer accounts* 0. investment income rom the customer(s

deposit balance held at the bank 1. ee income rom services

A. interest income on loans



*stimating inestment income!rom deposit balances

0. bank determines the average ledger 3book4balances in the account during the reportingperiod.

1. The average transactions %oat is subtractedrom the ledger amount.

A. The bank deducts re/uired reserves to arrive atinvestable balances.

B. $anagement applies an earnings credit rateagainst investable balances to determine theaverage interest revenue earned on thecustomer(s account.



Compensating balances

"n many commercial credit relationships,borrowers must maintain compensating depositbalances with the bank as part o the loanagreement. 2edger balances are those listed on the bank(s

books ollected balances e/ual ledger balances minus

%oat associated with the account "nvestable balances are collected balances minus

re/uired reserves



#ee income

When a bank analy#es a customer(s accountrelationship, ee income rom all servicesrendered is included in total revenue.

)ees are re/uently charged on a per-item basis,as with :!)T9<T+S wire transers, or as a &xed

periodic charge or a bundle o services,regardless o rate o use.



#ee income (some e$amples)

)acility ee

…the fee applies regardless of actual borrowingsbecause it is a charge for making funds aailable. The most common ee selected is a acility ee, which

ranges rom 09C o 0 percent to 091 o 0 percent o thetotal credit available

ommitment ee…seres the same purpose as a facility fee but isimposed against the unused portion of the line andrepresents a penalty charge for not borrowing

onversion ee

…a fee applied to loan commitments that conert toa term loan after a speci!ed period !/uals as much as 091 o 0 percent o the loan principal

converted to term loan and is paid at the time oconversion



Target proft

The target pro&t is then based on a minimum

re/uired return to shareholders per account.



Customer proftability analysis:Consumer installment loans

Two signi&cant diferences alter the analysis whenevaluating the pro&tability o individual accounts*

0. onsumer loans are much smaller thancommercial loans, on average

1. processing costs per dollar o loan are muchhigher than or commercial loans

2oans will not generate enough interest to covercosts i they are too small or the maturity is too

short, even with high interest rates. Thus, banks set minimum targets or loan si#e,

maturity, and interest rates.



'reak-een analysis o! consumerloans

The break-even relationship is based on theobDective that loan interest revenues net ounding costs and losses e/ual loan costs*

:et "nterest income8 "nterest expense 7 2oan losses

7 c/uisition costs 7 ollection costs



'reak-een analysis o! consumerloans general analysis

"*r 8 annual percentage loan rate 3E4d 8 interest cost o debt 3E4" 8 average loan loss rate 3E4

S 8 initial loan si#e8 avg. loan balance outstanding 3E o

initial loan4$ 8 number o monthly paymentsa 8 loan ac/uisition cost, andc 8 collection cost per payment

Then*3r - d - "4S3$9014 8 a 7 3c43$4



Pricing ne" commercial loans

The approach is the same, e/uating revenues

with expenses plus target pro&t, but now theloan oficer must orecast borrower behavior.

$arginal nalysis is appropriate using"ncremental data, not historical data

)or loan commitments this involves proDectingthe magnitude and timing o actual borrowings,compensating balances held, and the volume oservices consumed.

The analysis assumes that the contractual loanrate is set at a markup over the bank(s weightedmarginal cost o unds and thus variescoincidentally.



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+ome #acts

Sub 2< 2ending 3SF4 constitutes@>E o Total 2ending as $arch 1665.

Sub 2< 2ending 3)oreign banks4constitutes C0E o Total 2ending as$arch 1665.

Sub 2< 2ending 3vt. Sec4 constitutesCBE o Total 2ending as $arch 1665.

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2<G..!xtract rom 2ive $int in

1606 <" said that there is a perception that banks are charging lower

rates or corporates and higher rates to +M*s. HThere is apublic perception that banks( risk assessment processes areless than appropriate and that there is under pricing o creditor orporates, while there could be oerpricing o lending toS$!s

ompetition has turned the pricing o a signifcantproportion o! loans !ar out o! alignment "ith the'PLR and in a non-transparent manner,I R'6 said inits report on currency and fnance.

The report adds that the 2< has ceased to be areerence rate3enchmark <ate4, thereby hindering anassessment o the e7icacy o! monetarytransmission/

1>



<"G.2< There is a structural problem .

2< was introduced in 166A as a move towardsinterest rate deregulation in the anking sector

!ven though the industry is by and largederegulated, a ew lending rates are still mandated

and linked to banks( 2< )or example, loans to exporters are given at 1.?

percentage points below 2<. Similarly, all loansto small armers are priced cheaper than 2<.

This has prevented banks rom lowering their2< as the moment this benchmark rate is cut,automatically the loan rate or exporters and smallarmers declines.

1C



So banks preerred to keep their 2< atan arti&cially high level and charge most

o their borrowers a rate much below thebenchmark rate.

This is the only way they could preventloan rates or exporters and small armersrom decliningGdownward sticky

6n particular2 the f$ation o! 'PLRcontinues to be more arbitrary than rule-based/

There!ore2 the concept o! arriing at the

'PLR needs to be looked into "ith a ie" to

making it more transparent

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<"G.2<

8espite that2 most o! the banks endedup haing their 'PLRs in the samerange even though their cost o unds,overheads and level o non-perorming

assets were not alike.

Typically, State ank o "ndia, the largest

lender, takes the lead in setting the rateand others ollow.

A6



Why ase <ateG. The 'PLR system2 introduced in 3449, ell

short o its original obDective o bringingtransparency to lending ratesG. mainly becauseunder the 2< system, banks could lend below2<.

)or the same reason, it was also dificult toassess the transmission o! policy rates o the<eserve ank to lending rates o banks.

;ence, the 'ase Rate system is aimed at

enhancing transparency in lending rates o!banks and eficiency in transmission o monetarypolicy

The ase <ate system replaced the 2< systemwith efect rom July 0, 1606.

A0



Why ase <ateG. "ssues "n Transparency

'isclosure o "mportant ino on 2oan pricingGon all the components those are built into

:o ;idden additional costs !verything should be clear to the orrower at

the eginning )loating <ate 2oans

A1



AA

'ownward Stickiness o 2<

2< reuses to go down when ank(s costo und were lowGthough it was /uick to goup when cost o unds were high.

onsumers to pay high R6 even in allinginterest rate market but are orced to paymore when interest rate goes up.

$aDor Kictims are borrower in housing loan.



omponents o ase <ate

5/ Cost o! 8eployable 8eposits

Total 8eposits ;

Time deposits < Current 8eposits< +aings 8eposits

8eployable 8eposits ;

Total 8eposits less share locked in CRR = +LR'alances

AB



A?

3/,egatie Carry on CRR and +LR

:egative carry on << and S2< balancesarises because the return on <<balances is nil, while the return on S2<balances 3proxied using the A@B-dayTreasury ill rate4 is lower than the cost

o deposits .:egative carry cost on S2< and << was

arrived at by taking the diference

betweenReturn adjusted Cost o!#unds( RAC#) and the ost o 'eposits.

R6 on CRR is 4> and R6 on



A@

9/ &nallocated erhead Cost

*mployee Cost "rt/ 8eployable8eposits

Total deposits less share o depositslocked as << and S2< balances 30-BE-10.?E4G>B.?E o Total=utstanding 'eposits.



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@/ Return on 8eployable8eposits

(,et Proft8eployable

8eposits)

;( ,P ,. ) B (,. 8eployable 8eposits)



omponents o ase <ate

'ase rate ; 5<3<9<@

Loan pricing ; 'ase rate < Product +pecifc peratingcost

< 8e!ault Premium < Maturity Premium

<ating o the=bligor

Lield urve

AC

'eault premium



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pplicability o ase <ate ll categories o :ew 2oans should

henceorth be priced only with reerenceto the ase <ate.

The ase <ate could also serve as the

reerence benchmark rate or %oating rateloan products.

http*99new.axisbank.com9personal9loans9home-loan9home-loan-ees-charges.aspx

GG.

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;oweverThree other categories o loans willnot need to adhere to the base rate

ormulaO

0.loans to banks( own employees1.loans against bank(s own deposits.

A.'<" 2oans



Misuse o! 'ase Rate

bank can ofer loan to a top-rated

&rm at its base rate and pay 1percentage points higher than themarket rate on the deposit that the&rm keeps with the bank.

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"nternational omparison

"n the FS, the Prime rate(9/9> in 3455)O normally A percentage points higher that the )ederal

)und Rate(4/5>//in 3455)O

is the benchmark rate !or all consumer and

retail loans/

http*99www.ederalreserve.gov9releases9h0?9data.htm

http*99www.ederalreserve.gov9a/[email protected]

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+imilarly2 in the &D2

the 'ank o! *nglandEs base rate is thebenchmark rate !or consumer and retailloans2

"hile Libor is the benchmark !orcommercial loans/

http:"""/nytimes/cominteractie34534F54businessdealbookbehind-the-libor-

scandal/html

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The rate at which banks can borrowunds rom each other in the interbankmarket. ut this is an overnight rate and the

eforts to develop one-month and three-month $ibor have not yet met withsuccess.

LiborEs 6ndian counterpartis Mibor 2 or the Mumbaiinterbank o7ered rateG

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thanks

15- loan pricing

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