Loan Pricing

By Prof. Divya Gupta

Loan Pricing
Importance of loan pricing Determinants of loan pricing Methodologies of loan pricing

Objectives of loan pricing

Maintain margins Balance risk-reward profile Ensure market rates

(Risk premium, int rate: int earnd- int paid

Profit margin Cost of operation)

Maintains Margins
Ensures profitability. Average cost of funds. Pooled cost of funds.

Risk-Reward
Ensures sustenance Tenor of the loan - Interest rate increases with increase in tenor. Asset liability mismatch

Credit risk of the customer

Size of the loan- risk is high in one loan of more amt than more loans of small amounts. Servicing cost will definitely be higher in second case.

Market Rates
Ensures presence of bank in the market. Higher rates Lower rates

Cont ..
Market rates: if the rates charged by the bank are higher than the market rates, then it will lose its business to those offer cheaper rates If it lower its rate in order to increase its volume it will lose its profitability. Considering various factors influencing loan pricing decision of the bank , the bank has to develop a pricing model.

Cont
It also depend on the objective of the bank: 1. To earn spread 2. Risk-Reward objective 3. Market presence

Pricing Model
Cost plus loan pricing model Assessing profit margin- ROE Approach Default Risk Assessment Method Cost Benefit loan Pricing

Cost plus loan pricing model.

This model basically focuses on arriving at a loan price that ensures a certain margin after covering the cost of funds, operations costs, and cost of servicing . the process involved 1. Arrive at cost of funds 2. Assess the servicing cost 3. Quantify the credit risk and set premium 4. Relate the rate to a reference rate (Base rate or PLR) 5. Ensures market presence. Loan price= Cost of funds+ Operating costs Margin + and risk premium

Cost of funds
Average cost of funds Vs Pooled cost of funds. (funds having same interest rate) Ex-compute the loan price using both the average cost and pooled cost of funds approach for a loan proposal of Rs. 30 cr for three years, if it sets a margin of 2 percent maturity 6 mnths 1 yrs 2 yrs 3 yrs amount 25 15 15 30 rate (%) 5.00 10.00 12.00 13.00

Cont..
However, it has to be noted that when the average cost of funds is used for funding , the margins will be lower at higher maturities and higher at lower maturities For instance, if there is another loan proposal for a period of 6 months, then the loan price using avg cost of funds will be 10.45 percent, which is fairly higher than the cost of the 6 month liability which stands at 5 percent. If the pooled cost of funds are used, the loan price would have been 7 percent

Case:
Consider the previous case, calculate the loan pricing for AB ltd (having A+ rating), which has put up a proposal of Rs. 30crores to be paid up in 3 years. The bank cost of servicing is 3 % and it maintains the premium of 0.25% for a company having A+ rating for risk purpose. How much should this bank charge from AB Ltd, if it wants to earn a spread of 1.25%? Calculate using average cost of funds and pooled cost of funds??

Margins & ROE Approach

Margin in cost plus pricing method relates only to the profit margin. Margin can be decided by deciding ROE PAT= (int income-int expenses)+ (other income-other expenses)

Default Risk Assessment method

When there is a probability of default , the expected rate would be the aggregate of the following: E(r) = P(R ) x r + P(D ) x ({R(P+Pr)/P}-1)

Case:
Consider the case of ABC Bank whose average cost of funds is 11.75%. If the servicing costs involved for credit accommodation is 0.5% and if the company plans to maintain a 3% margin on the same. ABC bank has extended the loan for Rs.1500 crore to ODL Ltd. Based on the past performances, the company expects the probability of payment as 0.9. If the recovery rate for the loan is 80%, Compute the contractual rate which is adjusted for the possible defaults.

Risk premium
The difference between contracted rate of interest with expected rate of interest is called as risk premium charged to the customer.

Cost Benefit Loan Pricing

It gives you the estimate of the before tax yield to the bank The above can be calculated as: = estimated loan revenue/estimated funds outlay

Thank You!!!