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Loan Pricing

Prof. b.p.mishra.
Risk-adjusted returns on loans

When deciding what rate to charge, loan officers attempt to

forecast default losses over the life of the loan
Strong competition for loans tends to increase the banks under-
pricing of loans
The appropriate procedure is to identify expected and unexpected
losses and incorporate both in determining the appropriate risk
Credit risk, in turn, can be divided into expected losses and
unexpected losses.
Expected losses might be reasonably based on mean historical loss
In contrast, unexpected losses should be measured by computing the
deviation of realized losses from the historical mean.
The lending process and pricing
Relationship pricing:
Must consider all investment cash flows in the loan pricing decision.
Minimum spread:
Compare the lending rate to the cost of funds plus a profit margin.
Average cost versus marginal cost:
When market interest rates are changing, average cost could clearly be
If a loan was match funded by issuing CDs, the marginal cost is clearly more
Performance pricing:
Change the loan rate if the firms riskiness changes.
Monitoring and loan review:
Compliance with loan agreement.
Fixed rates versus floating rates

Floating-rate loans:
increase the rate sensitivity of bank assets, increase
the GAP
reduce potential net interest losses from rising
interest rates
Because most banks operate with negative funding
GAPs through one-year maturities, floating-rate loans
normally reduce a banks interest rate risk.
Given equivalent rates, most borrowers prefer fixed-
rate loans in which the bank assumes all interest rate
Banks frequently offer two types of inducements to
encourage floating-rate pricing:
1. Floating rates are initially set below fixed rates for

borrowers with a choice

2. A bank may establish an interest rate cap on floating-
rate loans to limit the possible increase in periodic
The lending process
Loan pricing

Index rate (i.e., prime rate) plus a markup of one or more

percentage points.
Cost of funds (i.e., 90-day CD rate) plus a markup.
These methods are simple but may not properly account for
loan risk, cost of funds, and operating expenses.
Loan pricing models: Return on net funds employed:
Marginal cost of capital (funds) + Profit goal = (Loan
income - Loan expense)/Net bank funds employed
Here the required rate of return is marginal cost of capital
(funds) + Profit goal.
Methods Used to Price Business Loans

Cost-Plus Pricing Models

Price Leadership Pricing Models
Below Prime Market Pricing (Markup Model)
Loans Bearing Maximum Interest Rates
Customer Profitability Analysis
Cost-Plus Loan Pricing

Cost of Estimated
Nonfund Bank's
Loan Raising Margin to
Bank Desired
Interest = Loanable + + Compensate +
Operating Profit
Rate Funds to Bank for
Costs Margin
Lend to Default Risk
Price Leadership Model

Risk Term Risk
Base or Premium Premium for
Interest = + +
Prime Rate for Non- Longer
Prime Term Credit
Below-Prime Market Pricing

Interest Cost
Loan Markup
of Borrowing
Interest = + for Risk
in the Money
Rate and Profit
Customer Profitability Analysis

Customer profitability analysis is a decision tool used to evaluate

the profitability of a customer relationship
The analysis procedure compels banks to be aware of the full
range of services purchased by each customer and to generate
meaningful cost estimates for providing each service.
The applicability of customer profitability analysis has been
questioned in recent years with the move toward unbundling
Customer Profitability Analysis (CPA)
Estimate Total Revenues From Loans and Other Services
Estimate Total Expenses From Providing Net Loanable Funds
Estimate Net Loanable Funds
Estimate Before Tax Rate of Return By Dividing Revenues Less
Expenses By Net Loanable Funds
Expense components

Credit Services
Cost of funds
Loan administration
Default risk expense

Noncredit services
Credit services
These costs include the interest cost of financing the loan, loan
administration costs, and risk expense associated with potential
Cost of Funds
the cost of funds estimate may be a banks weighted marginal cost of
pooled debt or its weighted marginal cost of capital at the time the loan was
Loan Administration
loan administration expense is the cost of a loans credit analysis and
Default Risk Expense
the actual risk expense measure equals the historical default percentage
for loans in that risk class times the outstanding loan balance.
Non-credit services

Aggregate cost estimates for noncredit services are

obtained by multiplying the unit cost of each service by
the corresponding activity level.
it costs $7 to facilitate a wire transfer and the customer
authorizes eight such transfers, the total periodic wire
transfer expense to the bank is $56 for that account.
Revenue components

Banks generate three types of revenue from

customer accounts:
1. investment income from the customers deposit
balance held at the bank
2. fee income from services
3. interest income on loans
Estimating investment income from deposit
1. A bank determines the average ledger (book) balances
in the account during the reporting period.
2. The average transactions float is subtracted from the
ledger amount.
3. The bank deducts required reserves to arrive at
investable balances.
4. Management applies an earnings credit rate against
investable balances to determine the average interest
revenue earned on the customers account.
Compensating balances
In many commercial credit relationships, borrowers
must maintain compensating deposit balances with the
bank as part of the loan agreement.
Ledger balances are those listed on the banks books

Collected balances equal ledger balances minus float

associated with the account
Investable balances are collected balances minus

required reserves
Fee income

When a bank analyzes a customers account

relationship, fee income from all services rendered is
included in total revenue.
Fees are frequently charged on a per-item basis, as with
wire transfers, or as a fixed periodic charge for a bundle
of services, regardless of rate of use.
Fee income (some examples)
Facility fee
the fee applies regardless of actual borrowings because it is a charge for
making funds available.
The most common fee selected is a facility fee, which ranges from
1/8 of 1 percent to 1/2 of 1 percent of the total credit available
Commitment fee
serves the same purpose as a facility fee but is imposed against the unused
portion of the line and represents a penalty charge for not borrowing
Conversion fee
a fee applied to loan commitments that convert to a term loan after a
specified period
Equals as much as 1/2 of 1 percent of the loan principal converted
to term loan and is paid at the time of conversion
Target profit

The target profit is then based on a minimum required return to

shareholders per account.

Equity Target return to

Target profit = Loan amount
Total assets shareholde rs
Customer profitability analysis: Consumer
installment loans
Two significant differences alter the analysis when evaluating
the profitability of individual accounts:
1. Consumer loans are much smaller than commercial
loans, on average
2. processing costs per dollar of loan are much higher
than for commercial loans
Loans will not generate enough interest to cover costs if they
are too small or the maturity is too short, even with high
interest rates.
Thus, banks set minimum targets for loan size, maturity, and
interest rates.
Break-even analysis of consumer loans

The break-even relationship is based on the objective that loan

interest revenues net of funding costs and losses equal loan

Net Interest income

= Interest expense + Loan losses
+ Acquisition costs + Collection costs
Break-even analysis of consumer loans general
r = annual percentage loan rate (%)
d= interest cost of debt (%)
I = average loan loss rate (%)
S= initial loan size
B= avg. loan balance outstanding (% of initial loan)
M= number of monthly payments
Ca = loan acquisition cost, and
Cc = collection cost per payment
(r - d - I)SB(M/12) = Ca + (Cc)(M)
Clarke recently stopped by the bank to request a $95,000 loan to
buy a sailboat. He indicated that he would put $18,000 down and
wants to borrow the remainder over three year with monthly
payment. What interest rate you would charge on such a loan given
the following information:
Cost of processing the loan application: $425
Collection cost per payment: $17
Loan loss rate on collateralized sailboat loans: 0.72%
Weighted marginal cost of bank funds: 8.5%

The proposed loan is an instalment loan with 36 monthly payments.

On average, the out-standing loan balance will equal 55% of the
initial loan.
Requsite interest rate
D = 8.50%
I =0.72%
S =77,000 ( 95-18)
B = 77,000 x 55% = 42350
M =36
Ca = 475
Cc = 17
Pricing new commercial loans
The approach is the same, equating revenues with expenses plus
target profit, but now the loan officer must forecast borrower
Marginal Analysis is appropriate using Incremental data, not
historical data
For loan commitments this involves projecting the magnitude
and timing of actual borrowings, compensating balances held,
and the volume of services consumed.
The analysis assumes that the contractual loan rate is set at a
markup over the banks weighted marginal cost of funds and
thus varies coincidentally.
Base rate

Prof. b.p.mishra


Bank lending objective is to promote growth

Interest rate distortions in any form lead to
misallocation of resources
Lending rate to be appropriate for institution & the borrower
Too high or too low rate affects credit quality
Affects financial stability
Lending rates are to be responsive to monetary policy changes.

Till 1980s interest rate regulated
Administered rate are different for different activities
Borrowers were charged different rate for the same loan amount
Since 1990s rationalization
Sept 1990- rates rationalized to six slab. Banks free to fix rate beyond
the limit of Rs 2 lakhs
!993- Six slab compressed to 3slabs
1994- complete deregulation of interest rate above Rs 2 lakhs
Introduction of PLR
1997- separate PLR for CC & Loan component
Oct,1997- separate PLR for term loan
1999- tenor linked lending rates introduced
2000- banks are free to charge Fixed & Floating rate.
2001, April- PLR ceased to be the floor rate for loan more than Rs2lakhs
2003- BPLR introduced reflecting the true cost of funds of the banks.


Some Facts
Sub PLR Lending (PSU) constitutes 67% of Total
Lending as March 2009.
Sub PLR Lending (Foreign banks) constitutes 81%
of Total Lending as March 2009.
Sub PLR Lending (Pvt. Sec) constitutes 84% of
Total Lending as March 2009.

There is a structural problem .
BPLR was introduced in 2003 as a move towards interest rate
deregulation in the Banking sector
Even though the industry is by and large deregulated, a few
lending rates are still mandated and linked to banks BPLR
For example, loans to exporters are given at 2.5 percentage
points below BPLR. Similarly, all loans to small farmers are
priced cheaper than BPLR.
This has prevented banks from lowering their BPLR as the
moment this benchmark rate is cut, automatically the loan rate
for exporters and small farmers declines.

So banks preferred to keep their BPLR at an
artificially high level and charge most of their
borrowers a rate much below the benchmark rate.
This is the only way they could prevent loan rates
for exporters and small farmers from
decliningdownward sticky
In particular, the fixation of BPLR continues to be
more arbitrary than rule-based.
Therefore, the concept of arriving at the BPLR needs
to be looked into with a view to making it more

Despite that, most of the banks ended up having
their BPLRs in the same range even though their
cost of funds, overheads and level of non-performing
assets were not alike.

Typically, State Bank of India, the largest lender, takes

the lead in setting the rate and others follow.

Why Base Rate.
The BPLR system, introduced in 2003, fell short of its
original objective of bringing transparency to lending rates.
mainly because under the BPLR system, banks could lend below
For the same reason, it was also difficult to assess the
transmission of policy rates of the Reserve Bank to lending
rates of banks.
Hence, the Base Rate system is aimed at enhancing
transparency in lending rates of banks and efficiency in
transmission of monetary policy
The Base Rate system replaced the BPLR system with effect
from July 1, 2010.

Why Base Rate.
Issues In Transparency

Disclosure of Important info on Loan pricingon all the

components those are built into
No Hidden additional costs
Everything should be clear to the Borrower at the Beginning
Floating Rate Loans

Downward Stickiness of BPLR

BPLR refuses to go down when Banks cost of fund were

lowthough it was quick to go up when cost of funds
were high.

Consumers to pay high ROI even in falling interest rate

market but are forced to pay more when interest rate goes

Major Victims are borrower in housing loan.

Components of Base Rate
1. Cost of Deployable Deposits

Total Deposits =
Time deposits + Current Deposits + Savings

Deployable Deposits =
Total Deposits less share locked in CRR & SLR Balances

2.Negative Carry on CRR and SLR
Negative carry on CRR and SLR balances arises
because the return on CRR balances is nil, while the
return on SLR balances (proxied using the 364-day
Treasury Bill rate) is lower than the cost of deposits .
Negative carry cost on SLR and CRR was
arrived at by taking the difference between
Return adjusted Cost of Funds( RACOF)
and the Cost of Deposits.

ROI on CRR is 0% and ROI on SLR is 364

T bill

3. Unallocated Overhead Cost

Employee Cost wrt. Deployable Deposits

Total deposits less share of deposits locked as

CRR and SLR balances (1-4%-21.5%)74.5% of
Total Outstanding Deposits.

4. Return on Deployable Deposits

(Net Profit//Deployable Deposits)

=( NP / NW ) X (NW / Deployable

Components of Base Rate

Base rate = 1+2+3+4

Loan pricing = Base rate + Product Specific Operating cost

+ Default Premium + Maturity Premium

Default premium Yield Curve

Rating of the Obligor


Applicability of Base Rate
All categories of New Loans should henceforth be
priced only with reference to the Base Rate.
The Base Rate could also serve as the reference
benchmark rate for floating rate loan products.

Three other categories of loans will not need to
adhere to the base rate formula

1. loans to banks own employees

2. loans against banks own deposits.
3. DRI Loans

Misuse of Base Rate

A bank can offer loan to a top-rated firm at its

base rate and pay 2 percentage points higher than
the market rate on the deposit that the firm keeps
with the bank.

International Comparison
In the US, the Prime rate(3.35% in 2011)
normally 3 percentage points higher that the Federal Fund
Rate( 2011)
is the benchmark rate for all consumer and retail loans.

Similarly, in the UK,
the Bank of Englands base rate is the benchmark rate for
consumer and retail loans,

while Libor is the benchmark for commercial loans.

Libors Indian counterpart is Mibor,
or the Mumbai interbank offered
The rate at which banks can borrow funds from
each other in the interbank market.
But this is an overnight rate and the efforts to
develop one-month and three-month Mibor have
not yet met with success.

MCLR Linked Interest Rate
w.e.f.1st April,2016
Banks are required to Switch to the
Marginal Cost of Funds based lending Rate(MCLR).
It will modify the existing Base rate System.
Banks have to prepare the MCLR s which will be the
internal Bench Mark Lending Rate.
Based on this MCLR, The interest rate for different Categories
of loans to be fixed in accordance with their risk profile.
The MCLR should be revised monthly.
Banks have to set five Benchmark rates from different tenures
from Overnight ( one Day ) to One Year.

The New method uses the Marginal cost or
the latest cost conditions reflected in the interest rates
of banks to obtain funds( From Deposits &
Borrowing from RBI) while setting the Lending Rates.

As such the marginal cost of Borrowing and Repo Rate

are the decisive factors in the calculation of MCLR.

In the base rate System, Banks considered

average cost of funds while calculating the base rate.

The MCLR system helps in monetary transmission-
effective passing on a Repo rate change to an interest change
by the Banking System.
Because it is mandatory for banks to consider Repo rate
while calculating MCLR.
Under the Base rate system, Banks changed the Base rate
after a time lag , while under MCLR, the change has
to be made monthly.
Any change in the Repo rate brings a change in the
marginal cost, hence the MCLR Will also be changed.


The actual lending rates will be determined by adding the

components Of SPREAD to the MCLR. Banks are allowed
to determine a spread above MCLR.
Spread means banks can charge a higher interest rate
depending on the risk profile of the borrower.
The spread is a function of Business strategy and
Credit risk premium.
To do this the bank must have a Board approved policy
delineating the Components of spread charged
to the Borrower.

MCLR to be reviewed monthly and publish the MCLR
on a Pre-announced date.

They will now be able to charge a higher premium

on loans With a longer repayment period.

No lending below MCLR.

Banks have the option to offer loans with reset date

linked Either to the date of sanction of the loan/
Credit Limit or To the date of review of the MCLR.

In the falling Repo rate, New borrowers to gain,

and Prepayment levy may enter in the back door.

In the rising interest rate due to higher Repo rate,

Existing Borrower customers will gain.