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Customer Profitability Analysis and

Loan Pricing
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 firm’s 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 bank’s
interest rate risk.
 Given equivalent rates, most borrowers prefer fixed-rate loans in
which the bank assumes all interest rate risk.
 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

2. A bank may establish an interest rate cap on floating-rate loans to
limit the possible increase in periodic payments
The lending process
 Loan pricing
 Markups:
Index rate (i.e., prime rate) plus a markup of one or more percentage
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
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 bank’s 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 loan’s 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.
 Example:
 it costs Rs 7 to facilitate a wire transfer and the customer authorizes
eight such transfers, the total periodic wire transfer expense to the
bank is Rs56 for that account.
Revenue components

 Banks generate three types of revenue from customer

1. investment income from the customer’s 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
3. The bank deducts required reserves to arrive at investable
4. Management applies an earnings credit rate against investable
balances to determine the average interest revenue earned on
the customer’s 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 bank’s 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 customer’s account relationship, fee
income from all services rendered is included in total revenue.
 Fees are frequently charged on a per-item basis, as with
NEFT/RTGS 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
 If:
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
 Then:
(r - d - I)SB(M/12) = Ca + (Cc)(M)
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 bank’s weighted marginal cost of funds and
thus varies coincidentally.

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.

PLR…..Extract from Live Mint in 2010
 RBI said that there is a perception that banks are charging lower rates for
corporates and higher rates to SMEs. “There is a public perception that
banks’ risk assessment processes are less than appropriate and that there
is under pricing of credit for Corporates, while there could be overpricing of
lending to SMEs
 Competition has turned the pricing of a significant proportion
of loans far out of alignment with the BPLR and in a non-
transparent manner,” RBI said in its report on currency and

 The report adds that the BPLR has ceased to be a reference

rate(Benchmark Rate), thereby hindering an assessment of the
efficacy of monetary transmission.

 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
declining…downward 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 pricing…on 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 Bank’s cost of fund were

low…though 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 bank’s 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 England’s base rate is the benchmark rate for
consumer and retail loans,

while Libor is the benchmark for commercial loans.

Libor’s 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.