A MODEL FOR PRICING BANK LOAN

Indrajit Dey MBA in Finance University of Calcutta

The Model
Interest Rate of Loan = Costs(%) + Risk Premium (%) + Economic Value Added (%)
 COSTS  RISK PREMIUM  Expected Loss Premium  Un Expected Loss Premium  ECONOMIC VALUE ADDED

The IRB Credit Risk Model

 The Models are different for Corporate, Retail and Residential Mortgage Exposures.  Capital Requirement for Retail Exposure as per the Model is Lower than that for Corporate and Residential Mortgage Exposures.  Correlation assumed in the Model for Retail Exposures is lower than Corporate and Residential Mortgage Exposures.

Model For Corporate Exposures

Capital Requirement(K) =[ LGD* N [ ( 1- R)^ -0.5 * G (PD) + (R /( 1-R) )^ -0.5 *G (0.999)] - PD * LGD] * ( 1- 1.5*b)^ -1 * ( 1+ M 2.5 ) * b ) Correlation(R)= 0.12*(1-EXP(-50*PD))/(1-EXP(-50)) + 0.24 * [ 1(1-EXP ( -50* PD) ) / ( 1- EXP (-50))] Maturity Adjustment(b) = (0.11852 0.05478 * In(PD)^2 PD : Probability of Default. LGD : Loss Given Default. G : Inverse of Standard Normal Distribution. N : Standard Normal Distribution. M : Effective Maturity ( or Duration ) of the Loan.

Model for Retail Exposures

Capital Requirement(K) = LGD * N ( 1-R)^-0.5*G (PD) + (R/(1-R))^ 0.5*G(0.999)]-PD*LGD

Correlation(R) = 0.33*(1-EXP(-35*PD))/(1-EXP(-35))+0.16*[1-(1EXP(-35*PD))/( 1-EXP(-35))]

PD : Probability of Default. LGD : Loss Given Default. G : Inverse of Standard Normal Distribution. N : Standard Normal Distribution.

Model for Residential Mortgages

Capital Requirement(K) = LGD * N (1-R)^-0.5*G(PD) + (R/(1-R)) ^ 0.5*G(0.999)]-PD*LGD Correlation(R ) = 0.15

PD : Probability of Default. LGD : Loss Given Default. G : Inverse of the Standard Normal Distribution.

ILLUSTRATION
Costs (%): To express costs as percentage, we may use earning assets as the denominator rather than advances since earning assets other than advances (including SLR investments) can also be expected to recover the interest and overhead costs. Since the interest expenditure attributable to instruments eligible for treatment as Capital Funds is not separately available from Annual Report of Banks, we are unable to exclude their effect. Interest Cost : Interest Expenses to Average Earning Assets of all Scheduled Banks for 2005-06 is used and it comes to 4.63%. Overhead Costs: Overhead Expenses to Average Earning Assets of all Scheduled Banks for 2005-06 is used and it comes to 2.54%. Total Costs (%): Total Costs(%) comes to 7.18%.

Cost of Capital Cost of Capital = Risk Free Rate of Return + Beta * Market Risk Premium. Risk Free Rate of Return : Average 10 years for Govt. Securities . during 2005-06 is used as a proxy. This comes to 7.12%. Beta : Beta (for the banking sector as a whole) has been estimated using daily returns on Bank NIFTY and S&P CNX NIFTY during the period 01.04.2005 to 31.03.2006. This comes to 0.9843. Market Risk Premium : Equity Risk Premium in India estimated by Jayanth R.Varma and Samir K Barua has been used. This comes to 12.50% (on arithmetic mean basis). Cost of Capital : Applying the CAPM formula, we arrive the Cost of Capital( Ex-Post) of Banking Industry at 19.42%.

Economic value Added : Pre tax Return on Equity for all Scheduled Banks for 2005-06 comes to 22.28%. So, the Economic Value Added for 200506 can be estimated at 2.86%.Applying this percentage to the Equity we will obtain the absolute value of EVA for 2005-06. Expressed as percentage of advances, this comes to 0.36%. Risk Premium : The value of the components of risk Premium, viz. Expected Loss Premium and Unexpected Loss Premium depends on the value of Probability of Default(PD) and Loss given Default(LGD). Values of PD and LGD have to be arrived at based on past data.

TABLES
TABLE 1 Shows the Expected Loss Premium at varying levels of PD and LGD. TABLE 2 Shows the Economic Capital required for different categories of borrowers at varying levels of PD and LGD. TABLE 3 Shows the approximate Equity capital requirement. TABLE 4 Shows the Unexpected Loss Premium, arrived at by multiplying each of the above table with Cost of Capital (calculated at 19.42%). TABLE 5 Shows Interest Rate to be charged for the loan arrived at by adding Cost(%), EVA (%) with the Expected loss Premium and Un Expected loss Premium.

We can estimate PD and LGD from NPA data of Scheduled Commercial Banks. The ratio of additions to gross NPAs to opening standard advances can be used as a surrogate for PD and the ratio of recoveries to opening gross NPAs can be considered as an approximate estimate of LGD. Based on data from 2000-01 to 2005-06, PD and LGD comes to 3.28% and 62.17%. Interest Rates at Empirical PD & LGD Corporate : 12.05% Residential Mortgage : 11.75% Retail : 10.59%

CONCLUSION
Adoption of this model will lead to a better alignment of the interest rates charged on a loan to the risk profile of the loan. It will also correct the current anomaly of retail borrowers being charged an interest rate far higher than corporate counterparts.

References
 The Management Accountant, April 2007, Vol. 42 No.4.  International Convergence of Capital Measurement & Capital Standards: A Revised Framework, Comprehensive Version, June 2006, Published by BIS.  An Explanatory Note on the Basel II IRB Risk Weight Functions, July 2005, published by BIS.  Report on Currency and Finance, 2003-04, RBI Publication.  RBI Circular DBOD. Dir. BC. 7/13.03.00/2005-06 July 01,2005 Master Circular- Interest Rates on Advances.  RBI Bulletin, November 2006.

References
 Changing Paradigms in Risk Management, Special Address by Smt. Shyamala Gopinath, Dy. Governor, RBI at FICCI-IBA Conference on Global Banking Paradigm Shift, September 27,2006, Mumbai.  Statistical Tables Relating to Banks in India 2005-06, RBI Publication.  A First Cut Estimate of the Equity Risk Premium in India, Jayanth R. Varma and Samir K. Barua, IIMA Working Paper No. 2006-06-04, June 2006.  RBI Circular No. DBOD. No. BP. BC.57/21.01.002/2005-2006 dated January 25, 2006 Enhancement of banks capital raising options for capital adequacy purposes.

Thank You