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# 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 .

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

risk is high in one loan of more amt than more loans of small amounts.Risk-Reward Ensures sustenance Tenor of the loan . Servicing cost will definitely be higher in second case. . Asset liability mismatch Credit risk of the customer Size of the loan.Interest rate increases with increase in tenor.

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

Considering various factors influencing loan pricing decision of the bank .. . the bank has to develop a pricing model.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.

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

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

Quantify the credit risk and set premium 4. Relate the rate to a reference rate (PLR) 5. Ensures market presence. Arrive at cost of funds 2. Assess the servicing cost 3. operations costs. and cost of servicing .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. Loan price= Cost of funds+ Margin . the process involved 1.

00 .00 12.00 13.Cost of funds Average cost of funds Vs Pooled cost of funds.00 10. if it sets a margin of 2 percent maturity 6 mnths 1 yrs 2 yrs 3 yrs amount 25 15 15 30 rate (%) 5. (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.

the loan price would have been 7 percent . However. if there is another loan proposal for a period of 6 months. If the pooled cost of funds are used. which is fairly higher than the cost of the 6 month liability which stands at 5 percent.45 percent..Cont. then the loan price using avg cost of funds will be 10. 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.

25% for a company having A+ rating for risk purpose. 30crores to be paid up in 3 years. The bank cost of servicing is 3 % and it maintains the premium of 0. How much should this bank charge from AB Ltd. calculate the loan pricing for AB ltd (having A+ rating). which has put up a proposal of Rs.Case: Consider the previous case. if it wants to earn a spread of 1.25%? Calculate using average cost of funds and pooled cost of funds?? .

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

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

1500 crore to ODL Ltd.9. Based on the past performances. the company expects the probability of payment as 0. ABC bank has extended the loan for Rs.5% and if the company plans to maintain a 3% margin on the same.75%. Compute the contractual rate which is adjusted for the possible defaults. If the recovery rate for the loan is 80%.Case: Consider the case of ABC Bank whose average cost of funds is 11. If the servicing costs involved for credit accommodation is 0. .

.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!!! .