Bank economics
Loan pricing
Build a minimum loan rate from funding cost, operating cost, expected loss and a charge for the capital the loan ties up.
Learning objectives
- Build a loan's minimum rate from funding cost, operating cost, expected loss and capital charge
- Convert an after-tax target return into a pre-tax capital charge
- Test whether a client's requested rate meets the bank's return target
A loan is priced well when its rate covers everything the loan costs the bank and pays shareholders for the capital at risk. Price below that and the bank grows its book while destroying value; price far above it and the client goes elsewhere. Relationship managers negotiate rates, but credit and finance teams set the floor with a pricing build-up like the one in this lesson.
The model here is a simplified educational version. Real banks use their own funds-transfer pricing, cost allocations, risk models and capital rules; every percentage below is illustrative.
Rate = Funding cost + Operating cost + Expected loss + Capital charge
- Funding cost
- the bank's internal transfer price for money of the loan's term (the marginal cost of funds)
- Operating cost
- annual cost of originating and servicing the loan, as a % of the balance
- Expected loss
- PD × LGD: one-year probability of default × loss given default
- Capital charge
- k × (pre-tax hurdle − funding cost), where k is capital allocated per riyal of loan
- Pre-tax hurdle
- target return on equity ÷ (1 − zakat and tax rate)
Included with a Formula Quest membership
The rest of this lesson is for members. Members get the full lesson, including its 3 graded exercises, and every other Finance Quest lesson.