© 2000 John Petroff
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© 2000 John Petroff |
Pricing of loans made by banks and various debt resulting from sales on open accounts, leasing or other financial contracts, takes place at two different moments: before the loan is issued, the sale completed or the contract executed, and after. Once a debtor has contracted an obligation, the creditor expects full compliance of the terms of that obligation. Any actual or potential failure to meet these terms decreases the value of the asset, necessitates actions by a loan officer or credit department, and often results in a provision of reserves for potential losses. The most important decision is made at the inception of the loan or contract. For open account customers and many other forms of contracts, the initial valuation is in the form of an estimation of the risk present in the customer or counter-party. If the risk is excessive, the rate of return from a sale or other contract is just insufficient, and the sale or contract is rejected. In the remainder of this section, the discussion will only deal with bank loans.
See review questions Q-3C.1 and Q-3C.2.
Once a loan application is accepted by a loan officer (as long the loan corresponds to bank's strategy described in Chapter 4 Section B), it implies that the risk for that client was judged not to be excessive (i.e. there isn't a reasonable doubt that the loan will be repaid). Then, the loan officer has several alternatives in structuring the loan, so that the loan is appropriate for the client and profitable for the bank. The interest charged by the bank is the price of the loan. The interest charged depends on several factors: cost of funds to the bank, type of loan, loan risk, fees charged and other income opportunities associated with the borrower, which are reviewed one by one below.
a)- Cost of funds to the bank
The cost of the funds to the bank is naturally a minimum for all
loans. It is usually the largest component of any interest rate
charged. [Each percent above that rate is referred to as one point,
and each one hundredth of a percent is a basis point.] Most
often, cost of funds is calculated as the average of interest
paid on different sources of funds (demand deposits, certificates
of deposits, interbank borrowing and long term obligations), plus
the cost of maintaining the required reserves related to these
funds and the cost of attracting new funds. Sometimes,
instead of average cost, a marginal cost of acquiring new funds
is used, especially when changes in economic conditions are anticipated
to bring changes to money markets. In addition, the cost of funds
is affected by timing of loan repayments and timing (or maturities)
of bank's sources of funds. The bank
may bear a significant interest risk when interest term structure
(described in Chapter 2 Section
D-4) changes, and the bank must offset this exposure by charging
higher rates and/or hedging (described in Chapter
4 Section B-1).
b)- Loan structure
The choice among loan types can be between
- seasonal self-liquidating loan,
- revolving credit loan,
- loan that is not self-liquidating but has the protection of
pledged receivables or inventory,
- term loan with or without mortgage.
As justified by a normally upsloping term structure discussed
in Chapter 2 Section D-4,
the interest charged on longer maturity is usually higher. The presence of collateral (i.e. pledged
receivables, inventory or mortgage) reduces risk somewhat, and
allows interest to be lower.
c)- Loan risk
This is a charge for the potential that the loan will result in
a loss to the bank. The potential
for borrower's default is at the heart of the analysis conducted
by the loan officer and the credit department. One systematic
approach is to set up a grading system. In the grading system,
grade points (i.e. not percentage points) are assigned to each
of the elements related to the loan:
d)- Fee charges
The bank must charge customers for costs and services in connection
with the loan. These charges are often built into the interest
rate, but sometimes some fees may be stipulated separately. There
are always administrative and servicing costs resulting from work
performed by a loan officer in analyzing the application, and
by operations department in disbursing and collecting the loan.
This charge is relatively larger for smaller loans. When a collateral
is pledged, inspection, evaluation, storage and monitoring movements
of the pledged assets represent costs which must be passed on
to the borrower. In the case of real estate, an origination fee
may be charged. The bank may also
charge for its cost of maintaining required reserves corresponding
to the amount of the loan, or require that such an amount be kept
in the checking account of the borrower, in which case this amount
is called a compensating balance.
e)- Bank income
Banks assign a profit margin (or interest spread) which is added
to the cost of funds. In addition,
income is protected by offering to customers a choice of either
a floating rate (i.e. variable or indexed rate), or a higher fixed
rate. When a variable rate is used,
a ceiling and a floor are stipulated to reduce excessive burden
for either party. Banks also earn income from commitment fees
which are charged on the unused portion of a loan, and prepayment
penalties which protect bank's revenue. Finally,
the borrower may generate income for the bank from non-loan services
the bank may provide, such as payroll, securities trading, cash
or trust administration.
-- Example of loan pricing --
See review questions Q-3C1.1 through Q-3C1.21.
See research assignment R-3.6.
Monitoring bank loans is described in Section B-4 of next chapter. Ranking of loans by banks is more refined than just using an aging schedule (describe for non-financial corporation in Chapter 8 Section G-3) and shows the additional analysis that goes into a loan officer's supervision of its customers. In addition to supervision by the loan officer, all loans are reviewed periodically by analysts in the credit department. As described in Section B-3 of next chapter, this review helps classify loans in a ranking system and verify that the loan portfolio is in line with bank strategy.
One such system ranks loans 1 through
9 with the following meaning
1- performing
2- performing but potential risk ahead
3- performing but client has experienced difficulties
4- performing but cash flows are deteriorating
5- one payment is outstanding less than 30 days
6- payments outstanding more than 30 days, but less than 90 days
7- non-performing, poor chance of partial recovery
8- non-performing, legal procedures have been initiated
9- no chance of any recovery
The ranking system allows to state
in an unambiguous manner the risk present in all loans of the
bank in a uniform manner and to set up reserves according to the
rating. Provisions for reserves illustrate the valuation of loans
downward. Each bank is free to set up reserves as it sees fit.
Many prefer to take quick actions to help a customer (if possible)
or write off the loan. A common loan
classification which results from the ranking leads to the following
reserves to be provided immediately:
- initial difficulties and payment overdue: reserves provision
of 20%,
- non-performing loan: reserves of 50%,
- recovery unlikely: reserves of 100%.
(Taking quick action has indeed resulted
in a low level of losses on loans in the U.S. where it has averaged
around 2 to 3% of loans outstanding.)
With outstanding loans classification and provision of reserves allow a bank to price every one of its loans and its entire loan portfolio.
| In Russia, banks also use a ranking system to reflect changing conditions of their loans. Providing for reserves is dictated by bank regulations which prevent setting up reserves until the delinquency of the borrower is certain. This delay in taking corrective action has contributed to a larger proportion of non-performing loans being kept on the books. The result is that 25% or more of the loans are non-performing, which is very worrisome for asset portfolios of many banks, and even for survival of some of the banks. In addition, many loans that have their maturities extended, or "prolongated", are not included as non-performing loans. |
See review questions Q-3C2.1 through Q-3C2.5.
See research assignment R-3.7.
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