Loan pricing is the process of determining the interest rate for granting a loan, typically as an interest spread (margin) over the base rate, conducted by the bookrunners. The pricing of syndicated loans requires arrangers to evaluate the credit risk inherent in the loans and to gauge lender appetite for that risk.
For market-based loan pricing, banks incorporate credit default spreads as a measure of borrowers’ credit risks. It is standard procedure in loan pricing to benchmark a loan against recent comparable transactions (“comps”) and select the base rate on which the financing costs are pegged. A comparable deal is one with a borrower in the same industry, country and of the same size with the same credit rating, for which a certain market rate of return is required.
A bank’s credit rating has a direct impact on its cost of funding and, thus, the pricing of its loans. Banks with a high credit rating generally have access to lower cost funds in debt markets and low counterparty margins in swap and foreign exchange markets. The lower cost of funds can be passed on to borrowers in the form of lower loan pricing.
Banks compete for lead arranger mandates on syndication strategy and pricing. Some banks are very effective at pricing loans, while others have better bargaining power, are more effective in borrower monitoring, or have better incentive-inducing scheme.
Benefits of Loan Pricing
This methodical approach can help ensure the best loan and terms are matched to the borrower so that the financial institution makes the sale and keeps the customer. Loan pricing models or loan profitability models can allow banks or credit unions to set prices based on other institution goals, too, including goals related to profitability targets or loan portfolio composition. In talking with banks, Abrigo has learned these institutions thought a conservative estimate was that they could pick up an additional 5 to 10 basis points in interest if they had more structured pricing methodologies in place.
One overall benefit of effective loan pricing is that it is one of the many ways a financial institution can optimize capital. Optimizing capital is important because it provides institutions with the ability and freedom to deploy capital for developing new products and new markets, addressing regulatory issues or navigating shifts in the macroeconomic environment.
Another benefit of having a loan-pricing policy or model is that it provides the institution with defensible measures for justifying pricing changes and for avoiding charges of discriminatory pricing, which some lenders have faced in recent years. Officials with the banking regulatory agencies recently outlined best practices they encourage as they relate to evaluating an institution’s fair lending risk, and one of those best practices was to document pricing and other underwriting criteria, including exceptions.
Considerations of Loan-Pricing Models
What are some considerations related to loan-pricing models for an institution’s loan origination system (LOS)? According to James L. Adams, supervising examiner at the Federal Reserve Bank of Philadelphia, pricing is a key underwriting factor that should be addressed as part of a sound loan policy. A simple cost-plus loan pricing model is one method of pricing loans, he wrote in a newsletter for community banks that cites the Fed’s Commercial Bank Examination Manual (CBEM). A cost-plus pricing model requires that all related costs associated with extending the credit be known before setting the interest rate and fees, and it typically considers the following:
- Operating costs associated with servicing the loan or loans
- Cost of funds
- Risk premium for default risk
- A reasonable profit margin on capital.
- Probability of default
Probability of default is defined as the probability that the borrower will not be able to make scheduled principal and interest payments over a specified period, usually one year. The default probability depends on both the borrower’s characteristics and the economic environment.
For individuals, the default probability is determined by the FICO score, and lenders use the score to decide whether or not to extend credit. For business entities, the default probability is implied by the credit rating.
Usually, credit rating agencies are required to assign a credit rating to entities that issue debt instruments, such as bonds. Borrowers with a high default probability are charged a higher interest rate to compensate the lender for bearing the higher default risk.
- Loss given default
Loss given default is defined as the amount of money that a lender stands to lose when a borrower defaults on the debt obligations. While there is no accepted method for quantifying the loss given default per loan, most lenders calculate loss given default as a percentage of total exposure to loss in the entire loan portfolio.
For example, if ABC Bank lends $1,000 to Borrower A and $10,000 to Borrower B, the bank stands to lose more money in the event that Borrower B defaults on repayments.
- Exposure at default
Exposure at default measures the amount of loss that a lender is exposed to at any particular point, due to loan defaults. Financial institutions often use their internal risk management models to estimate the level of exposure at default.
Initially, the exposure is calculated per loan, and banks use the figure to determine the overall default risk for the entire loan portfolio. As borrowers make loan repayments, the value of exposure at default reduces gradually.