Customer Profitability

Analysis and Loan Pricing

Risk-adjusted returns on loans

When deciding what rate to charge, loan officers attempt

to forecast default losses over the life of the loan
Strong competition for loans tends to increase the banks
under-pricing of loans
The appropriate procedure is to identify expected and
unexpected losses and incorporate both in determining
the appropriate risk charge.
Credit risk, in turn, can be divided into expected losses
and unexpected losses.

Expected losses might be reasonably based on mean

historical loss rates.

In contrast, unexpected losses should be measured by

computing the deviation of realized losses from the
historical mean.

The lending process and pricing

Relationship pricing:

Minimum spread:

When market interest rates are changing, average cost

could clearly be incorrect.
If a loan was match funded by issuing CDs, the marginal
cost is clearly more appropriate.

Performance pricing:

Compare the lending rate to the cost of funds plus a

profit margin.

Average cost versus marginal cost:

Must consider all investment cash flows in the loan

pricing decision.

Change the loan rate if the firms riskiness changes.

Monitoring and loan review:

Compliance with loan agreement.

Fixed rates versus floating rates

Floating-rate loans:
increase the rate sensitivity of bank assets, increase the
GAP
reduce potential net interest losses from rising interest
rates
Because most banks operate with negative funding GAPs
through one-year maturities, floating-rate loans normally
reduce a banks interest rate risk.
Given equivalent rates, most borrowers prefer fixed-rate
loans in which the bank assumes all interest rate risk.
Banks frequently offer two types of inducements to
encourage floating-rate pricing:
1. Floating rates are initially set below fixed rates for
borrowers with a choice
2. A bank may establish an interest rate cap on floating-rate
loans to limit the possible increase in periodic payments

The lending process

Loan pricing
Markups:
Index rate (i.e., prime rate) plus a markup of one or
more percentage points.
Cost of funds (i.e., 90-day CD rate) plus a markup.
These methods are simple but may not properly account
for loan risk, cost of funds, and operating expenses.

Loan pricing models:

Return on net funds employed:
Marginal cost of capital (funds) + Profit goal = (Loan
income - Loan expense)/Net bank funds employed
Here the required rate of return is marginal cost of capital
(funds) + Profit goal.

Methods Used to Price Business

Loans

Cost-Plus Pricing Models

Price Leadership Pricing Models
Below Prime Market Pricing (Markup
Model)
Loans Bearing Maximum Interest Rates
Customer Profitability Analysis

Cost-Plus Loan Pricing

Price Leadership Model

Below-Prime Market Pricing

Customer Profitability Analysis

Customer profitability analysis is a decision tool

used to evaluate the profitability of a customer
relationship

The analysis procedure compels banks to be

aware of the full range of services purchased by
each customer and to generate meaningful cost
estimates for providing each service.

The applicability of customer profitability analysis

has been questioned in recent years with the
move toward unbundling services.

Customer Profitability Analysis

(CPA)

Estimate Total Revenues From Loans and Other

Services
Estimate Total Expenses From Providing Net
Loanable Funds
Estimate Net Loanable Funds
Estimate Before Tax Rate of Return By Dividing
Revenues Less Expenses By Net Loanable Funds

Expense components

Credit Services

Cost of funds
Loan administration
Default risk expense

Noncredit services

Credit services

These costs include the interest cost of financing

the loan, loan administration costs, and risk
expense associated with potential default.

Cost of Funds

the cost of funds estimate may be a banks

weighted marginal cost of pooled debt or its

weighted marginal cost of capital at the time the
loan was made.

Loan Administration

loan administration expense is the cost of a

loans credit analysis and execution.

Default Risk Expense

the actual risk expense measure equals the

historical default percentage for loans in that risk

class times the outstanding loan balance.

Non-credit services

Aggregate cost estimates for noncredit services

are obtained by multiplying the unit cost of each
service by the corresponding activity level.
Example:

it costs Rs 7 to facilitate a wire transfer and the

customer authorizes eight such transfers, the total
periodic wire transfer expense to the bank is Rs56 for
that account.

Revenue components

Banks generate three types of revenue

from customer accounts:
1.

2.
3.

investment income from the

deposit balance held at the bank
fee income from services
interest income on loans

customers

Estimating investment income

from deposit balances
1.

2.

3.

4.

A bank determines the average ledger (book)

balances in the account during the reporting
period.
The average transactions float is subtracted
from the ledger amount.
The bank deducts required reserves to arrive at
investable balances.
Management applies an earnings credit rate
against investable balances to determine the
average interest revenue earned on the
customers account.

Compensating balances

In many commercial credit relationships,

borrowers must maintain compensating deposit
balances with the bank as part of the loan
agreement.

Ledger balances are those listed on the banks

books
Collected balances equal ledger balances minus
float associated with the account
Investable balances are collected balances minus
required reserves

Fee income

When a bank analyzes a customers account

relationship, fee income from all services
rendered is included in total revenue.
Fees are frequently charged on a per-item basis,
as with NEFT/RTGS wire transfers, or as a fixed
periodic charge for a bundle of services,
regardless of rate of use.

Fee income (some examples)

Facility fee
the fee applies regardless of actual borrowings
because it is a charge for making funds available.

The most common fee selected is a facility fee, which

ranges from 1/8 of 1 percent to 1/2 of 1 percent of the
total credit available

Commitment fee
serves the same purpose as a facility fee but is
imposed against the unused portion of the line and
represents a penalty charge for not borrowing
Conversion fee
a fee applied to loan commitments that convert to
a term loan after a specified period

Equals as much as 1/2 of 1 percent of the loan principal

converted to term loan and is paid at the time of
conversion

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Target profit

The target profit is then based on a minimum

required return to shareholders per account.

Customer profitability analysis:

Consumer installment loans

Two significant differences alter the analysis when

evaluating the profitability of individual accounts:
1.

2.

Consumer loans are much smaller than

commercial loans, on average
processing costs per dollar of loan are much
higher than for commercial loans

Loans will not generate enough interest to cover

costs if they are too small or the maturity is too
short, even with high interest rates.
Thus, banks set minimum targets for loan size,
maturity, and interest rates.

Break-even analysis of consumer

loans

The break-even relationship is based on the

objective that loan interest revenues net of
funding costs and losses equal loan costs:

Net Interest income

= Interest expense + Loan losses
+ Acquisition costs + Collection costs

Break-even analysis of consumer

loans general analysis

If:

r = annual percentage loan rate (%)

d = interest cost of debt (%)
I = average loan loss rate (%)
S = initial loan size
B = avg. loan balance outstanding (% of
initial loan)
M = number of monthly payments
Ca = loan acquisition cost, and
Cc = collection cost per payment

Then:

(r - d - I)SB(M/12) = Ca + (Cc)(M)

Pricing new commercial loans

The approach is the same, equating revenues

with expenses plus target profit, but now the
loan officer must forecast borrower behavior.
Marginal
Analysis
is
appropriate
using
Incremental data, not historical data
For loan commitments this involves projecting
the magnitude and timing of actual borrowings,
compensating balances held, and the volume of
services consumed.
The analysis assumes that the contractual loan
rate is set at a markup over the banks weighted
marginal cost of funds and thus varies
coincidentally.

BASE RATEW..E.F
JULY,2010

25

Some Facts

Sub PLR Lending (PSU) constitutes

67% of Total Lending as March 2009.
Sub PLR Lending (Foreign banks)
constitutes 81% of Total Lending as
March 2009.
Sub PLR Lending (Pvt. Sec) constitutes
84% of Total Lending as March 2009.

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PLR..Extract from Live Mint in

2010
RBI said that there is a perception that banks are charging lower

rates for corporates and higher rates to SMEs. There is a

public perception that banks risk assessment processes are
less than appropriate and that there is under pricing of credit
for Corporates, while there could be overpricing of lending to
SMEs

Competition has turned the pricing of a significant

proportion of loans far out of alignment with the
BPLR and in a non-transparent manner, RBI said in
its report on currency and finance.

The report adds that the BPLR has ceased to be a

reference rate(Benchmark Rate), thereby hindering an
assessment of the efficacy of monetary
transmission.
27

RIP.BPLR

There is a structural problem .

BPLR was introduced in 2003 as a move towards
interest rate deregulation in the Banking sector
Even though the industry is by and large
deregulated, a few lending rates are still mandated
and linked to banks BPLR
For example, loans to exporters are given at 2.5
percentage points below BPLR. Similarly, all loans
to small farmers are priced cheaper than BPLR.
This has prevented banks from lowering their
BPLR as the moment this benchmark rate is cut,
automatically the loan rate for exporters and small
farmers declines.
28

So banks preferred to keep their BPLR at

an artificially high level and charge most
of their borrowers a rate much below the
benchmark rate.
This is the only way they could prevent
loan rates for exporters and small farmers
from decliningdownward sticky

In particular, the fixation of BPLR

continues to be more arbitrary than rulebased.

Therefore, the concept of arriving at the

BPLR needs to be looked into with a view to
making it more transparent
29

RIP.BPLR

Despite that, most of the banks ended

up having their BPLRs in the same
range even though their cost of funds,
overheads and level of non-performing
assets were not alike.

Typically, State Bank of India, the largest

lender, takes the lead in setting the rate
and others follow.

30

Why Base Rate.

The BPLR system, introduced in 2003, fell

short of its original objective of bringing
transparency to lending rates. mainly because
under the BPLR system, banks could lend below
BPLR.
For the same reason, it was also difficult to
assess the transmission of policy rates of the
Reserve Bank to lending rates of banks.
Hence, the Base Rate system is aimed at
enhancing transparency in lending rates of
banks and efficiency in transmission of monetary
policy
The Base Rate system replaced the BPLR system
with effect from July 1, 2010.
31

Why Base Rate.

Issues In Transparency

Disclosure of Important info on Loan pricing

on all the components those are built into
No Hidden additional costs
Everything should be clear to the Borrower at
the Beginning
Floating Rate Loans

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Downward Stickiness of BPLR

BPLR refuses to go down when Banks cost
of fund were lowthough it was quick to go
up when cost of funds were high.
Consumers to pay high ROI even in falling
interest rate market but are forced to pay
more when interest rate goes up.
Major Victims are borrower in housing loan.

33

Components of Base Rate

1.

Cost of Deployable Deposits

Total Deposits =
Time deposits + Current Deposits
+ Savings Deposits

Deployable Deposits =
Total Deposits less share locked in CRR & SLR
Balances

34

2.Negative Carry on CRR and SLR

Negative carry on CRR and SLR balances

arises because the return on CRR
balances is nil, while the return on SLR
balances (proxied using the 364-day
Treasury Bill rate) is lower than the cost
of deposits .
Negative carry cost on SLR and CRR was
arrived at by taking the difference
between
Return
adjusted
Cost
of
Funds( RACOF)
and the Cost of Deposits.
ROI on CRR is 0% and ROI on

35

3. Unallocated Overhead Cost

Employee Cost wrt. Deployable
Deposits
Total deposits less share of deposits
locked as CRR and SLR balances (14%-21.5%)74.5% of Total
Outstanding Deposits.

36

4. Return on Deployable
Deposits
(Net Profit//Deployable
Deposits)
=( NP / NW ) X (NW /
Deployable Deposits)

37

Components of Base Rate

Base rate = 1+2+3+4
Loan pricing = Base rate + Product Specific Operating
cost
+ Default Premium + Maturity Premium
Default premium

Yield Curve

Rating of the
Obligor
38

http://banks-india.com/banks/bank-base-ratescomparison/

http://thebankingbible.com/iob-andhra-bank-icicibank-sbt-ubi-uco-bank-dcb-ing-vyasa-bank-jk-bankps-bank-vijaya-bank-united-bank-corporation-bankkokatk-mahindra-bank-sbbj-syndicate-bank-revisesbase-rate-and-1567
http://www.corpbank.com/asp/0100text.asp?
presentID=1714&headID=733
http://www.sbi.co.in/user.htm
http://www.corpbank.com/asp/0100text.asp?
presentID=1715&headID=19

39

Applicability of Base Rate

All categories of New Loans should

henceforth be priced only with reference
to the Base Rate.
The Base Rate could also serve as the
reference benchmark rate for floating rate
loan products.
http://new.axisbank.com/personal/loans/ho
me-loan/home-loan-fees-charges.aspx

.
40

However
Three other categories of loans will
not need to adhere to the base rate
formula
1.loans to banks own employees
2.loans against banks own deposits.
3.DRI Loans

41

Misuse of Base Rate

A bank can offer loan to a top-rated
firm at its base rate and pay 2
percentage points higher than the
market rate on the deposit that the
firm keeps with the bank.

42

International Comparison

In the US, the Prime rate(3.35% in 2011)

normally 3 percentage points higher that the Federal
Fund Rate(0.1%..in 2011)
is the benchmark rate for all consumer and
retail loans.

http://www.federalreserve.gov/releases/h15/data.htm

http://www.federalreserve.gov/faqs/credit_12846.ht
m
43

Similarly, in the UK,

the Bank of Englands base rate is the
benchmark rate for consumer and retail
loans,
while Libor is
commercial loans.

the

benchmark

for

http://www.nytimes.com/interactive/2012/07
/10/business/dealbook/behind-the-liborscandal.html

44

Libors Indian counterpart

is Mibor, or the Mumbai
interbank offered rate
The rate at which banks can borrow
funds from each other in the interbank
market.
But this is an overnight rate and the
efforts to develop one-month and threemonth Mibor have not yet met with
success.
45

thanks
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