Chapter 13 : COMMERCIAL BANK OPERATIONS 3ed

How banks make lending

decisions and how they price
their loans.( Pg. 392-400)
What do commercial bank DO :
• Open accounts ;saving account, current account.

• Deposit & withdraw money.

• Safe boxes.
• Issue cheques.
• Money transfer locally & internationally.
• Provide loans; personal ; auto (car); mortgages.
• Provide credit card.
• Leases.
• Other services: ATM, bank account …etc.
• D
Individuals Commercial Bank Corporate

What are the advantages and disadvantages for dealing with Individuals customers ?

+
-

What are the advantages and disadvantages for dealing with corporate customers ?
+
-
What do commercial bank DO :
Which of the following consider as a commercial
bank :

GBCORP
 Commercial Bank
• A financial institution that provides services, such as
accepting deposits, giving business loans and auto
loans, mortgage loans, personal loans and basic
investment products like savings accounts and
certificates of deposit.

• Loan & leases considered primary business activity for

Commercial banks .
• Loan & leases represent 55% of bank asset.
• Commercial bank main RISK ?!
 Commercial Bank
• Bank manage their assets and liability to make
profit.
– Loans.
– Deposits.
– Leasing.

Which of the above considered asset or liability ?!

From bank point of view
Loans and Leases:

Major categories of bank loans:

• Commercial and Industrial Loans (Business Loans)
– Bridge Loans: Supplies cash for specific transaction with repayment
coming from an identifiable cash flows.
– Seasonal Loans: Term financing for temporary discrepancies
between business revenues and expenses because of manufacturing
or sales cycle of business.
– Long-term Asset Loans: loans to finance purchase of assets.
• Loans to Depository Institutions
– Bank loan to other depository institutions (not federal funds). Loans
provided for variety of purposes and maturities.
• Real Estate Loans
– Mortgage loans to finance purchase, construction of both residential
housing and commercial facilities.
• Agricultural Loans
– Supply both short and long term loans for farmers with specialized
knowledge of farming required for loan officer while analyzing the
applicant.
• Consumer Loans
– Bank Credit Cards.
– Personal Loans. 7
Leases
A lease is an agreement between two parties
where the lessor owns assets that it allows the
lessee to use the asset.
•once the term ends, the lessee is obligated to return the asset
back..
.. in some agreements the lessee will own the assets.
•The terms and condition is too complicated!
•Considered lending activity.
Loans and Leases:

• Secured or Unsecured Loans: Most bank loans are

secured.
– Backed with an asset, ex. car, land, stocks ..etc.
– How about personal loans in Bahrain ?!

• Promissory notes: Unconditional promise made in writing

by the borrower to pay the lender a specific amount of
money, usually at some specified future date. Repayment
can be made in periodical installments, total payment on
single date, or on demand.
– It include : Amount of loan, payment, rate and date, interest …etc.

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Promissory Note Example
Loans Repayment
1. Periodically installment.

2. One single payment.

3. On demand! (extremely rare)

– Lender or borrower can end the contract at any time!
• Fixed-rate : Interest rates on a fixed-rate loan
does not change over the loan’s term.

• Floating-rate : interest rates change (fluctuate)

due to many factors .

When do bank prefer fixed or floating

rate?!
 Loan Pricing
There are 3 key consideration for pricing a loan :
1.Earn a high enough interest rate to cover the cost of loanable
funds.
– Cost of loanable fund : Deposits, Money Market securities, their capital.
2.Recover administrative costs.
– Staff cost, rent ..etc.
3.Provide sufficient compensation for Risk.
 Higher risk >> higher interest rate charged by a bank.
 Customer working in government OR a customer working in private
company ?
Prime Rate
• Lowest rate charged by commercial banks.
• …Charge their most credit-worthy
customers.
• Other borrowers were typically charged some
spread above prime.
Prime Rate

Now, lenders choose among several other

benchmark rates (as a prime rate):

• LIBOR—“London Interbank Offered Rate”.

• Treasury rates.

• Fed Funds rate.

Base rate pricing: marking up from a
minimum offered the least risky
borrowers

• Possible base rates: Prime, LIBOR, Treasury, Fed Funds.

• Markups include three adjustments:

1. For increased default risk.
2. For term-to-maturity (time)
3. For competitive factors.

• rL = BR + DR + TM + CF
where: rL = individual customer loan rate
BR = the base rate
DR = adjustment for default risk above base-rate
customers
TM = adjustment for term-to-maturity
CF = competitive factor
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Example : How to determine the rate

• Bank base rate is 7%,two customers a small firm and a

large firm want loans. The large firm is well known
nationally, has sold commercial paper on occasion, and
wants a floating rate loan. The smaller firm wants a 1 year
fixed rate loan.1 year T. securities sell for 0.75% above 3
month T-bill.
Pricing Factor Small Firm Large Firm
Base rate 7% 7%
Default risk 3% 2%
adjustment
Term to 0.75% 0.00
maturity
adjustment
Competitive 1% 0.00
factor
adjustment
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Loan rate 11.75% 9.00%
Matched-funding loan pricing

• One way that banks can control the interest rate

risk in fixed-rate loans is through matched
funding of loans.
• Fixed-rate loans are funded with deposits or
borrowed funds of the same maturity.

Deposit 2% KFH Loan 4%

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Matched-funding loan pricing

Deposit 2% KFH Loan 4%

What if Deposit rate decrease to 1% & loan increase to 6%?

What if Deposit rate increase to 3% & loan decrease to 4% ?

What is Competitors effects ?!

The competition between banks narrow the gap between
deposit rate and loan rate.

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 Analyzing, managing, and pricing credit risk

Five “C”s of Credit:

1. Character (willingness to pay): borrower’s integrity, credit

history, and past business relationship with bank.

2. Capacity (cash flow): borrower’s projected income statements or

cash flow generated from a job.
– Corporation : income statement.
– Individuals : Salary + other source of income ex. rent.

3. Capital (wealth or net worth): borrower’s balance sheet or

residual wealth (e.g. stock or land ownership)
– Corporation : balance sheet
– Individuals : personal wealth ex. stocks, real estates ..etc.

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Analyzing, managing, and pricing credit risk

4. Collateral (security for the loan): assets that can

be taken by the bank and liquidated if a loan is
not repaid.
-No collateral, car, or stocks ?!

5. Conditions (economic conditions): Borrower’s

vulnerability (ability)
– Economic Condition : recession or expansion

Higher credit scoring mean lower risk.

Analyzing, managing, and pricing credit
risk

• Default risk premiums for identified risk categories

– Once the five Cs are analyzed, a customer is assigned to
a credit-rating category.
– The default risk premium for each category is
determined from an analysis of the bank’s credit losses
over several business cycles.
– For example a bank with five credit categories may
develop the following loan-pricing scheme:
Credit Category Default Risk Premium
1 Prime-rate Customers
2 10-49 Basis points
3 50-99 Basis points
4 100-200 Basis points
Copyright© 2006 John Wiley & Sons,
5 Inc. Reject Credit 23
Credit Example
Customer Noor Sara

Character Good Credit History Not paying on time

twice
Capacity Fixed Salary ( 600 300 BD + 1% Sales
BD ) = 800 – 600 - 700
Collaterals NO Collateral A car

Condition Working in a Working in luxury

( recession ) minister Car show rooms
Which Customer will
have better rate ?

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Effective Interest Rate (EIR)

Amount of loan 30,000

- Interest Amount 6%
- Compensation balance amount 10%
- Calculate Effective interest rate ?
Answer : Effective Interest Rate (EIR)

InterestAm ount
EIR 
loan. Amount  CompensationBalance

6% * 30,000 1,800
  0.666  6.67%
30,000  3,000 27,000
 Thank You

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