Pricing of a loan from a Commercial Bank: Part 1

2019-08-02T10:10:56+00:00August 1st, 2019|News|

Banks contribute positively to society by enabling simple, safe and efficient management of money, writes Pierre Venter. This is the first of a six-part series over successive days.

Banks are profit-orientated businesses which strive to provide both investors and shareholders alike with a reasonable return on their money. The vast majority of the loans which they provide to customers are financed by depositors’ money.

They therefore strive to balance the risk they incur on lending these monies as they have a fiduciary responsibility to safeguard a depositor’s funds. For a bank to attract investors and shareholders to place their money with them, so that this money can in turn be lent out to customers, banks are required to pay these investors a return on their investment and depositors’ interest on their deposits. This is referred to as the cost of funding.

Banks are also required to cover the cost of maintaining the infrastructure (such as computer systems, premises and staff) required to enable a bank to fulfil its role as a bank, and to fulfil every transaction or deal required by its customers.

The cost of funding as well as infrastructure costs are collectively known as the hurdle rate. Each product house is required to achieve the hurdle rate in order for a bank’s treasury department (which manages a bank’s assets and liabilities) to allocate finite capital to it, for lending to customers.

This short document aims to explain, in general terms, how banks determine an interest rate for a loan – including a mortgage loan.

Overview of inputs taken into consideration when determining an interest rate

Below are key inputs that are considered when determining an interest rate:

  • The term of the Loan
  • The loan amount
  • The probability that the customer will default – termed probability of default (PD)
  • Once the customer defaults, the loss that the bank will incur on the loan – termed loss given default (LGD)
  • Cost of funding the loan
  • Capital required and the cost of holding such capital (banks are required to retain sufficient capital to meet depositor requests for the repayment of their deposits)
  • Any income expected to be received over the term of the loan
    • Interest income
    • Any other income (such as fees)
  • Any expenses expected over the term of the loan.
Figure 1: An example of an income and expenses flow that can be considered.

Figure 1: An example of an income and expenses flow that can be considered.

 

Pierre Venter is the general manager, Human Settlements in Market Conduct Division at the Banking Association South Africa.