Pricing of a loan from a Commercial Bank: Part 5

2019-08-06T12:08:06+00:00August 7th, 2019|News|

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

Other income

Apart from interest income, which forms the majority of the income stream, banks may charge an initiation fee on a loan, as well as a monthly service fee, and potentially any insurance commissions earned. Such fee income formulas or ceilings are prescribed within the National Credit Act, 34 of 2005. The thinking behind an initiation fee is to offset the costs of setting up the loan, including the valuation fee, to cover the cost of valuing the property, and the monthly service fee is to offset the ongoing cost of managing such a loan.

Example

Analysing a loan of R400 000, a PD of 5% and an LGD of 20% over a 48-month breakeven period. This means that loans are priced such that a breakeven point of the required return on equity is achieved in 48 months. This would therefore indicate that loans are most likely not profitable prior to this period.

Table 2: Bank profit over 48-month breakeven period.

INCOME R144 250
   Interest (@ 10.2%)    R139 300
   Initiation Fee    R3 500
   Annual fee    R1 450
EXPENSES R120 274
   Cost of Funds (@ 6.34%)    R86 390
   Cost of Capital    R5 797
   Account Set up Costs    R12 670
   Account Maintenance    R2 631
   Bad Debt Provision    R12 786
FINAL PROFIT R23 976

Table 2, above, shows that after 48 months; the bank realises a profit of R23 976. This is based on a return to capital of 20% per annum.

Looking at this a different way, the bank makes a profit of 1.7% of the average loan balance in the 48-month period after the figure is annualised. The split below shows the composition of the interest rate and is based on average balance.

Table 3: Composition of interest rate based on average balance.

Interest Rate 10.2%
   Cost of Funds    6.34%
   Cost of Capital    0.42%
   Cost of Risk    0.92%
   Business Costs    0.7%
   Profits    1.7%

 

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