Pricing of a loan from a Commercial Bank: Part 2

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

• PART 1 

How does a bank model?

In order to remain viable and to attract depositor and shareholder funds, a bank has a hurdle rate requirement that it needs to achieve, termed its return on equity. A model is used to establish the hurdle rate required for a portfolio of loans.

The model only considers the projected income and expenditure over the entire loan term. In other words, the cost versus the profit of the loan to the bank. The other factors of the loan, such as the capital and the loan amount determine the income and expenses of the loan to the bank. The interest rate is the only factor which can be altered to get to the hurdle rate requirement. The model therefore keeps all other factors besides the interest rate constant (this means the loan amount and term can’t be changed), with the interest rate varying in order to achieve the hurdle rate.

Loan amount and term

Generally, the bigger the loan amount and the longer the loan term, the lower the interest rate will be. This is because:

• The nett interest rate income received is higher on larger loans as compared to smaller ones, for example 1% on R100 000 is R1 000 per annum and 1% on R 1 000 000 is R10 000 per annum;
• The time required for a bank to cover all its fixed costs and thus achieve the desired return is greater for longer term loans.

Expenses are not necessarily directly proportional to the balance of the loan. Only the Cost of Funds and Cost of Capital would be, everything else stays constant. For example, the cost of approving and placing a loan on a bank’s books is say R4 000 per loan, and thereafter the cost of maintaining a loan on a bank’s books is say R40 per month. These costs reflect a fixed cost for a bank, irrespective of the loan amount.

Generally, the interest income generated from a R500 000 loan will be more compared to a R100 000 loan. It follows that a bank will still be able to recover its costs if it offers a lower interest rate on bigger loans.

Consider Figure 2, below, which is a depiction of how the interest rate decreases with a higher loan amount for a 240-month loan.

Figure 2: Depicting how the interest rate decreases with a higher loan amount for a 240-month loan.