bank loan pricing

Until 2007 or 2008 treasurers and their firms got used to very low loan pricing from banks, and therefore also from the rest of the market, such as the bond market. This was a low point, however, and there have been many fluctuations in the past as capital to lend has become more or less freely available.

We all now seem to accept that loan pricing will be more expensive but it is worth considering some of the theory behind that. A simple model is to look at three dimensions of bank management. In crude terms a bank is subject to essentially three different constraints in how it manages it balance sheet and profit and loss account:

• Return on equity. Shareholders expect a certain return on their capital, or else that capital will go to other more profitable causes
• Capital / Asset ratios. This is the classic ratio that we are aware of and is currently the major regulatory focus. This ratio provides protection against loan losses and in Basel II was set at 8% of risk weighted adjusted assets
• Liquidity ratios. This is the ratio which shows how much cash is available to meet the demands of depositors for their money back. It is almost certain that this ratio will be regulated and so issues such as what qualifies as liquidity, not an easy question, is subject to debate.

The higher the capital / asset ratio, the more margin is required on loans made to earn a certain return on equity. The higher the liquidity ratio, the more margin is required on loans made to earn a certain return on equity as cash earns nothing.

There is a simple formula connecting these, and assuming the cost of funds is nil, produces this table for different ratios of protection:



This shows how high margins might need to go to satisfy the demands of future regulation.

Note that this is a very simplified model, with zero interest rate and no income from fee earning business such as cash management or trading, but does indicate the margins that could be implied into loans.

By Will Spinney