Home » Pricing » Loan pricing by banks vs fixed interest investors

Loan pricing by banks vs fixed interest investors

Banks using a risk based pricing approach, charge interest rates on loans to cover:

  • The cost of borrowing or funding

  • Expected cost of loan default

  • Expenses to service the client

  • A rate of return on capital employed

Different banks will potentially charge different interest rates to the same client.  The differences depend on the banks’ source of funds, the rate of return required and level of capital employed.  Of course, differences in the banks’ strategies or in their view of the client’s default risk will also result in different rates being offered.

On the other hand, the investors approach to pricing assets is different.  Typically an investor would discount the cash flows at a rate built up as follows:

  • Risk free rate

  • Expected cost of loan default

  • Risk premium

How do these reconcile?  If a bank makes loans at rates less than what an investor would accept to invest in the debt directly, then does this mean an investor could theoretically create risk free profits (arbitrage) by shorting the bank shares and buying the debt? If you built up interest rates using both approaches do you get close or are they materially different?

The way that a bank thinks about covering the cost of bearing risk compared to an investor is seemly different.  The investor is concerned about the correlation between the returns on the loan to the “market portfolio” in determining the risk premium.  However the bank uses a rate of return (perhaps based on its own correlation to the market) and a measure of capital using a VaR type measure.  Are these equivalent?

It would be interesting to work through a simple example to see if the approaches are theoretically equivalent and under what conditions or assumptions.  

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1 Comment

  1. […] an earlier post, I talked about how banks set interest rates for loans compared to investors. I would like to […]

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