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Exploring risk based pricing for corporate loans
Previously I wrote about an approach to pricing loans, where the spread is set to cover expected losses from default, and to make a return on capital allocated. In this article I use the framework to explore the drivers of credit spreads that banks would calculate if they used the Basel IRB formula to calculate the amount of capital required.
Some banks may use regulatory capital to derive capital as this reflects the amount of regulatory capital required for the loan. The regulatory approach as specified by BCBS captures key drivers of risk such as probability of default, loss given default, systemic risk, and term.
This simple pricing approach reveals some interesting dynamics of the required credit spread. For example, with higher rated securities, the spread is driven by capital requirements and not the expected loss. Drivers of capital such as correlation between defaults and term to maturity have a larger influence.
Risk based pricing of loans by banks
Introduction
In an earlier post, I talked about how banks set interest rates for loans compared to investors. I would like to explore the bank’s approach over a couple of posts. This post covers one approach to setting the interest rate to charge for a corporate loan.
The interest rate charged is:
- The cost of borrowing funds
- Expected cost of loan default
- Expense margin
- A rate of return on capital employed
Components of interest rate
Loan pricing by banks vs fixed interest investors
Banks using a risk based pricing approach, charge interest rates on loans to cover:
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The cost of borrowing or funding
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Expected cost of loan default
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Expenses to service the client
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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:
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Risk free rate
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Expected cost of loan default
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Risk premium
Risk Return Sweet Spot 