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Risk based pricing of loans by banks


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 price waterfall



Sound capital planning practices according to the Basel Committee

The Basel Committee on Banking Supervision (BCBS) released a paper titled “A Sound Capital Planning Process: Fundamental Elements” in January 2014.  This paper does not propose changes to standards or capital requirements.  Instead, it reports on a study carried out by BCBS on the capital planning process at a number of banks.

The paper has a good overview of what is good capital planning and is worth reading if you work in bank capital management.  It covers the following fundamental elements: internal control and governance, capital policy and risk capture, forward-looking view and management framework for preserving capital.

Banks must forecast future capital needs under a range of conditions as part of their  internal capital adequacy assessment process (ICAAP).  ICAAP is an part of Basel 2, Pillar 2 requirements.  The BCBS document “Enhancements to the Basel II framework” outlined measures to strengthen Pillar 2 requirements.  For Australian banks, the requirements are set out in Australian Prudential Regulation Authority’s standards and practice guides (APS 110 and CPG 110 respectively).

A number of the components of a sound capital planning process are already requirements under the current standards or guidance that Australian banks need to follow. (more…)

BBVA’s purchase of fintech start-up BankSimple

BBVA purchased financial technology start-up BankSimple for $117m in late February.  I came across this news on a couple of blogs I follow: Jim Bruene from NetBanker and Ron Shevlin from Snarketing 2.0.  Both have insightful posts on this deal.

Jim Bruene’s post has a link to Bank Simple’s presentation at Finovate’s 2011 Fall event.  This video incorporates a short demo of BankSimple’s interface. BankSimple’s proposition is a simple and easy to use internet only banking product.  It is not ground breaking.  BankSimple offers a neater internet banking platform than most other banks.  Some features are:

  • A single interface for all products
  • Natural language search capability for transactions
  • Use of geo-spatial data and machine learning to better categorise and clean transactions.

In my view, BankSimple has taken some of the technology that is common place in e-commerce and search engines and incorporated it into a net banking platform.  I can see most banks adding these features to their net banking platforms in the near future.  As Ron Shevlin notes, the technology and the size of the deal would not qualify BankSimple as a major disruptor.

The fact is that BBVA paid $117m for something they could have built on their own for less.  This is around $1200 per customer.  Many commentators have speculated on why.   Perhaps the value of brand, or to acquire the team that created Bank Simple.  There is plenty of debate on the blogosphere on whether this was a good deal.

For me, this transaction highlights the growing focus on providing a seamless banking experience from both customers and banks.  On one hand BankSimple had 100,000 customers who had consciously shifted from their current bank in search of an easier banking experience.  On the other hand, BBVA felt it worthwhile to spend $117m to pick up BankSimple.

Catastophe bonds surge

There has been a lot of press recently on the growth of the catastrophe bond market.  Investors, in particular pension funds, are jumping in seeking attractive yields and potentially greater diversification.  How well do investors understand catastrophe bonds?  Are they the “free lunch” they appear to be?

This post examines three aspects of catastrophe bonds:

  • Catastrophe bonds and how they work

  • Typical returns on catastrophe bonds

  • Risks


Reading list to kick off February…

Here are four recent blog posts I found interesting:

Increasing the threshold for applying internal rating to boost SME lending?

The Australian government has kicked off an inquiry into the banking system.   It will be chaired by David Murray the former CEO of Commonwealth Bank of Australia.  A draft terms of reference has been released and a number of interested parties have commented on it.

The Commercial Asset Finance Brokers Association of Australia Limited (CAFBA) submission caught my eye as it had a specific suggestion to change the regulatory capital requirements for banks to make it easier to lend to SMEs.  The CAFBA submission outlines a number of issues that potentially makes it harder for SMEs to borrow money.

APS 113 details the prudential requirements for banks who are accredited to use their internal models to calculate regulatory capital requirements.  According to CAFBA, banks have more onerous requirements for loans in excess of $1m, and hence are reluctant to lend over this amount.  CAFBA recommends lifting this threshold.


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