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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
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…)
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.
BCBS coming down hard on trading books
The Basel Committee on Banking Supervision (BCBS) has been ruminating on changes to prudential rules for trading activities at banks. In October of this year, BCBS released its second consultation paper. It follows the first document released in May 2013, and has definitive views of how trading books should be regulated.
The changes will be far-reaching and significant. The phrase “Fundamental Review…” in the title of consultation paper is indeed appropriate. Market risk managers need to be thinking about the proposal, and what will be required in the next few years as the changes hit. Some banks may even need to debate the value of continuing their trading activities.
Risk Return Sweet Spot 