The pricing of loans is a crucial decision for banks. The pricing has to be attractive to consumers and at the same time, be competitive in market. It must earn a premium over the costs incurred to deliver and service it during its tenor. In financing arrangements, banks assume credit risk, and face costs owning to the risk of loan default as well as the risk of non-performance measured by expected credit loss. Moreover the activity of banks as intermediaries includes accessing funds to finance loans with the attendant cost of financing. As a result, a Bank must take account of the cost of borrowing, cost of capital supplied( both debt and equity- computed as the weighted average cost of Capital) and usual overhead costs.
The risk borne by the Bank in a loan contract is defined by the riskiness of the obligor( borrower) , assessed at the time of sanctioning the loans based on approved criteria. A scoring model with qualitative and quantitative elements is quite common to arrive at obligor risk. Once the weighted average cost of fund and overheads are arrived at using cost accounting models , the riskiness of the loan becomes a critical determinant to loan pricing. Credit risk assessment of the obligor, type of loan, country risk, industry segment and obligor characteristics determine the risk component on the loan which is added to the cost component.
As banks are intermediaries channelizing unused deposits to productive activity, Loan pricing is also dependent on deposit pricing . Deposit pricing strategies usually depend on the prevailing interbank rate and Credit Default Spreads ( risk premium). Regulatory regimes also influence deposit pricing. With the introduction of new liquidity ratios such as Liquidity Coverage Ratio( LCR) and Net Stable Funding Ratio( NSFR) the cost of meeting the High Quality Liquid Assets( HQLA) is also factored in deposit pricing decision. Any negative impact due to LCR and NSFR maintenance gets factored in deposit pricing with implications for loan pricing . Finally, the pricing arrived is topped up with a profit margin based on competitive pressures in the market and marketing and business strategy.
Loan prices are adjusted from time to time based on business decisions, product promotions, marketing drives and competitive considerations. Macroeconomic factors also impact such pricing decisions. The risk free interest rates set by the central banks also have a bearing on the pricing decision. Thus, loan pricing do demonstrate a delayed but cyclical pattern tailing the interest rate cycle. The stickiness of fixed rate loans often lead customers towards floating rate arrangements where loan rates are tied to some benchmark rates ( such as SOFR). Pricing floating rate loans is similar to pricing fixed rates with additional considerations for the benchmark index and reset frequency.
From an organizational perspective, Asset-Liability management Committee ( ALCO) is commonly entrusted with reviewing and recommending pricing methodology, for final consent of the Board of Directors.
Pricing strategies adopted by banks face a multiplicity of challenges in a changing business environment. New risks, such as climate and environment risks need to be factored in loan pricing decisions which require complex modeling. Moreover, digitalization renders historical data irrelevant for pricing decisions. Therefore, pricing strategies require periodic monitoring and tweaking. Overall, the practice of loan pricing plays a critical role in firm profitability and business strategy.
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