If you scan major business dailies, there will be a section on prevailing interest rates. Some business papers even go to the extent of quoting the prime rates given by major banks or financial institutions. Borrowers who are brave enough to seek credit, especially those new in the field, are then surprised that when they apply for loans with these banks, the rates will be substantially different. A brief explanation is that the pricing of loans which translate to interest rates consider the expected returns of the banks and the credit or default risk on the loans. Hence, the pricing of loans is a complex decision process.
Just like any business organization, a major objective of financial institutions is to maximize the wealth of their shareholders. The traditional role of banks has been to take deposits and make loans. The interest charged on loans is greater than the interest paid on deposits. That price must cover administrative cost and potential loan losses. Some borrowers will fail to make the agreed payments of interest and principal thus reducing the return to its owners. Banks will aim to cover all these costs when pricing the interest rates.
Modern banks go to a large extent to review the trade-off between risk and return when making a credit decision. The management of financial institutions requires a good control system than assumes that all risks are identified and mitigated. Since obviously loans represent a major risk of the bank, primary attention is given to its measurement. As they say in financial circles, “what you cannot measure, you cannot control”.
The measurement of credit aims to achieve three things. One, the lender wants to set appropriate limits on the amount of credit extended to one borrower or the loss exposure it accepts from a particular counterparty. Two, the lender will aim to earn adequate compensation for the level of risk relative to the facility award. And three, the lender attempts to reduce the risk of credit loss by neutralizing, transferring, or removing those risks that contribute to lender’s economic loss.
The interest rate determined will therefore come from a calculation of the promised return a bank achieves on any loan amount. And it will consider any fees related to the loan, the credit risk premium on the loan, the collateral backing the loan, the term or tenor of the loans and other nonprice terms (such as compensating balance and reserve requirements from regulators).
The measurement of credit risk considers the theory of markets with asymmetric information. What can uninformed lenders do to improve their outcome in a loan market characterized by asymmetric information especially of borrower characteristics? The lender will aim to measure the probability of borrow default. And this depends largely on the availability and quality of information about the borrower. That information is critical to the decision process and modern financial institutions try to use well studied and sophisticated methods in assessing default probabilities.
This column will not have enough space to run through default risk models. Suffice it to say that these vary from the relatively qualitative to highly quantitative models. And these models are not mutually exclusive. Financial institutions and banks often use more than one methodology or approach to reach a credit pricing or loan quantity rationing decision. And these are further refined in consideration of actual market and competitive scenarios.
Moreover, banks will not just look at a single account, your credit request, but will consider it in relation to other similar loans both active and in the pipeline. This is the trademark of modern credit analysis, its consideration of the whole portfolio. Credit portfolio analysis is performed on an aggregate level for borrowers, companies, markets, industries, asset classes and geographical regions. Your loan application is not analyzed on its own but in relation to other clients. Concentration limits due to credit events and exposure are then assessed.
So, the next time you approach a bank for a possible loan, be mindful that the bank’s internal process will probably subject you and your firm to such an evaluation. Of course, there is benefit to knowing what the published prime rates are because these serve as standards you can measure your loan application against. Prime rates are the interest rates usually charged to the most creditworthy customers or those with the highest rating score. At least you would have some ideas on how your application has been evaluated.
(Benel Dela Paz Lagua was previously Executive Vice President and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)