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Week 12 loan pricing - Lecture notes 12
Commercial Banking And Finance (Monash University)
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Week 12 loan pricing
1. Approaches to loan pricing
- Target rate of ROE (minimum required return to shareholders) and loan
pricing
+ theoretical models can be used to determine the ROE
- Dividend valuation model
- Capital Asset Pricing Model
- Simple targeted returns model
- Today, loan pricing models seek to cover the related costs, account for risks,
and generate at least the required rate of return on equity and so maximise
shareholder value.
2. Customer classification
- Prime customers
+ Have alternative sources of funds and banking services
- Large credit worthy corporate borrowers
- Housing loan borrowers
+ Are sensitive to price and service levels
+ Require competitive (user-pays) pricing on all products.
+ Otherwise these customers will go elsewhere.
- Perceived value customers
+ These customers believe they receive extra value from dealing with our bank
instead of competitors.
+ Will borrow where the marginal perceived benefits are greater than the
marginal costs.
+ Convenience can outweigh higher cost; e.g. the customer may not find it
easy to access alternative markets.
+ Loans and services can be priced to achieve a higher return, within the
customer’s value perception.
Relationship customers
- Use, or have the potential to use, a broad range of bank products and services
- Good source of future business - cross-selling opportunities
- Pricing based on yield of total product usage, that is, the bank may price the overall
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relationship – this is called bundled product pricing
Prime customers
- Be competitive on each product
- Achieve required rate of return on each product
Perceived value customers
- Banks can get a higher return because the customer prefers your bank.
Relationship customers
- Be competitive overall
- Achieve the required rate of return on the overall relationship
1. User pays pricing
User pays pricing (UPP), sometimes called standalone pricing, is when each product is
priced separately so that it yields the required rate of return on equity.
The loan price must cover:
– All bank costs
– All associated risks
– Required rate of return for shareholders (target ROE)
Advantages
– Customers pay only for what they use – this is competitive
pricing suitable for prime customers.
– Helps identify profitable products
– Useful for future planning
– Stimulates product innovation
Disadvantages
– The cost of calculating and collecting fees for low volume
products may exceed the returns.
– Customer resistance to user pays methods
● UPP is used for prime customers where competitive pricing is important in retaining
their business.
● With user pays pricing, the mix of products purchased by each customer is not
important – the return will always be the target ROE.
● Cross-subsidisation is not important in user pays pricing.
● Loan price = nominal interest rate + fees
● Nominal interest rate should cover:
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– Required rate of return on the loan:
+ Cost of debt
+ Funding on-costs
+ Fixed costs
– Cost of expected losses
● Fees should cover:
– Any non-funding variable costs incurred in relation to the specific transaction, e.g.
credit assessment costs
- Cost of funds
+ Cost of funds = Cost of debt + funding on-costs
- Cost of debt (discussed in lecture 5)
- Funding on-costs: additional costs measured by a margin
(over the cost of debt)
+ Cost of Equity Capital Funding:A bank must generate
funding from a mix of both deposits and bank capital.
+ Cost of providing liquidity to cover liquidity risk: A bank
must hold liquid assets in addition to the new loan.
- Non-funding fixed cost
+ Non-funding fixed costs (Mf) are also called overheads or loan
expenses and are incurred regardless of whether loans are made.
- Examples: wages & salaries, rent, utilities, etc.
- For pricing, we need to include a margin for fixed costs.
+ This margin is calculated using accounting data: Mf = total fixed costs
/ total earning assets
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● Non-funding variable costs are those associated with the processing of the loan (no
loan = no costs) e.g. credit assessment, valuation, security preparation
- These may vary from one loan to another.
- They are not included in the interest rate but rather covered by specific fees.
- Pricing for risk
+ Lending involves credit risk so the bank must price for risk while
remaining competitive.
+ It is vital to measure and price risk accurately.
- Prices too high = lose market share
- Prices too low = rate of return will fall below shareholder
requirements
+ To price for risk, must cover:
- Expected losses
- Unexpected Losses
- We analyse credit risk by using past data to estimate the
frequency distribution of losses. This gives
+ expected losses from default equal to the mean
+ unexpected default losses by measuring the volatility
of the distribution.
2. Bundled product pricing
- Bundled product pricing is where a bank identifies a typical bundle of products
used by most customers.
- It then sets the prices for this bundle of products so that overall it will yield
the required rate of return on equity.
- Most bank products were once prized along these lines.
- For a group of products, each product has a separate price, some may even
be “free”.
- But the set of prices are based on:
+ an overall required rate of return for the group or bundle of products,
+ with an assumed level of sales of each product.
+ Note: customers are not forced to buy the entire bundle.
- EXAMPLES OF BUNDLED PRODUCTS
+ Loans – e.g. personal loans, overdrafts, housing loans
+ Account keeping services
+ Cheque facilities
+ Cash collection and delivery (for a business)
+ Supply of bank statements
+ Withdrawals and deposits
+ Electronic banking services
+ Credit and debit cards
- Outcome:
+ If all the customers buy the same two products (the same bundle of
products), then the bank will receive the same total revenue of $2.80 from
bundled product pricing as from user pays pricing.
+ That is bundled product pricing relies on the cross subsidisation between
products
- Cross-subsidisation occurs where:
- overpriced products subsidise underpriced products.
- Over-priced products on a standalone basis earn more than the
required rate of return.
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- Under-priced products on a standalone basis earn less than the
required rate of return.
Advantages
– Lower administration costs
– Customer friendly
– Suitable for relationship customers
Disadvantages
– Requires actual sales to be at assumed levels
– Discerning customers & increased competition undermine this pricing approach.
– Cherry-picking (customers only buy underpriced products)
– Important to monitor to see which customers are profitable for the bank
3. Specific product pricing strategies
- Grouped product pricing
e.g. free credit card with home loan
e.g. free insurance for the first year
- Loss leading/enticement pricing
e.g. honeymoon rate on home loan for the first year
e.g. waiver of application fees
- Discounts for low cost customers e.g. first five withdrawals free
Loan Pricing revision
1. distinguish
- User pays pricing
- Bundled product pricing
- Define cross subsidisation
2. Cherry picking
This happens in bundled product pricing, where customers successfully identified
and purchased the under-priced product ONLY without buying the overpriced
product. Students must be able to give an example to show how cherry picking leads
to the bank earning less than the required ROE.
3. Describe three main groups of bank customers and the loan pricing method most
suitable for each group.
Prime customers:
▪ Have alternative sources of funds and banking services – Large credit worthy
corporate borrowers – Housing loan borrowers
▪ Are sensitive to price and service levels
▪ Require competitive (user-pays) pricing on all products. Otherwise these customers
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will go elsewhere.
Perceived value customers:
▪ These customers believe they receive extra value from dealing with our bank
instead of competitors.
▪ Will borrow where the marginal perceived benefits are greater than the marginal
costs.
▪ Convenience can outweigh higher cost; e.g. the customer may not find it easy to
access alternative markets.
▪ Loans and services can be priced to achieve a higher return, within the customer’s
value perception.
Relationship customers:
▪ Use, or have the potential to use, a broad range of bank products and services
▪ Good source of future business - cross-selling opportunities
▪ Pricing based on yield of total product usage, that is, the bank may price the overall
relationship – this is called bundled product pricing
4. What factors contribute to determining the total loan price if the bank is using the
user pays approach to pricing? (refer to a diagram from the lecture).
▪ Cost of debt
▪ Funding on-costs: additional costs measured by a margin (over the cost of debt)
– Cost of equity capital funding: A bank must generate funding from a mix of both deposits
and bank capital.
– Cost of providing liquidity to cover liquidity risk: A bank must hold liquid assets in addition
to the new loan.
▪ Non-funding fixed costs (Mf) are also called overheads or loan expenses and are incurred
regardless of whether loans are made. – Examples: wages & salaries, rent, utilities, etc.
▪ Allowance of Expected Losses
▪ Non-funding variable costs are those associated with the processing of the loan (no loan =
no costs) e.g. credit assessment, valuation, security preparation
– These may vary from one loan to another.
– They are not included in the interest rate but rather covered by specific fees
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