Pricing of Bank Loans

As we wrap up 2016, and reflect on issues affecting Indian Banking industry during the year (apart from Demonetization), Profitability of Banks crops up as one of the most outstanding issues. The subject got into focus in the face of write-offs of doubtful or bad loans, requiring a provision to be made out of profits. For the uninitiated it presented a strange scenario whereby Banks continued to register ‘operational profits’, but the bottom line showed ‘net losses’ mainly on account of additional provisioning for doubtful debts.

In this context, for a layman, it is relevant to understand nuances in fixation of loan pricing, as provisioning for doubtful debts and its impact on profitability shall continue to shadow Banks in 2017 as well.

Let us first understand Bank’s profitability model. Bank’s profits are mainly driven by the difference in interest it earns on loans as against interest it pays out on deposits, with the margin getting squeezed by administrative expenses. But net pricing of loans is a slightly more complicated affair as discussed below.

Interest payment on deposits is rather simple, with rates and slabs being determined for a class of depositors eg Savings Bank or Term deposits with different maturities. But loan pricing is much more complex, with interest rates being fixed for each individual borrower, unless they are covered under schematic loans like Car loan or Housing loans etc. In such cases, Banks determine their costs and risks in general and suitably fix interest rate.

But in large number of business loans, it remains a mystery for borrowers themselves that how one borrower gets a better pricing compared to others. Many questions arise -

·        Why Banks charge different interest rates to different borrowers ? and

·        How is it determined that what rate is to be charged from a particular borrower ?

To a novice, the matrix is simple. Since Bank’s viability depends on their profitability which in turn is a function of difference between interest earned and interest paid, banks should naturally go for high priced loans. But this is not so. Because, pricing of a loan not only takes into account costs of funds and administrative / loan monitoring costs but it also accounts for cost of risk associated with loans, chiefly borrower default risk. So while the Bank is aware of its average cost of funds as well as administrative costs which form the base, final loan pricing is dependent on risk assessment for a particular class of borrowers or borrower and the risk premium shall determine the final interest rate offered to such a borrower.  

Loan pricing models

In India we see an amalgamation of several internationally accepted pricing models, so that the final product gets the best out of everything. Let us briefly discuss some of these models -

Cost linked pricing  

This model is based on the following four facets -

(i)         Cost incurred for raising funds or resources, forms the base. This mobilization could be through whatever legitimate means Banks can adopt eg from customer deposits or through equity capital, market bonds etc. Generally loan pricing is in direct proportion to interest paid on deposits/cost of capital, and both move in tandem ie higher the payout , higher the loan rates and vice versa.                

(ii)        Next top-up is through administrative or operating costs. Banks incur costs towards initial processing of loan (this cost is sometime met through a separate initial loan processing fee) , salaries and wages , office maintenance expenses /overheads etc. There are several indirect costs also eg statutory costs and opportunity costs for maintaining certain regulatory reserve requirements which means that funds kept as reserves do not earn anything and this cost also has to be factored in / loaded.

(iii)        The most important component of loan pricing which really impacts cost to an individual borrower is the default risk premium, the Bank chooses to load on the above two costs . This risk premium is based on a internal rating system developed by the Bank and an external credit rating exercise undertaken by a third party. Under the Basle II accord, the Bank is required to rate each one of its borrower, and then depending on the rating score, assign a “probability of default” . This default matrix determines the premium, Banks load to the interest cost.

(iv)       Lastly, a profit margin is loaded on all the above costs which allows the Bank to provide an adequate return on capital deployed or return to its shareholders. This is market related and depends on economic circumstances prevailing from time to time.

Other factors which may impact pricing variation are as under  -

Administrative costs - Slight variation may also occur due to administrative costs as long term fixed maturity loans like home / car loans carry very little admin cost over the life of loan.

Profit margin - It may wary depending on market competition,  credit worthiness of the customer etc.

Risk Assessment and pricing 

Historically, Banks have struggled to find out an objective assessment tool for assigning risk to a borrower and link interest pricing to such a risk, so that low risk customers are given better pricing. This helps in attracting safer and sound business to Bank’s books. Risk element attached to a loan varies widely according to the loan characteristics eg borrower’s industry and his own profile. Therefore risk assignment or consequential loading of a risk or default premium becomes one of the most complex aspect of pricing.

Banks have tried to devise various methods to factor the risk element - judging the borrower from both Qualitative and quantitative aspects. For this, individual Banks had developed their own internal models / matrix to assess risks associated with a loan proposal. These chiefly involve rating a loan on the basis of a credit scoring system. The rating system although varying widely from Bank to Bank with differing emphasis on various risk parameters, broadly covered the borrower’s past credit history, the security available and loan repayment period eg a loan which is unsecured (credit card) is the priciest, compared to a vehicle loan or home loan (secured loans).

This scenario was prevalent till the year 2009 when Reserve Bank of India formalized the system and instructed all the Banks to implement guidelines issued under the Basle II accord. One of the pillars of Basle II linked a Bank’s required regulatory Capital to credit risk in its portfolio. This involves rating of a loan on certain parameters and assignment of pre-determined Risk weights to different ratings. The risk weights were assigned by Reserve Bank who accorded higher risk weight to Productive lending (loans for manufacturing and service sector) and lower risk weights to Consumptive loans (to retail sector like Vehicle loans, home/mortgage loans).  

So it is extremely important from the perspective of a Bank’s profitability that it not only chooses its assets (borrowers) prudently, but also be clear about identifying, measuring and pricing of risk attached to the loan. This forms the basis of a Bank’s business policy and goals.

Loan Pricing in India

Historically Banks in India have been rather arbitrary in charging interest on loans to borrowers and although rates were linked to overall market conditions, but there was a very wide variation from Bank to Bank and from borrower to borrower within the same Bank. The only semblance of regulation was that the Bank had to fix a Prime Lending Rate  (PLR) and peg rates for individual borrowers as a percentile margin over or under PLR. But neither fixation of PLR nor the margin were transparent. Although the very concept of PLR meant that this would be the best rate offered to best clients, but there was an unhealthy practice of charging very low sub PLR rates to large corporates. This meant that the Banks ended up charging higher rates from small and medium borrowers in order to compensate for losses arising from sub PLR lending to large corporates and to maintain their bottom line.

To improve the interest rate mechanism and make it more transparent, in February 2010 RBI replaced PLR with a new interest rate regime, which came to be known as Base rate. Banks were barred from lending below base rate. Further, fixation of base rate was practically linked to Bank’s cost of funds or the RBI’s policy rates. But still there was an arbitrariness in fixation of Base rates, and the margin variation for individual borrowers over base rate was also not consistent. Banks like State Bank tried to introduce transparency by fixing margin slabs over base rate linked to various bands of external commercial ratings. In this sense, the interest rates got linked to the Bank’s cost of capital.  

The Base rate system helped interest rate administration by ending the practice of sub PLR lending , but it did not achieve another policy objective of a fair transmission of interest rate changes to the customer. Banks were not passing on to the customer, benefits of policy interest rate reduction being announced by RBI from time to time. So, RBI further refined interest rate administration by introducing Marginal Cost of Funds based Lending Rate (MCLR). The rate rolled out from April 2016 shall replace the Base rate regime completely by end March 2017. As this is the current interest rate regime, we shall discuss MCLR and its implications, in detail.

RBI mandated that “Existing loans and credit limits linked to the Base Rate may continue till repayment or renewal, as the case may be. Existing borrowers will also have the option to move to MCLR at mutually acceptable terms.” Every bank is now required to calculate its marginal cost of funds across different tenors and then top it up with operating costs and a tenor premium. Thus Banks are required to set five benchmark rates for different tenors or time periods ranging from overnight (one day) rates to one year. Different tenors cover different premia to compensate for time risk. Another distinguishing feature of MCLR is that banks are now obliged to readjust interest rate monthly. This means that there is a better chance of any change in RBI policy rates, getting transmitted to the customer.

Certain categories of loans are exempted from MCLR mechanism, such as loans under a restructuring package or Government schemes, loans to depositors against Fixed deposits and loans to Bank’s own employees.

The calculating mechanism of MCLR takes into account the following components -

(i)         Marginal cost of funds;

(ii)        Cost incurred by Bank for maintaining Cash Reserve Ratio ;

(iii)        Operating costs;

(iv)       Tenor premium.

MCLR mechanism mandates that Banks should factor their cost of funds (average interest paid to depositors) with RBI’s Repo rate (rate at which Banks can borrow from the central Bank) and return on networth. A weightage ratio of 92:8 has been laid down between cost of funds and return on networth. Negative carry on account of CRR, is the cost incurred by Banks for maintaining mandatory cash reserves with RBI, on which no interest is received. Cost of these idle funds can be charged from loans.  Operating costs are Bank’s operating expenses.  Tenor Premium compensates for lending risk associated with time, because with lapse of time it becomes more and more risky to project a business scenario. 

Conceptually MCLR is similar to earlier PLR or Base rate mechanisms, as they all denote a benchmark lending rate, but the difference lies in their respective computation methodology and application. While sub PLR lending was widely prevalent, this malpractice was curbed with Base rate. MCLR introduced further transparency in rate computation and rate transmission, as it compelled the Banks to announce MCLR at pre-determined monthly intervals.

Main features of MCLR are summarized hereunder -

·        Loans freshly sanctioned or renewed w.e.f April 1, 2016 are priced based on MCLR ;

·        MCLR is a tenor-based benchmark instead of a single rate. This ensures that Banks link loans carrying different tenors with different MCLRs which in turn are based on Bank’s cost of funds for that tenor ;

·        Banks are required to publish MCLRs of different maturities every month on a pre-determined date.

·        Banks can set at least 5 MCLR rates viz. overnight, 1 month, 3 months, 6 months and 1 year. Banks can choose to have more (for longer tenors).

·        As MCLR is only a benchmark, the final rates will include a spread over MCLR. Spread shall take into account a borrowers credit score or credit worthiness ;

·        In existing accounts interest can be reset on option of the customer or on next review date ;

·        Banks have option to link a category of borrowers to MCLR of particular maturity ;

·        Once a borrower opts for MCLR, switching back to base rate system is not allowed.

·        Like base rate, banks are not allowed to lend below MCLR, except for specified categories eg loans against deposits, loans to bank’s own employees etc.

·        MCLR does not cover fixed Rate loans like home loans, personal loans, auto loans etc.

Rounding up this discussion, we have come a long way from the days of indiscriminate fixing of interest rates for different customers, to a interest rate regime which is more transparent and takes into account periodical modifications in RBI’s policy rates. Theoretically, MCLR is a double edged sword and customers should be prepared for reduction and increase in rates in consonance with policy rates but practically customers shall stand to gain as earlier Banks were very prompt to pass on interest hikes but invented excuses for giving benefit of interest reduction.