Loan pricing model -

Abstract

Loan pricing is a critical aspect of the asset liability management and an essential component in a bank’s operations. Loan pricing decisions have a direct impact on the financial institution’s earnings, credit risk and capital adequacy. This is why financial institutions must price loans in the optimal way to cover costs, maintain a credit buffer for expected losses, and achieving an adequate level of return for continuous growth while ensuring the pre-defined level of capital. Once the loan pricing model is in place, assessing its effectiveness is critical in evaluating the financial institution capital, earnings, liquidity and sensitivity to market risks. The methodologies for loan pricing, adopted by financial institutions, range from simply matching the competition, to complex, risk-adjusted performance measures (RAPM). The study is based on a loan pricing model based on RAPM. The aim of the study is to enhance an existing model based on Basel II Standardized Approach, in terms of risk weights’ assumptions. The existing model does not consider the quality and rating of the obligor while calculating the interest rate applied on the loan. Enhancements to the exiting model include the implementation of Basel II IRB approach through the introduction of risk components to the RAPM components. The enhancements will ensure better risk adjusted performance measure of both the borrower and the facilities granted to him. Better performance measure will guarantee an appropriate pricing if loans to cover the credit risk while providing an adequate return to the institution.