PRICING FOR LENDING

Pure transfer prices are the cost of financing a loan. Other components of pricing should include:

• all operating costs are expressed in % of total loans

• the cost of credit risk when lending

• plus a mark-up (lending) or a mark-down (deposits) that should be in line with the target profitability of the bank.

Target profitability is commonly defined as a target return on capital ("ROC") or return on equity ("ROE"). Risk-based pricing requires moving from the global target ROC to target commercial spreads (customer rate - transfer price) and target clients' rates.

The All-in Cost of Funds of the Mirror Debt

The pure economic benchmark is the notional economic cost of funds, described above, which is the cost of funding that mirrors exactly the loan. We assume here that this cost of funds is 7%.

The "all-in" funding cost of the loan adds up the operating costs. We use here an add-on of 0.5% to obtain an "all-in" cost of funds of 7.5%. Other commercial mark-ups or mark-downs might add up to the all-in cost of funds to move to the customer price. Ignoring the commercial items, the all-in cost sums up the cost of funding plus operating costs. The minimum client's rate to absorb these costs would be 7.50% (Table 29.2). We consider all costs as a percentage of the loan balance.

Note that revenues from borrowers include interest rate charged plus some non-recurring fees, or upfront fees, plus some recurring fees. Non-recurring fees create distortion of revenues across time. The common solution to correct such a distortion is to use an annualized all-in-revenue, which averages all revenues, recurring and non-recurring, over the life of the transaction. Similarly, the "all-in-spread" is the annualized spread above the cost of debt calculated as an annual average over the life of the transaction. In what follows, the rate charged to borrower is an "all-in rate," or inclusive of fees.

However, using operating plus funding cost would not absorb the cost of credit risk, which is borrower- and transaction-specific. Since pricing to client is before tax, we use the before

TABLE 29.2 All-in cost of funds

tax cost of capital. Taking k% = 25% as target ROC before tax, we need to find the additional margin compensating this target ROC.