How do banks price interest rates on loans?

During the counseling I meet many interesting people, from the crime scene investigator to the famous football player to the world-wide disc jockey. This is one of the reasons I like to do consulting besides making money, getting to know a lot of interesting people and professions.

I also met Bence, who was in charge of lending at a large bank. He decides what credit should be given for how much risk the bank is worth.

Many people have asked what a bank charges for a loan

bank

It depends on many things, from family status, education, job, location, type of property and a thousand other things. (Therefore, you don’t have to take online credit calculators too seriously, they are just for raising awareness rather than working with real data.)

We talked to Bence to write an article on the subject so readers can see why and how a bank should charge a loan to take all risks into account. (The interest rate premium on a loan must cover not only the bank’s current gain, but also the risk capital loss. A 100% lost personal loan carries 14 times the full 7% return on a loan.)

So his article will follow. If you like it, write to him in the comments that you would like to read more from him. ?

Reports have previously been made in previous articles commenting on the basis and how banks judge their transactions, why they have so much interest, and many other issues related to the background of their loans. I would like to highlight these briefly.

About myself, I’ve been an avid reader of the blog for a long time, and have been in the financial industry for over a decade.

So let’s start with what a bank lives for

bank

This is primarily due to interest margins on deposits and loans and commission income. Obviously, a bank gets a loan at a lower interest rate than it borrows, which is the bank’s margin.

However, do not think of a large amount here, as at present 2.5-4% can be obtained home loans, so from this amount the bank has to finance the personal expenses and the maintenance of the infrastructure (IT systems, hardware and software needs) , office building and account rentals, liquidity costs, and more.

However, in addition, the biggest cost for a bank in a crisis is the risk cost. After all this, of course, there is an expected return on capital, so after accounting for the above costs (which will have to be managed from the above mentioned interest margins), the bank will have to pay a meaningful dividend to the owners.

To put it briefly: if you have a bank with a core capital of $ 100 billion and a loan of $ 1,000 billion due to leverage. This may mean that the bank may face a capital requirement of HUF 100 billion against the HUF 100 billion capital, which is the amount of unexpected loan losses.

This is 12.5 times the risk-weighted asset value

bank

Which, in the current regulatory environment, is divided by two, on average, between capital buffers and the so-called SREP rate (set by the MNB as a quasi “multiplier” for each bank). Based on the above math, approx. 100×12.5 / 2, i.e. approx. The bank may have a risk-weighted asset value of HUF 600 billion. So in this case, if the average risk weight is 60%, we get a loan of HUF 1,000 billion. If the bank had more risky (100% risk-weighted) customers, it would only have an exposure of HUF 600 billion. (This is one of the reasons why riskier customers get more expensive credit.)

Thus, staying with the original example (HUF 1000 billion exposure), this yields a profit of HUF 20 billion (2%) in the current interest environment. Assume that deposits and commission income generate another HUF 30 billion in profits. Out of this 50 billion, let’s deduct, say, the wage cost of 1,500 employees (average 600,000 gross, this is super-grossed at $ 14 billion a year), at least that amount for different IT and rentals, and all other expenses. After that, HUF 20 billion will remain. Turning back to the HUF 1,000 billion loan portfolio, a very conservative, 1% average provisioning for a portfolio deterioration amounts to HUF 10 billion.