Pricing of Loans: A perspective to Bank Rate

How to price a bank loan An overhaul of the loan pricing regime in India was long overdue and hence the move by the Reserve Bank of India (RBI) to replace the benchmark prime lending rate (BPLR) with a new base rate is welcome. The BPLR was supposed to be the benchmark rate in the credit market but as much as three-fourths of bank lending is done below BPLR, with many implications. One, it is hard to figure out how lending rates in India are moving and whether they are correlated to changes in policy rates. Two, large companies with bargaining power can force banks to lend to them at very low rates as a result of which small companies are forced by banks to pay higher rates to protect bank profit margins. Three, the limitations of the BPLR system meant that the money markets do not have a risk-free reference rate to price credit and (in the future) credit derivatives. The new base rate that the central bank proposes to introduce from 1 April is a clear advance over the BPLR. The big advantage will be that the rates at which consumers and companies borrow from banks will move in tandem with the changes in policy rates made by RBI, unlike now, when floating rate loans do not get reprised when the central bank cuts the rates it controls. The base rate will be good news for borrowers and also strengthen the monetary transmission mechanism in India. The fear is that India has moved into a new regime of administered interest rates, with the base rate acting as an artificial floor linked to the cost of funds of banks. This is a cost-plus approach to pricing loans, which will help public sector incumbents with a nationwide branch network and a huge low-cost deposit base. Newer players who necessarily depend on high-cost deposits in their early years may find themselves shut out of many deals. This is an issue RBI should consider. True, there are many countries such as Japan, Singapore and Taiwan that use a costplus method to determine the benchmark or base lending rate. But India needs to

develop a robust term money market which ensures that participants decide on a benchmark credit rate through price discovery. Banks can then price loans at or above this benchmark, depending on their risk assessment of the customer and loan tenure. There is little doubt that the new base rate is better than the BPLR it replaces, but the monetary authorities should see this as a necessary stop on the long road to an active term money market, rather than as an end in itself.

Indias New Loan Pricing

Indian banks will have to switch over to a new loan pricing system from July 1. The Reserve Bank of India says a new rate, called the base rate, must be used to price all lending, including home, auto and business loans. On Wednesday, the countrys largest lender, the State Bank of India offered a hint of what its rate will be and said it will likely officially announce the number on June 15. As other banks ready their new rates, India Real Time offers a primer on how the base rate will work. Bank lending rates are set to become more transparent from July 1. What is the base rate? The base rate, as the name suggests, will be the rate below which banks cannot price any loans, and should include all the elements of lending costs that are common across all types of borrowers. Each bank can have its own base rate depending on the cost of its funds. What are banks using now? Currently, banks use the benchmark prime lending rate, or BPLR, which has been in vogue since 2003. A committee published a report in October 2009 looking at the BPLRs evolution and flaws. Why do Indian banks need to use the new system?

The BPLR was often set quite high because it also functioned as the ceiling for pricing higher-risk small loans. The system seems to have worked to the benefit of higherrated corporate firms who got cheaper loans, while overpricing credit for agriculture and smaller enterprises. Intense competition among banks resulted in nearly 70%75% of loans being priced below the BPLR. That has hampered the central banks monetary policy transmission process. When the RBI lowers policy rates to stimulate credit demand in the economy, as it has done repeatedly between the fall of 2008 through most of last year, those signals havent been transmitted to the official rates because of the prevalence of sub-BPLR lending. The new system doesnt set the base rate as a cap for loans of 200,000 rupees or less in fact theres now no ceiling for pricing these loans which may make banks more responsive. How will the base rate be calculated? Banks may choose any benchmark to arrive at the base rate for a specific tenor, as long as they are transparent and consistent. Lenders may include the cost of deposits, the opportunity cost for locking bonds and cash to meet reserve requirements, unallocated overhead costs and profit margins. And for different sorts of borrowers, banks can add customer-specific charges to the base rate. Which loans are exempt from the base rate system? Three types of loans will be exempt from the base rate system loans offered under the differential rate of interest scheme where funds are provided at reduced rates to low-income borrowers, loans to banks own employees and loans to bank depositors against their own deposits. What happens to existing loans? The base rate will be applicable for all new loans from July 1 and for any old loans that come up for renewal after that date. Existing loans may run till their maturity. But if borrowers want to switch to the new system before their existing terms expire, banks

can offer them that option on mutually agreeable terms. Banks arent supposed to charge a fee for switching over, though. Where is the base rate likely to settle in percentage terms? The base rate will generally work out to be lower than the BPLR. State-run banks are expected to set their base rates between 8% and 8.5%, according to bankers. The State Bank of India, the countrys largest lender, expects its base rate to be between 7.5%8.5%, bank chairman O.P. Bhatt said on Wednesday. Its BPLR is presently 12.25%. How will bank customers know what their banks rates are? The RBI requires banks to review their base rates at least once in a quarter. The banks must also display information on their base rate at all branches and on their websites.

Some of the Relevant Questions

How is Base Rate different from BPLR? Under the existing Benchmark Prime Lending Rate (BPLR), banks can give loans below BPLR, called sub-BPLR lending. In fact, as at the end of March 2009, 67 per cent of total loans in the entire banking system were contracted at below BPLR. This is not possible under the new Base Rate System. Banks are not allowed to lend at below Base Rate. It is the minimum lending rate banks have to charge to their customers. However, there are a few exceptions to this rule (the details are given elsewhere). How is Base Rate calculated? Banks are given freedom to decide their own Base Rates based on cost of deposits, adjustment for CRR/SLR maintenance, unallocatable overhead costs and average return on net worth. According to RBI, Base Rate shall include all those elements of the lending rates that are common across all categories of borrowers. Banks may choose any benchmark to arrive at the Base Rate for a specific tenor to be disclosed transparently. An RBI illustration, for computing the Base Rate is given below:

ACTUAL CALCULATION
BASE RATE = Cost of deposits/funds + Negative carry on CRR/SLR + Unallocatable overhead cost + Average return on net worth

Banks are free to use any other appropriate methodology, provided it is consistent and is made available for RBI review/scrutiny. Strictly speaking, the above is only for illustrative purposes. RBI has given freedom to banks to use their own methods for the calculation of Base Rate. Will customers be able get loans at Base Rate? RBI says that banks can calculate the actual lending rate by adding customer specific charges to the Base Rate. Frankly speaking, Base Rate is not equal to lending rate that will be charged ultimately to the customer. While arriving at the actual lending rate, banks will add certain appropriate charges specific to the customer, like overhead costs, credit risk premium and tenor premium. As per the Deepak Mohanty Committees report, actual lending rate can be arrived at as follows:

Actual lending rate * = Base Rate + Product specific operating cost + Credit risk premium + Tenor premium

* Actual lending rate that will be charged by banks to the borrowers

Credit risk premium: All loans carry credit risk meaning that the borrower may fail to repay the loan. The extent of credit risk differs from one borrower to another borrower depending on the borrowers overall credit standing and other factors. So, the credit risk premium may be lower for a customer with good track record and may be higher for customers with not-so-good record.

Tenor premium: In general, the longer the maturity of the loan, the higher the risk for a lender. As such, banks usually charge higher rates for long-term loans compared to short-term loans, other things being equal.

Example: As all loans will be linked to Base Rate, whenever a bank changes its Base Rate, the loan rates of customers will change accordingly. Suppose Bank Efficient has kept its Base Rate at 8 per cent. And the Bank Efficient has fixed car loans at Base Rate plus 4 per cent (ie, 400 basis points), the car loan rate will be 12 per cent (8 + 4). After a few months, Bank Efficient has revised the Base Rate to 9 per cent, the car loan rate will be revised to 13 per cent (Base Rate plus car loan premium = 9 + 4). Moreover, the Bank has got freedom to revise the car loan premium. Depending on the market conditions and other considerations, the Bank may decide to increase the loan premium to 5 per cent from 4 per cent. Then, the car loan rate will be revised to 14 per cent (9 + 5). What is transparency in loan pricing? Transparency in bank lending means that banks should be able to provide adequate information to borrowers so that the latter fully understand the terms and conditions. Higher levels of transparency can be achieved by disclosing information on how the loan rates are arrived at by the bank. Transparent lending is equal to borrowers correctly understanding the loan pricing mechanism and other fees before signing the loan agreement. Banks should not indulge in charging any hidden costs and unexpected rate increases. To achieve greater levels of transparency, banks shall ensure that all charges and possibility of rate increases are made clear to the borrower at the beginning of the agreement. Given the large proportion of sub-BPLR lending by the banking system, concerns have been raised on the transparency aspect of computation of BPLRs by banks.

References:http://www.livemint.com/2010/02/11215332/How-to-price-a-bank-loan.html https://www.wellsfargo.com/mortgage/loan-programs/homebuying-loans http://blogs.wsj.com/indiarealtime/2010/06/09/a-guide-to-indias-new-loan-pricing/

What is credit appraisal? Credit Appraisal is the process by which a lender appraises the technical feasibility, economic viability and bankability including creditworthiness of the prospective borrower. Credit appraisal process of a customer lies in assessing if that customer is liable to repay the loan amount in the stipulated time, or not. Here bank has their own methodology to determine if a borrower is creditworthy or not. It is determined in terms of the norms and standards set by the banks. Being a very crucial step in the sanctioning of a loan, the borrower needs to be very careful in planning his financing modes. However, the borrower alone doesnt have to do all the hard work. The banks need to be cautious, lest they end up increasing their risk exposure. All banks employ their own unique objective, subjective, financial and non-financial techniques to evaluate the creditworthiness of their customers.

Components of Credit Appraisal Process While assessing a customer, the bank needs to know the following information: Incomes of applicants and co-applicants, age of applicants, educational qualifications, profession, experience, additional sources of income, past loan record, family history, employer/business, security of tenure, tax history, assets of applicants and their financing pattern, recurring liabilities, other present and future liabilities andinvestments (if any). Out of these, the incomes of applicants are the most important criteria to understand and calculate the credit worthiness of the applicants. As stated earlier, the actual norms decided by banks differ greatly. Each has certain norms within which the customer needs to fit in to be eligible for a loan. Based on these parameters, the maximum amount ofloan that the bank can sanction and the customer is eligible for is worked out. The broad tools to determine eligibility remain the same for all banks. We can tabulate all the conditions under three parameters.

Parameter Technical feasibility Economic viability Bankability

DOCUMENTS Field Investigation, Market value of asset LTV(Loan to Value), IIR Past month bank statements, Asset and liabilities of the applicant

Besides the above said process, profile of the customer is studied properly. Their CIBIL (Credit Information Bureau (India) Limited)score is checked.

Parameter components & How bank asses your creditworthiness through it Technical Feasibility Living standard Locality Telephonic Verification Educational Qualification Political Influence References What bank is looking for Decent living standard with some tangibles like T.V. & fridge will provide assurance to bank regarding your residential status. Presence of some undesirable elements like local goons or controversial areas adversely affects yourloan appraisal process. At least one response is need from person to establish the identity of the person from contact point of view. Not an essential barrier but essential to understand the complex terms & conditions of bankloan. An interesting reference point in the sense that they are one of major category of loan defaulters. To establish the residential identity of person from human contact point of view & cross check of theirloans.

The 3 methods used to arrive at Eligibility

Installment to income ratio Fixed obligation to income ratio Loan to cost ratio

Installment to income ratio This ratio is generally expressed as a percentage. This percentage denotes the portion of the customer's monthly installment on thehome loan taken. Usually, banks use 33.33 percent to 40 percent ratio. This is because it is has been observed that under normal circumstances, a person can pay an installment up to 33.33 to 40 per cent of his salary towards a loan.

Example; if we consider the installment to income ratio equal to 33.33 per cent, and assume the gross income to be Rs 30,000 per month, then as per the ratio, the applicant is eligible for a loanwith the maximum installment of Rs 10,000 per month.

Fixed obligation to income ratio

This ratio signifies the importance of the regularity in the repayment of previous loans. In this calculation, the bank considers the installments of all other loans already availed of by the customer and still due, including the home loan applied for. In other words, this ratio includes all the fixed obligations that the borrower is supposed to pay regularly on a monthly basis to any bank. Statutory deductions from salary like provident fund, professional tax and deductions for investment like insurance premium, recurring deposit etc. are exempt from these fixed obligations.

Example; assume that monthly income of an applicant is Rs 30,000 and the applicant has acar loan installment of Rs 4,000 per month, a TV loan installment of Rs 1,000 per month. In addition to this his proposed housing loan installment is Rs 10,000 per month. Numerically, the ratio is equal to Rs. 15,000 or 50 percent (i.e. 50 percent of the monthly income). If the bank has decided on the standard of 40 per cent of ratio as the criteria, then the maximum total installments the person can pay, as per the standard, would be Rs 12,000 per month. As he is already paying Rs 5,000 for the car and TV, he only has Rs 7,000 left out. Hence, the customer would be given only that loan for which the EMI would be equal to Rs 7,000, keeping in mind the repayment capacity of the applicant.

Loan to cost ratio This ratio is used by banks to calculate the loan amount that an applicant is eligible to pay on the basis of the total cost of the property. This ratio sets the upper limit or the maximum loan amount that a person is eligible for, irrespective of the loan eligibility under any other criteria. The maximum amount of loan the borrower is eligible to pay is pegged as equal to the cost or value of the property. Even if the banks calculations of eligibility, according to the above mentioned two criterions, turns out to be higher, the loan amount can't exceed the cost or value of the property. This ratio is set equal to between 70 to 90 per cent of the registered value of the property.

Hence, while deciding on the maximum amount of loan a customer can be given, the banks use these three parameters. These parameters help in computing loan eligibility, which is crucial in calculating the creditworthiness of a customer. It also acts as a guide to determine the loan amount. Economic viability

Installment to income ratio

IIR for salaried cases would be capped at 60% of Net income in general Pension Income cases IIR to be restricted to 40%a

Fixed obligation to ratio Loan to cost ratio

income FIOR kept at 55% LTV amount to 80%

Bankability Parameters Parameter Bank Statements Norms Checkpoints

6 months bank statements need To check the average to be furnished amount client is maintaining in the account is sufficient to pay the installment amount or not. returns made To enquire primary source of income.

Business proof

continuity Two year IT compulsory

Credit interview

For the big loan amount credit To check the general interview is necessary. attitude of customer along with efforts are put in to understand their needs better. Salaried professionals get an Secured source of income edge over business income give them a edge people. Asset of value equal to or more To safeguard bank interest than loan amount taken has to be against any future default. put as pledge or collateral. To be on the name or blood To establish the ownership relative of applicant. claim of the loan applicant. To check the credit history of the Bank tool to check any bank applicant. default incidence in loaning history of applicant.

Profile of customer

Security

Ownership title CIBIL Report

These are the parameters which help banks in deciding your creditworthiness & help them in granting the loan to the seekers.
http://www.slideshare.net/BabasabPatil/credit-appraisal-in-banking-sector-ppt-bec-doms for more info