Loan Pricing

Lending to small business is one of the most important services banks undertake. It enables businesses to grow, take on more employees and generate greater wealth across the economy. But, its important that banks can earn a return on this activity in order to sustain that service throughout the business cycle.
Ultimately, the price of lending is determined by the market. It is one of the most competitive areas as firms of all sizes choose where to place their business. Banks that overprice will lose out, while those that underprice will not be able to sustain their operations. There are three key drivers behind how banks price lending:

1. Cost of funds
In order to lend money to businesses, banks need to attract funds from depositors by paying them interest. They also need to aim to hold deposits for similar lengths of time as the term of loans financed. For this reason many institutions must pay higher interest rates for deposits.

2. Cost of capital and risk

For every loan a bank makes, it must set capital aside to ensure the bank remains solvent and depositors are secure, even if that loan isnt repaid. To ensure the confidence and security of savers, all banks around the world are currently holding higher levels of capital than in recent years. There is a cost to holding this capital and as banks have increased the amount set aside, this cost has risen along with it. Price also reflects the probability in the banks experience and according to its data of the borrower not being able to repay the debt. The higher the level of risk, the higher the price must be to cover the likely loss. This amount of risk is also influenced by the level of security offered by the borrower; when the value of security falls, for example commercial property values, the risk of the bank not being able to recover the full amount lent increases, and vice versa. The methodology and calculations used to determine the cost associated with the risk of lending are set by the Basel regulatory framework. Riskreflective pricing enables higherrisk but still viable businesses to access finance while lowerrisk and wellmanaged firms get the benefit of lowercost funding. Pricing to risk is in businesses interest: it means even more marginal businesses can still get access to finance, albeit at a higher price..

3. Cost of administration
Meeting a business customer, assessing an application for finance, setting up a facility, providing the documentation, then monitoring and controlling that facility as well as providing regular information and revising facilities as required has a cost. While banks may use credit and performancescoring tools, most will also require a judgment to be made by an experienced relationship manager. Smaller facilities tend to have a relatively higher administrative cost per pound lent than larger facilities, and not all of that cost can be recovered through fees. So small facilities tend to bear higher margins, even if the risk is comparable with larger lending.

What has changed since the financial crisis?

In the runup to 2007, some banks used the wholesale markets to source a proportion of their deposits that they lent to businesses. At the time that money was relatively inexpensive and enabled banks to offer lower lending prices than was historically normal. However, from 2008, with the dramatic freezing of wholesale markets, this source of funding proved much less attractive. This has increased demand for other, more traditional funding sources, such as retail deposits, which in turn has increased the costs of banks raising funds to lend to something more like a historical norm. Banks have also been asked by regulators to raise deposits over longer terms than they have historically, and to hold greater liquidity buffers against unforeseen circumstances. This means that banks must pay higher market rates for longer term deposits, and that a higher proportion of those deposits raised cannot be lent to customers but must be put aside, incurring additional cost.

Combined, these factors mean that (although reference rates like Bank of England Base Rate and LIBOR continue to be used in quoting finance costs for example, 2% over Bank of England base rate) they dont reflect the real cost of funding and banks real costs are considerably higher. In addition to changes in how banks fund lending, the amount of capital banks are required to hold by regulators has risen sharply, leading to a corresponding increase in the cost of capital that is included in the price of debt. As economic conditions have become more severe the likelihood of borrowers being able to repay debt has reduced and, in line with banking regulations, banks must hold higher provisions against these potential losses. All these factors have considerably increased the cost to banks of providing finance compared to the more benign economic conditions in 2007 and prior.