Jul 16

Contractually promised gross loan return

by David Harper, CFA, FRM, CIPM

FRM |

2008 FRM AIM: Compute, given the contractual rate and non-interest charges, the contractually promised gross return on a loan

Per Saunders, we need five assumptions:

Base lending rate plus margin: likely the bank's cost of capital plus a profit margin. Note this pricing already includes expected losses (EL) on the loan. The promised return is greater than the expected return due to default risk; the expected losses due to default risk are priced into a component of the margin.
Origination fee
Compensation balance (a.k.a., offsetting balance): held by bank
Reserve requirement: This is a determined by regulators. Reserve requirements are one of central banks' tools for influencing the demand for liquidity. Varies by country and, within country, often by complex rules pertaining to type/size of deposits. Could be 0%, 2%, 5%, 10%.

For example, assume:

8% base lending rate (BR) + 2% margin (m) = 10% loan rate
Origination fee (f): 0.125% (one-eight of one point)
Compensation balance (b): 10%
Reserve requirement (R): 5%

Then the contractually promised gross loan return is given by:

Note the impact of the denominator is to lever up the return. If the compensating balance is zero, then the promised gross loan return in this case is simply 10.125% (base rate + margin + fees).

Here is the EditGrid calculation: