Sep 09

Promised Return on Loan – 5 min screencast

by David Harper, CFA, FRM, CIPM

FRM |

fed_cb

The contractually promised return (k) is a function of loan features. The numerator contains the elements of bank revenue: origination fee (f) plus base lending rate (BR; e.g., LIBOR or something approximating cost of capital) plus margin (m; includes credit risk premium):

promised_return

The denominator includes:

  • Compensating balance (b): portion of loan held on deposit at the bank. As the borrower does not access this portion, it increases the borrower’s cost and is an additional source of return to the bank
  • Reserve requirement (RR): the Fed requires the bank to hold reserves against the compensating balance. Notice its effect is exactly analogous to the compensating balance: the compensating balance reduced the borrower’s proceeds (1-b) and the reserve requirement does the same thing to the bank (1-RR).

Screencast:

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