1. Pricing Commercial Loan
In order to help fund a loan request of $10 million for one year from one of its best customers, Lone Star Bank sold negotiable CDs to its business customers in the amount of $6 million at a promised annual yield of 3.50% and borrowed $4 million in the Federal funds market from other banks at today’s prevailing interest rate of 3.25 %.
Credit investigation and recordkeeping costs to process this loan application were an estimated $25,000. The Credit Analysis Division recommends a minimal 1 % risk premium on this loan and a minimal profit margin of one-fourth of a percentage point. The bank prefers using cost-plus loan pricing in this cases.
a. What loan rate would it charge?
b. What is the interest cost in order to break-even?
2. Pricing Commercial Loans
A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10%. The bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2%, based on two years of historical data. The current market interest rate for loans in this sector is 12%
a. Using the RAROC model, determine whether the bank should make the loan?
b. What should be the duration in order for this loan to be approved?
c. Assuming that duration cannot be changed, how much additional interest and fee income will be necessary to make the loan acceptable?
d. Given the proposed income stream, what adjustment in the loan rate would be necessary to make the loan acceptable?
Review Questions a) What are the major risks faced by financial institutions and why it is important that each is carefully managed?
b) Explain how you believe economic activity would be affected if there were no financial institutions.
c) What is moral hazard? Do you think this is a big issue for financial institutions?
d) What do you understand by financial intermediation?
e) Discuss benefits of intermediation services.