Pricing Your Loans II: The Risk Premium

In my last post, we examined how setting an interest rate must start with observing your cost of funds, because the first goal is to maintain a loan with a higher interest rate than an interest rate you are paying on deposits.

The next question is, how far above your cost of funds should you price a loan? Well, that all depends on the risk, and different risks have different premiums associated with them. Common risks to consider are the risk of default, interest rate risk (often referred to as duration risk), and liquidity risk.

The risk of default is probably the most common risk people think of, and of course the higher the chances of default, the higher the interest rate should be. Although, in the field of banking (which includes credit unions), you will not see a particularly large band of interest rate variance for default risk, because there is only so much risk of default the industry is willing to tolerate. Remember, depository institutions need to be right 99% of the time for fear of rapidly depleting capital. An extraordinarily above-market interest rate on a commercial loan may indicate the default risk is too high for the loan to be considered a bankable asset.

Interest rate risk or duration risk is another consideration, and it harkens back to the discussion on match-funding. If an institution will deploy a significant amount of loan proceeds fixed for 5 years or 10 years, it may be unable to match-fund all loans appropriately. The institution may then demand a higher interest rate in order to be compensated for the amount of risk they are taking on. Take note, pricing this risk only makes sense if you know the interest rate risk profile of the institution, and institutions that can do the best job at match-funding should be able to price more competitively.

Liquidity risk has to do with the rate at which your principal is returned and interest is received. Your institution needs funds to not only make new loans to match prevailing market conditions, but also payoff liabilities (such as deposits) as they mature or are withdrawn. The longer it takes to have your principal returned, the more liquidity risk you are taking. That is why loans that amortize over a longer period of time will command a higher interest rate.

There is also a market risk component to the loan collateral as well, in which the longer collateral secures a loan into the future, the harder it is to predict an adequate market value for the collateral in real terms today. Also, if the collateral is not easily marketable, that is an additional risk that may warrant higher pricing as well.

To summarize, many people are preoccupied with pricing for the risk of default, but truthfully that is only a small piece of the puzzle. Any pricing decision should start with considering the cost of funds first, with the intent to match-fund the loan. A margin is then placed on top of the cost of funds, which is not only driven by default risk, but also by liquidity risk, duration risk, and even inherent risk in the collateral. Interest rates are not driven by default alone, but should be a systematic construction based on cost of funds, with adding a premium to compensate for several potential risks.