Academic journal article ABA Banking Journal

Keeping Loan Pricing Rational and Profitable

Academic journal article ABA Banking Journal

Keeping Loan Pricing Rational and Profitable

Article excerpt

Nothing is more important to a banker faced with the pricing of loans and evaluation of investments than accurately assessing the cost of his raw material: money.

Thanks to years of development by the Federal Reserve of its Functional Cost Analysis, bankers have a tool for guiding them to the present cost of money. Even if an individual bank has not done its own homework, it can safely use the Fed figures in the knowledge that its own costs are probably not significantly different, and its competitors are probably looking at the same basic data when they make their pricing decisions.

With the Fed's help, then, the calculation of the present cost of money becomes relatively simple. Noninterest-paying demand deposits have costs resulting from such functions as opening accounts, cashing checks, and issuing statements. There is also related overhead, which in 1988 for 217 banks in the $50 to $200-million size range, amounted to 4.05 %. Interest expense on the entire class of demand deposits totalled 2.36%, and service charge income was 1.56%. Cost of demand deposits, then, was 4.85%.

The structure of time deposit costs for these same banks was: interest expense 6.51%, plus operating costs of .77%, less service charge income of .03%--net total 7.26%.

The bank without a detailed cost analysis of its own could quite reasonably calculate a cost of money by getting a weighted average of its own demand and time deposits using the Fed's cost figures. It isn't terribly cost effective, anyway, to spend too much time analyzing costs down to the last penny because competition and market prices are going to have a much stronger influence on pricing of loans and investments than will actual money costs.

The really difficult problem comes when one tries to project the cost of money into the future when trying to predict the profitability of a loan or investment. No one can accurately predict the future, but we must make a stab at it if we are to make loans other than "prime-floating" or 30-day maximum investments.

Probably as good a guide as any for pricing longer-term loans is to look to the biggest market of all, U.S. Treasury securities, and ask what the market tells us about the pricing premium out to the future, which is the same thing as the yield curve. This has to be approached with great care, however, because a person who looked at the yield curve last March, for example, would find there was practically no spread between 30-day rates and 30-year rates-7. …

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