27 Nov The Cost of Your Loan: Agribusiness & Commercial

A quick soldier’s five on the cost of your loans with sneak preview into the “Inquiry into Small Business Loans” (by the Australian Small Business and Family Enterprise Ombudsman).  Be the soldier and take the 5, you will not be disappointed.

The price you pay for a loan comprises 4 key characteristics;

1. Cost of Funds: is the cost of supplying the capital and also includes the capital requirements.  This is where the banks hold a certain minimum amount of capital (defined by APRA).  That amount is defined as a proportion of their Risk Weighted Assets, which is a measure dependent on Expected Loss.

2. Cost of Providing the Product is the cost of overall operations.

3. Cost of Risk covers the expected losses.  That is, the risk the borrower does not pay back in full or a portion of the funds owed.

4. Profit: the return on effort for the shareholders.

Capital Requirements

If loans on the Bank’s book become riskier, the Bank is obliged to hold more capital accordingly to be able to offset foreseen credit losses and continue to be solvent as a financial institution.  Holding more capital is expensive for the banks, so they manage their level of Expected Losses in order to find a desired balance of risk and capital cost.

Banks leverage their Non-Monetary Default clauses to be able to “step in sooner” to reduce the Loss Given Default and capital requirements.  This practise is appropriate in circumstances of proven financial distress or borrower fraud.

It is not appropriate if the bank triggers defaults with the sole purpose of rebalancing the risk profile of their lending portfolio across segments or industry sectors.  This also includes credit managers who want this ability to cover all risks they have not predicted and/or included in the loan price.

Calculating Expected Loss for Each Loan

Expected Loss = Probability of Default (estimated risk that he borrower won’t repay the loan on time or in full) x Exposure of Default (estimated exposure to the bank which is usually the loan amount) x Loss Given Default (estimated portion of the exposure at default that the bank is likely to lose in the event of a default.

Risk costs might change over the life of a loan due to external events outside a borrower’s control.

Success of the Costing Model

The success of the costing model used by the banks is evident in the low number of loans, as a percentage of whole loan books that move from default to impaired.  That statistics provided by the Australian Banking Association in its PJC submission indicate this;

“For the Year ending March 2015 less than 1 percent of business and agribusiness customers had impaired loans and a tenth of 1 percent were in recovery action.  In only a handful of cases were substantial changes to LVRs (loan to valuation ratios) the major factor that created the impairment of the loan.  The overwhelming majority of defaults were a result of monetary breaches of the loan covenant or a combination of both monetary and non-monetary breaches.”

Concluding Remarks

Consequently, if the recommendations by the Australian Small Business and Family Enterprise Ombudsman Inquiry into small business loans are adopted, the Inquiry considers that there is no justification for the banks to increase the costs of commercial loans up to $5.0m