The 5 Ws behind three simple digits
Complex calculations that determine your cost of debt are reduced to just three digits… and that’s your lending margin.
These little percentage figures impact profitability by setting the cost of your debt.
To determine the margin to charge a borrower, a lender must ask;
Who is my borrower?
A bank’s appetite to extend funding is unique to each business’ history and bank relationship. This is the credit worthiness angle, which we have previously touched upon, and boils down to a quantitative metric known as the ‘probability of default’ or PD. This is important, because a financially strong borrowing entity should receive superior pricing over that of a weak entity, due to their lower PD. This is to satisfy the law of risk vs return that higher risks require higher rewards, and vice versa.
What are the costs?
The major costs to consider are cost of funds and cost of capital as they both make up a significant portion of margin funding.
Cost of capital is related to the ‘who’. A riskier borrower requires larger unexpected loss capital to be set aside to cover losses in the event of a default. Cost of funds is a blend of the bank’s funding portfolio costs including wholesale and customer funds.
Which product suits the borrower?
The type of product can also impact pricing. Different product classes include term lending, revolving facilities, asset and equipment financing or contingent liabilities such as bank and performance guarantees.
When does the facility expire?
The facility term is an important factor in margin pricing as it factors into both cost of capital and cost of funds calculations. Much like a riskier borrower, a longer commitment attracts a higher level of risk-capital to cover unexpected losses.
And in keeping with the risk vs reward principle, the price of raising term wholesale funding increases with tenor. 5-year wholesale funding should cost more than 3-year wholesale funding.
Why is the funding needed?
While not strictly a quantitative factor in risk-based pricing, the intended purpose of the funds is an important consideration for the bank. The purpose for the funding is more likely to contribute towards appetite for funding via a binary ‘yes or no’ but will feed into the more credit decision process in a more general blend of a ‘who + why’.
The basic premise here is that a bank has a responsibility to its shareholders to be prudent managers of other people’s money. Shareholders are receiving debt returns for (wait for it…) the provision of debt. Hence, it would be cheeky for a company to ask for debt funding to simply cash out other shareholders serving to replace equity with debt. Likewise, CFOs may have asked for 100% acquisition funding only to be met with a requirement to ‘put some skin in the game’ with an equity contribution. At its simplest this is just appropriate risk sharing between debt and equity holders.
So, what does it mean?
The above ‘who-what-which-when-why’ gives an introduction to margin pricing has been designed to provide an intuitive feel for some drivers of your margin. If you’d like to go into a deeper dive, get in touch with the BankEdge team.