Deciphering the math: How banks set interest rates on loans

Money Markets

Banks use different concepts to determine interest rates. It is, however, important to note that many lenders charge fees as well as interest to raise revenue. Photo/FILE 

By Edwin Mucai

In Summary

Banks typically price credit facilities by taking into account three main factors — a benchmark rate, a credit risk premium based on the credit quality of the borrower and lastly a term-funding premium for credit facilities whose tenor is more than one year.
To lower the cost of credit

• Government needs to work towards a balanced budget primarily by ensuring that the tax base is increased – in terms of volume and value.
• Banks to look into ways of lowering their costs of delivering credit through innovation as well as investment in state of the IT technology to enable more efficient processing and monitoring of credit facilities post origination.
• Borrowers awareness of when to borrow and how much will improve overall credit quality which will lower the credit premiums charged.

For quite some time in Kenya, there has been a lot of debate in the public domain about the interest rates charged in respect of the credit facilities.

In this article, I hope to clarify, as a practitioner in the financial services industry, some of the considerations that banks take into account when they determine the interest rate to charge for loans. The term loans and credit facilities have been used interchangeably through-out the article.

Before going into the detail of the loan pricing, it is important to set some context by first explaining the balance sheet structure of a typical bank.

A balance sheet is the financial statement of an entity’s financial position which shows the bank’s sources of funding on one hand and how that funding has been deployed to acquire assets on the other hand.

A bank is funded primarily from two sources—from shareholders’ equity (in the form of share capital, share premium) and from depositors’ funds. The other side of the balance sheet, is a bank’s assets which are primarily cash and bank balances, other near-cash investments such as Treasury bills, fixed assets (such as branches and IT infrastructure) and last but not least, loans to customers.

Banks typically price credit facilities by taking into account three main factors — a benchmark rate, commonly referred to as a base rate, a credit risk premium based on the credit quality of the borrower and lastly a term-funding premium for credit facilities whose tenor is more than one year.

Further, the base rate is typically determined using two main inputs — the risk free interest rate and the cost of delivering credit to borrowers.

The risk free interest rate is typically the rate at which the government borrows at – in our case, the rate Central Bank pays to raise funds in the Treasury bills and bonds auctions.

The government is considered risk free since its highly unlikely to default on its debts as it has a number of tools at its disposal to manage the default risk such as increasing taxes to avail more money to pay its obligations and in an extreme situation, it can print money to repay its obligations though this would be highly not an advisable move.

In our Kenyan market, we lack a consistently applied Kenya shilling benchmark rate on which to set the risk-free rate as is the case internationally where, for example, US dollar Libor rates of different maturities are used to price US dollars for those maturities.

As a result, depending on an individual bank’s desired balance sheet structure, the practice of setting a risk-free benchmark will vary with some banks using the three-month, six-month and one year Treasury bill rate as their benchmark resulting in the benchmark rate sitting in a range. For the last 12 months, this rate has fluctuated between 10 and 12 per cent.

Upon establishing the risk-free rate, a bank would typically add to it, its cost of delivering credit facilities.

Whilst the composition of these costs will vary significantly from bank to bank, they would typically include the cost of staff employed in the credit department to originate, evaluate and manage the credit portfolio post origination, a charge for the IT infrastructure used in performing credit scoring, booking and maintaining the loan records, the cost of other credit department units such as its legal department which manages lending agreements and securities provided by borrowing customers amongst other costs.

My estimate is that for a typical bank providing unsophisticated loans they incur between three per cent to five per cent to deliver credit facilities.

Based on the above analysis, the estimated base rate will vary from 13 per cent to 17 per cent - being Government benchmark rate of 10 per cent - 12 per cent plus the average cost of delivering credit of three per cent five per cent.