Question

risk-adjusted income = loan principal × all-in spread

all-in spread = interest rate – expenses per $ of loan + fees per $ of loan

value at risk = loan principal × LGD × unexpected default rate

TD Bank is planning to make a $1,500,000 business term loan. All interest and principal should be paid after one year. The bank offers an 8% prime rate to its best customers. According to the loan committee’s credit assessment, the appropriate risk premium for this business borrower is estimated to be 3%. The bank charges a 0.25% origination fee to cover overhead costs. The bank normally incurs a 0.15% advertising expense on business loans and 10.8% cost of funding the loans. Using past 100 years of data to construct a loan default distribution, the bank predicts that the probability of default for this type of loans should be 4% if the worse-case scenario occurs in the economy. Finally, if the borrower defaults on the loan, the bank will seize the collateral but will still have to bear a 60% loss.

Questions: 1) What is the all-in spread for this loan?

        2) What is the RAROC of this business loan?

        3) Suppose that the bank’s ROE is 10%, should the bank make this loan or not? If the bank’s ROE is 15%, would your recommendation change?

Answer 1