Question

A bank offers one-year loans at a rate of 10%. For a certain segment of customers, the bank also charges a 100 basis point risk premium. This bank charges a .20% loan origination fee and imposes a 9% compensating balance requirement. The bank pays a 5% reserve requirement to the Fed. What is the return to the bank on these loans? If the bank would like to increase their return, what could they do?

Answer 1

Actual loan =Bank loan *(1-(Origination Fees + Compensating Balance Requirement))

Actual Loan = 100 * (1 - (0.2% + 9%))

Actual Loan = 100* 90.8% = $90.8

One Year Loan Rate = 10%

Bank Reserve requirement = 5%

Net Margin available to bank = One Year Loan Rate - Bank reserve requirement = 5%

Actual Return generated on $ 100 loan = $ 5

Return to bank on these loan = $5/$90.8 = 5.5%

There are two ways to increase return:

• Increase interest rate from 10% to higher
• Increase origination fees or compensating balance requirement