Question

Commerce Bank makes a $1,000,000 business term loan. All interest and principal will be paid after one year. The bank offers a 4% prime rate to its best customers. Based on the loan officer’s credit analysis, the appropriate risk premium for this business borrower is estimated to be 2%. The bank charges a 0.2% origination fee to cover costs incurred during the underwriting and some of the overhead expenses. The borrower is required to keep a 10% compensating balance according to the contract. The Federal Reserve imposes a 3% minimum reserve requirement on all banks.

1). What is the return to the Bank on this loan?

2). If the borrower has 3% chance of defaulting and the loss given default is 40%, what is the expected return on this loan?

3) If the return is not large enough, what can this bank do to increase the return and expected return?

Answer 1

The minimun reserve of 3% indicarles that the Bank of a deposit of $1,030,927.84 will retain $30,927.84 and Will be able yo lend $1,000,000.

For question #1 the return yo the Bank = (cash inflow within 1 year / cash outflow at tome 0) - 1

This equals:

Cash inflow =

Amount of the loan + 2% for Cost + 10% balance of compensation = $1,000,000 + $1,000,000*0.2% + $1,000,000*10% = $898,000

Cash outflow =

Loan payments + 4% interest +2% risk premium - 10% compensation balance = $1,000,000 + $1,000,000*4%+ $1,000,000*2%+ $1,000,000*10% = $960.000

Return of the Bank = (960,000/898,000) - 1 = 0.0690 * 100 = 6.90%