A Loan Pricing Model: The Influence of the Lender's Credit Rating

Abstract

Within the context of a banking institution, economic capital is a statistical measure of the amount of resources required to meet unexpected losses over a specified time period and specified level of certainty. The amount of economic capital held by banks is thus a function of their target insolvency rate (the probability that losses will exceed a certain threshold) and is linked to an implied credit rating. In Australia, for example, the top four banks maintain sufficient economic capital to achieve a target credit rating of AA, which is equivalent to a 0.03% probability of insolvency. The benefits that accrue to banks from a high credit rating, in general, are access to lower cost funds in debt markets and low counterparty margins in swap and foreign exchange markets. However, as banks increase their economic capital to achieve a higher credit rating, the breakeven price on their asset portfolios will rise to the extent that the bank prices these assets to achieve a minimum return on economic capital. Ceteris paribus, the increase in loan rates may make the bank uncompetitive in specific asset markets, depending on the extent to which loan rates and other asset prices are market driven. Thus an increase in the solvency standard for a bank has two opposing effects on bank asset prices. To the extent that a bank prices its assets to achieve a target return on economic capital, an increase in economic capital will increase the net income that the bank needs to earn on its assets, resulting in higher asset prices. Offset against this, is the impact of a higher solvency standard on the cost of funds and market credit spreads for the bank. We propose that a bank that carries a large proportion of its funding book in retail funds may not benefit by targeting a high credit rating, depending on the sensitivity of retail depositors to incremental changes in credit rating. We model this relationship to ascertain an optimal economic capital requirement, varying the relative proportion of retail funds in the funding book. We compare the results of our model to empirical data on bank credit spreads in capital to markets to assess the extent to which an upgrade in the credit rating of a bank will be beneficial to the bank.