A financial institution is planning to give a loan of $5 million to a firm. It e

Question

A financial institution is planning to give a loan of $5 million to a firm. It expects to charge an up-front fee of 0.20% and a service fee of 5 basis points. The loan has a maturity of 8 years. The cost of funds for the financial institution is 10%. The institution has estimated a risk premium of 0.15%. The current market interest rates for this type of loan is 10.1%. The 99th (extreme case) loss rate for borrowers of this type has historically run at 4%. The dollar proportion of loans of this type that cannot be recaptured on default has historically been 85%. Using the RAROC model, would you recommend that the institution make this loan? Why?

Explanation / Answer

LGD(loss given default)=85%

Probability of default(PD)=4%

Expected Loss=EL=4%*85%=3.4%

$EL=3.4%*5000,000=$170,000

capitalized EL over 8 years=$170,000/8=$21250

Revenues=$ 10.25%*5000,000=$512500(interest on loan given)

Cost of funds=$ 10%*5000,000=$500000

The one time  up-front fee +service fee=.20%+.05%=.25% can be capitalized over 8 years of loan so per year capitalized expense=.25%*5000,000/8=$1562.5

RAROC numerator=profit=Revenues-Cost of funds-capitalized upfront expense-capitalized EL=$(512500-500000-1562.5-21250)=$-10312.5<0 not recommended, losses.

RAROC denominator=Economic capital

RAROC=-10312.5/Economic capital <0 ,therefore you would not recommend that the institution make this loan as it would be making losses on the loan.

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