Pricing of Corporate Lending Under Basel III: A Practical Model Based Approach

Abstract

The rapid boom in regulation of the banking sector over the past couple of decades has resulted in significant changes for the sector, implementing demanding and costly requirements. The increased regulation is widely considered to have negatively impacted the profitability of the financial sector as a whole. With this in mind we set out to investigate the effects of the regulation implemented through the Basel III framework in the EU on Danish banks. The focus is strictly limited to corporate lending. We seek to develop a pricing model of bank loans to corporates, which under a set of widely used economic assumptions, will provide a framework for estimating the “true” cost of bank financing for corporates. Thus the model sets the lower limit on interest rates, which banks can offer without incurring an economic loss, when issuing loans. Relaxing the assumptions of perfect competition and rearranging the terms of the model, the model can used to price corporate lending given a target level of excess return. The model is derived from the drivers of banks’ economic costs, which given the assumption of perfect competition will exactly match all costs of issuing the loans. Cost of lending includes operating expenses and financing costs of raising the principal. Cost of financing is largely driven by the capital requirements under EU legislation, where minimum requirements of quantity and quality are stipulated. After fulfilling the legislative capital requirements the residual financing needs are assumed fully financed by deposits. Generally the model assumes that cost of capital, do, matter and that the costs related to different types of capital instruments differ. A number of arguments behind this statement is discussed including the low risk anomaly and risk transfer through non risk-related contributions to insurance programs. As a result of this debt financing is preferred and we can thus derive the target capital structure directly from the minimum requirements to equity capital. Further along these lines, banks will fund the required the liquidity buffer under Capital Requirement Regulations (CRR), with as high a degree of deposits as possible. In addition to these primarily regulatory driven costs, there is also the cost of the client’s default risk. This is estimated through credit default swaps. The costs involved in a marginal loan will therefore consist of an operating cost, a cost of regulatory capital, a funding cost, a liquidity cost and a credit risk cost. We establish the quantity of each, which a new marginal loan issue will require them to hold, given the current regulation. In turn we then estimate the corresponding price of the different capital classes. The costs are then expressed in relation to the invested capital, to give the effective after tax interest rate that the loan must earn, for the bank to cover its costs.