Loan Pricing Under a Rising Cost of Funds
A corporate lending desk is pricing a GHS 50m five-year term loan to a manufacturing client rated BBB. The bank's marginal cost of funds is currently 18.5% and is expected to rise 150 bps over the next 12 months. The loan will be priced at a fixed rate. Operating cost allocation is 2.2%, expected credit loss (through-the-cycle) is 1.4%, and the bank targets a 3.0% return on the GHS 50m economic capital allocated at 8% of exposure. The client has an alternative offer at 22.0% fixed from a competitor and is pressing hard. The relationship generates GHS 1.8m of annual fee income (transaction banking) that would be lost if the client walks.
1. Calculate the minimum economically viable fixed rate and compare it to the competitor's 22.0%.
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Build the rate:
- Cost of funds: 18.5% (but see funding-risk adjustment below)
- Operating cost: 2.2%
- Expected credit loss: 1.4%
- Capital charge: economic capital = 8% × 50m = GHS 4.0m; required return = 3.0% × 4.0m = GHS 0.12m; as a % of the 50m exposure = 0.24%
Base minimum rate = 18.5 + 2.2 + 1.4 + 0.24 = 22.34%.
That already exceeds the competitor's 22.0% before accounting for funding risk. Because the loan is fixed-rate for five years while funding costs are rising 150 bps, the bank bears repricing risk. If we assume the average funding cost rises ~75 bps over the loan's life, the true hurdle is closer to 23.1%.
Judgement: At 22.0% the loan is value-destructive on a standalone basis.
2. Decide whether to match the competitor's 22.0%, factoring in the relationship.
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Relationship economics: The GHS 1.8m annual fee income, capitalised at roughly the same 3% return-on-capital lens, is worth considering. If the loan is priced at 22.0% versus a 22.34% standalone floor, the shortfall is 0.34% × 50m = GHS 0.17m per year, or about GHS 0.85m over five years undiscounted. The fee stream of GHS 1.8m/year (GHS 9m over five years) vastly exceeds that shortfall.
But matching 22.0% does not cover funding risk on a fixed-rate basis. The resolution is structural, not just price: offer 22.0% but convert to a floating rate (or a 2-year fixed with a repricing reset), which removes the 150 bps funding-risk exposure. If the client insists on five-year fixed, price at 22.5% and accept losing the deal only if fees cannot be cross-sold at renewal.
Recommendation: Match 22.0% only with a floating/reset structure; retain the relationship and its fee income. Do not lock five-year fixed at 22.0%.