When it comes to product pricing, adhering to a disciplined approach is critical. Often, institutions use an economic transfer price as a benchmark for performance and product pricing, also known as a funds transfer pricing (FTP) framework. Returns based on economic pricing can be thought of as an economic return on equity (ROE). Economic ROE has the important distinction of being market-based, eliminating arbitrage by business units and borrowers.
Firms often benchmark pricing to market-based sources to avoid having commercial spreads fluctuating with the market. For example, in a rising rate environment, if the offer rate on an auto loan is not adjusted to account for a higher yield curve, the effective credit spread charged to the borrower is diminished.
This situation is illustrated in Figure 1, showing two rates charged to two borrowers: one with a negative credit spread, and the other with a positive credit spread – both of which we have witnessed. Certainly, positive spreads are frequently more beneficial to an institution, but negative spreads aren’t automatically bad. Perhaps more important than the numerical value of the spread is ensuring that the value is intentional – does the institution recognize the corresponding costs and benefits?
Basics of an Economic ROE Benchmark
The following elements should be considered when economically pricing loans for FTP purposes or for pricing offer rates:
- Cost of debt funds
- Operating costs
- Credit costs
Cost of Debt Funds
Sometimes called the cost of the mirror debt, the economic cost of funds is simply the benchmark interest rate curve. The mirror debt fully replicates the asset’s cash flows, such that the margin of the asset is immune to interest rate movements. When run in an option-adjusted spread (OAS) cash flow model, the mirror debt is constructed from a series of zero-coupon debt positions. For mortgages and other option-embedded assets, the options cost should be included in the pricing.
While it may sound complex, the calculation is actually straightforward and simple to produce, given the right tools. The significant benefits arise from the avoidance of arbitrage from the typically upward-sloping yield curve. Additionally, it allows for cross-comparison between assets of varying maturities and embedded options.
To be comparable to a spread mark-up, operating costs should be expressed as a percent of loans. While operating costs often are expressed as a fixed fee, converting to a percent can be done by dividing by the loan amount. Operating costs represent acquisition costs (such as a broker fee) and ongoing servicing costs. Sometimes, servicing income is generated, which would be netted to produce an all-in noninterest cost.
Especially with the addition of the current expected credit losses (CECL) policy to accounting standards, measurement of the cost of credit risk has come under increased scrutiny. Also important to the credit loss assumption is an assumption of capital charge. A risk-free asset has expected losses of zero, and therefore no capital charge. However, for credit-risky assets, an expected credit loss assumption and risk-weighting must be used.
Commonly, credit losses are derived from historical loss data. However, they must be forward-looking for projecting economic return. Credit losses can be divided into two components: probability of default and loss given default (LGD). The capital charge is then based on the perceived riskiness of the asset. In a regulatory framework, the risk weighting would drive the capital charge.
Adjustments to the economic benchmarks for business purposes are called mark-ups, whether for spurring loan growth, disincentivizing certain products, adjustments for perceived risks, etc. When calculating an economic ROE, the mark-up represents the risk-adjusted profit spread based on the expected costs of the asset.
As we have witnessed with the recent rate movements, some institutions are charging mark-downs, meaning after all costs are incorporated, risk-adjusted spreads are negative. This leads to negative on-the-margin ROEs. While this could be intentional, as in the case of a firm with low cost of funds passing the savings on, it could be an inadvertent effect of rising interest rates.
Figure 2 demonstrates the essential elements of a lending rate discussed in this article. Pricing to economic benchmarks not only helps an institution price risk more effectively, but it has the added benefit of separating economic variables from business and lending decisions.