Sesiones

As part of the methodologies used in this project and in order to have meaningful results, I use a loan-pricing model similar to Bauer and Agarwal (2014) to derive the credit spread for the SMEs classified in each of the 10 portfolios:

R_𝑖 =𝑝𝑖(𝑌 = 1)

𝑝_𝑖(𝑌 = 0)𝐿𝐺𝐷 + 𝑘

Where Ri is the credit spread for portfolio i, pi(Y = 1) is the probability of default for

portfolio i; pi(Y = 0) is the probability of non-default for portfolio I; LGD is the loss in

The bank rejects all firms with probabilities that fall in the top 10% (highest probability of default) while offering credit to all others at a credit spread it derives using the above model. The reason for rejecting the top 10% (or top 5% in practice) of firms is because, from a lender’s perspective, the cost of granting credit to a firm that fails subsequently is much higher than the cost of refusing credit to a firm that does not fail. As a result, it would be less costly for the bank to reject credit to firms with the highest probability of default (Dietsch and Petey, 2002; Stein, 2005; Blöchlinger and Leippold, 2006).

The essential factors in debt pricing are the term structure of risk-free rates and the default risk of the borrower. Many models have used leverage to determine the default risk after Merton (1974). The pricing of loans is spread over the cost of funds of banks. Credit evaluation concentrates diverse arrangements of logical factors, taking into account the interest rate. In general, SMEs are less sensitive to loan pricing due to lack of financing. Most SMEs tend to accept higher pricing and sometimes, the owners of these SMEs use several funding sources such as credit cards. SMEs are vulnerable to changes in pricing (Walker, 2010).

Berger and Udell’s (1990) study on a portfolio of loans reveals that the pricing of loans is based on a margin that is added to an interbank lending rate. The study has a high confidence level at 5% and indicates that there are factors that affect loan pricing decisions. These are the natural logarithm of the loan amount, the tenor, the security provided by the borrower, the type of facility as a non-revolving or committed facility and the type of commercial paper supporting the loan. Other factors include the cross- border boundaries in which the loan is extended and whether it is a local bank or foreign bank. The type of financing affects the loan pricing in cases when it has bilateral or

syndicated financing. The cost of fund benchmark is also a major determinant for loan pricing (Berger and Udell, 1990).

Similarly, another high confidence study (Booth, 1992) at 5%, demonstrates that there are other factors affecting loan pricing. These are the logarithm of revenues, collateral provided by the borrower, the amount of financing and the availability of commitment fees paid by the borrower. Other factors include the terms in which the financing is extended (as committed financing or uncommitted financing). More determinants include the type of financing such as working capital, CapEx financing, or acquisition finance. The completion and the availability of similar borrowers in the industry has an effect on the pricing of debt. The legal structure of the ownership and corporate governance influence the pricing as well. The credit rating, in general, is the determining factor of the loan pricing (Booth, 1992).

Furthermore, Peterson and Rajan’s (1994) study of a bank’s portfolio shows that there are several determinants for banks to price loans extended to customers. These are:

 The rate at which the loan is extended (floating or fixed).

 The client’s historical performance and revenue growth.

 The risk-free rate in which the loan is priced.

 The spread between the sub-investment-grade rating and risk-free rate.

 The number of years the entity has been running.

 The entity’s gross profit/assets.

 The debt service coverage of the client.

 The risk rating of clients.

Berger and Udell (1995) utilize a similar dataset even though it is designed to investigate the spreads over risk-free rates. They reveal 22 factors affecting loan pricing at. They show that the most important factors determining pricing are the history of default and the length of the association between the client and bank (Berger and Udell, 1995).

There are several loan pricing methodologies. One of the most well-known methodologies is the risk-adjusted return on capital (RAROC). RAROC is used by banks in pricing loans based on the economic capital against the risk rating of the borrower. The idea was created by Investors Trust and its main creator Dan Borge in the late 1970s (Diebold, Doherty and Herring, 2008). The following is the formula for calculating RAROC:

RAROC = Expected Return / Monetary Capital or,

RAROC = Expected Return / Value at Risk (Prokopczuk et al., 2007).

Value at risk takes into consideration the different types of risk including credit, operational, liquidity and other economic risks.

Economic capital is the capital needed to sustain credit default. RAROC is one of the pricing approaches Basel III recommends (BCBS, 2010). There are some disadvantages in using RAROC. The most common disadvantage is the opportunity cost as a result of net lending money. For example, in some cases, banks refuse to lend to certain clients because the calculated RAROC for the client, based on this risk rating, is lower than the benchmark. The client at the same time refuses to take the loan because of pricing issues. In this case, the bank will leave the loan in the balance sheet at a risk-free rate for quite some time, during which the bank can incur opportunity cost as a result of lending to this client. In these cases, the bank has to manage the liquidity and decide on

the optimal investment/lending mix in order to maximize the return on equity, risking an adjusted return on capital (RAROC) (Dermine, 1998). In order to simplify the research, I am using a pricing method based on Bauer and Agarwal (2014), which offers a useful balance between the academic literature and the practical aspect of my research since I do not have to include the several cost components used in RAROC.