Question

Q3) A bank is planning to make a loan of $5,000,000 to a firm in the steel industry. It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The cost of funds (the RAROC benchmark) for the bank is 10 percent. The bank has estimated the maximum change in the risk premium on the steel manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market interest rate for loans in this sector is 12 percent Using the RAROC model, determine whether the bank should make the loan?

Answer 1

The formula to calculate loan risk is given below: Change in risk premium Loan risk = -Duration of loan * Loan amount | 1+interest rate Substitute 7.5 for duration of loan, $5,000,000 for loan amount, 0.042 for change in risk premium and 0.12 for interest rate, Loan risk =-7.5x$5,000,000x 0.042 (1+0.12) =-$37,500,000 0.0375 = -$1,406,250 The total fee and interest income received on loan is calculated below:

Total fees and interest = Expected interest +Service fee - Cost of funds T(0.12 * $5,000,000) = +(0.005$5,000,000) -(0.10 $5,000,000) = $600,000+ $25,000-$500,000 = $125,000 The RAROC is calculated below: Total fees and interest RAROC = Loan risk $125,000 $1,406,250 = 0.089 The RAROC is 8.90% and the cost of fund is 10%. Here, the cost of fund is higher than the RAROC. Thus, the loan should not be given by the bank.