A risk management approach to commercial loan pricing : comparative analyses across large & small banks

Abstract

Local Banks offer various services such as investment services, personal and commercial loans, direct credits amongst others. Commercial loans are considered one of the most important businesses that generate revenue to banks. Most banks grant commercial loan facilities for short, medium and long - term depending on the nature, capital expenditure and the expected economic useful life of the investment being made in the business. However one has to take into consideration the risks involved in such business. In fact, banks must be aware of the consequences and effects when a particular loan defaults, especially, if the particular loan is a commercial one Once the decision to grant credit has been made, the terms of the loan must be set, including the price of the loan or its rate of interest. Non price terms include, such items as compensation balance requirements, size of the loan, maturity, and collateral requirements. The aim of this dissertation is to review the existing theory and practice concerning the risk management approach to commercial loan pricing as well as the strategies and techniques used. Another aim is to analyze the stage and stand at which Maltese banks operate as regards to Commercial Loan Pricing techniques, by comparing to what is done in practice and mentioned in theory, and also by comparing and contrasting as to what is done abroad. Finally the aim of this dissertation is to put any recommendations for any possible improvement that local banks could apply in the Risk Management Approach to Commercial Loan Pricing systems. After various meeting with the heads of the commercial loan department of the four main banks, mainly HSBC, BOV, Lombard Bank. and APS Bank, it was found that a sufficient percentage of bank loans consist of commercial loans. As a consequence, necessity was felt for bank to gradually increase their risk management policies and strategies. One can conclude that in some areas such as internal controls, client's reviews and staff training amongst others are considered very important by local banks. In fact, from the survey bank re-payment defaults rarely occurred, meaning that local banks have a sound and adequate risk management approach. However given the limitation of availably of data might be impeding local banks to implement new credit models or lending practices. It was found, that most of the local banks do not make use of credit models such as credit scoring models. It was also found that most banks lack an adequate internal rating system which is very useful in assigning prices in relation to risk. In addition to this, local banks should also consider other techniques and methods to manage credit risk, such as securitization, asset backed securities, collateralized loan obligation, credit derivatives and other hedging instruments. Although the role of credit analyst is not used by most banks especially small banks, it should be considered in the risk management approach to commercial loans as his role will surely help small banks to enhance risk management of commercial loan and also help the bank in deciding whether a particular loan application should be accepted or refused, which he thinks is of best interest for the risk exposure of the bank.