Overview
Loan funding refers to the mechanism by which a bank obtains funds from the public, in order to make loans to its customers. Sources of funding include
- Deposits
- Intrabank Borrowing
- Bank Issues Bonds
- Repo
Loan Interest Expense
When a loan is priced, the rate charged for the loan must cover the cost of funding the loan. That is, the bank borrows money at the funding rate, and then lends it out. The rate received from bank lending must be higher than the funding rate.
However, a bank has money sources of funding, each with a different rate being charged, and many different loans. There are various methods that can be used to assign an interest expense to any given loan.
- Simple Blended Rate
- the simple blended rate just takes a weighted average rate from the banks funding sources and assigns it to each loan.
While simple, this approach ignores the fact that different loans have different maturities and hence different interest rate
risk profiles. The banks source of funding also has different maturies and risk profiles. In general, the banks treasury
will (and should) alter the banks source of funding in response to the risk profile of its loans.
If a simple blended rate is assigned, loans of shorter maturity will be charged a rate that reflects a loan of longer maturity, and vice versa. This means that short term loans will be priced out, and the bank will overweight its longer term loans. - Matched Maturity Rate - matched maturity charges the loan a rate that reflects the term of the loan, at a theoretical rate that the bank would receive if it were to raise those funds at the time the loan is originated. That is, if the loan is a 5 year loan, the bank calculates the rate that it could raise the required funds from the market for a 5 year term (this wold the risk free rate for 5 year funding plus a spread for the credit risk that the market associates with the bank) and then charges that rate to the loan in its loan pricing calculation.