Along with credit risk, origination and servicing costs, the cost of funding a commercial loan is probably the least understood, and represents the highest cost in the loan pricing process. There are many methods for determining the funding cost, anywhere from a “guesstimate” to very sophisticated techniques that when all is said and done, none are perfect. To be perfect, the funding behind the loan needs to have exactly the same re-pricing characteristics as the loan being funded. If the financial institution “matched funded” every loan it originates, this would indeed eliminate the risk being discussed here. This is very difficult to do and quite honestly may not be the best from a profitability standpoint. To match fund every loan eliminates interest rate risk but at the same time eliminates interest rate opportunity. However, that interest rate risk/return variable should be monitored and controlled by the treasury function of the organization. The pricing of the loan should not bear that burden, nor benefit if interest rates go up or down.
Many in-house pricing models use current funding costs for setting the cost of funds which can be significantly different than the economic cost of funds, thereby either inflating or deflating the value of the loan being priced.
Other models may use a yield curve based on the institution’s certificate of deposit maturity structure. This is only valid if the institution is indeed booking certificates of deposit of similar duration to the loan being priced. Oftentimes most certificates of deposit received by an institution have durations of much less than one year while the duration of many fixed-rate loans exceed one year.
The pricing of the loan should be based on the “economic cost of funds”. This cost is set based on a proxy of what a matched cost of funds would be had the loan been matched funded. The only way to get this proxy is to determine what the duration of the loan is and then find a funding source with exactly the same duration. The cost of that matched funding source then becomes the cost of funds. Although the institution may have the ability to get funding behind the proxy as an available source of funds, it is up to the treasury area of the bank to take advantage of that funding or not and therefore, taking that funding risk/opportunity from the pricing of the loan.
This is yet one more reason that a sophisticated analysis of the duration of a loan is extremely important in the pricing of a commercial loan. We at the hurdle group have spent a great deal of time considering the best of the alternative methods for determining the duration and have incorporated it into its loan pricing model.