Loan Pricing

Loan pricing is a surprisingly multifaceted undertaking touching on asset-pricing theory, accounting principles, corporate finance, and the fundamentals of risk management. Taking a tour of these modern financial concepts, this chapter builds on previously discussed economic-capital ideas to construct a risk-adjusted return on capital. Each loan decision is treated as a separate investment project with these risk-adjusted returns acting as a (fair) enterprise-wide decision criterion; this is accomplished by incorporating cost recovery, firm capital structure, portfolio concentrations, and the risk-return characteristics of the individual loan. The following discussion, quite naturally given our focus, touches solely on the quantitative aspects of loan pricing. Market forces and an institution’s mandate or strategy play an equally important role, but are beyond the scope of this work.