How a Bank Sets Their Interest rates for Commercial Lending

How a bank sets their interest rates for commercial lending.

Recently I have had a number of conversations with clients around how banks set the interest rates for business, commercial investment and development lending and what might happen if the OCR begins to fall later this year. I thought it would be prudent to put a blog together on risk-based pricing and how it differs from residential property.

All unsecured business, commercial investment and development lending interest rates are determined utilising risk-based pricing with NZ banks. In simple terms this means that the bank's interest rate margin is set relative to the perceived risk of the lending and is therefore unique to each loan.

Each bank is required to carry certain levels of capital relative to the risk of their underlying loans. Each bank is also a publicly traded entity and therefore they seek to maximise their return on that capital. The risk of a loan is broken out into two key metrics being the Risk of Default and the Risk of Loss.

Risk of Default

Risk of Default is the risk that a borrower will default on its loan. It is a reflection of the risk of the credit and can be affected by many different things.

For a trading business this could be the level of growth of the business (high growth companies are risky as they require a lot of cash), the profitability of the business or the strength of the businesses balance sheet (think level of equity, current ratio etc).

For investment properties it can be to do with the level of gearing, the interest cover ratio, location or strength of the tenant.

For developments it relates to the Loan to Cost ratio (equity), development margin (profitability) and pre-sale cover as well as the experience of the developer and project team.

Risk of default also includes intangible items such as the strength of the sponsor (how much wealth / capital they have), experience and expertise of key parties, credit history with the bank and even integrity of the borrower.

The stronger these items, the lower the risk of default and therefore the less capital a bank is required to allocate to a loan. The less capital allocated the better your interest rate.

Risk of Loss

Risk of Loss is the risk that a bank will lose money if the borrower defaults. This focuses on the security position of a bank. If a borrower defaults and the bank is required to sell down assets to repay the loan this is a measure of how likely they are to receive enough money to repay all the debt.

In property secured lending (Development and Investment) this is a focus on the level of gearing against the property – the Loan to Value Ratio (LVR). If the borrower defaults and the assets are sold at a discount how likely will the bank get their money back.

In senior business lending there may be property security attached to the loan, however often there isn’t. Lending is, for certain businesses, made against the forward cash flow of the business and its balance sheet. In these instances, there is a review of the strength of the businesses balance sheet (debtors, stock, fixed assets etc.) to make a judgement as to the level of recourse a bank would have in the event of default.

Like the Risk of Default, the lower the Risk of Loss (i.e. the more secure the banks position) the less capital the bank is required to carry against the loan. Again, the less capital the better your interest rate.

The other facet of bank pricing is competition. When banks are seeking to grow their balance sheets (take on further lending) they may set their risk criteria slightly above competitors or set their interest rates slightly below competitors. The greatest example of this we have seen in recent years is KiwiBank who have taken a slightly higher risk position to most other trading banks in order to grow their commercial and property books and win business.

We do, also, see banks price very competitively for strong deals where it is a great benefit to win them.

So, if you are looking to improve your interest rates with a bank the best thing you can do is to remove risk. If you need someone to help you do that, reach out today and we can give some advice and put you in touch with the right people to help!