Recently I have had a number of conversations with clients around how Banks price their business, commercial investment and development lending and why at the moment we are not seeing commercial rates fall with the alacrity of the OCR. I thought it would be prudent to put a blog together on risk-based pricing and how it differs to residential property. All unsecured business, commercial investment and development lending is priced utilising risk-based pricing with NZ banks. In simple terms this means that the banks margin is priced for 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 and they all seek to maximise their return on that capital. The risk of loans is broken out into two key metrics being the Risk of Default and the Risk of Loss.
Risk of Default is the risk that a borrower will default on it’s 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), the profitability of the business or the strength of the businesses balance sheet. For investment properties it can be to do with the level of gearing, the interest cover ratio or amount of tenancies the property has. For developments it relates to the Loan to Cost ratio (equity), development margin (profitability) and pre-sale cover.
Risk of default also includes intangible items such as the strength of the sponsor or management, experience 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 a bank can price a loan.
Risk of Loss is the risk that a bank will lose money if the borrower defaults. This is focusing on the security position of a bank. In property backed lending (Development and Investment) this is a focus on the level of gearing against the property, how highly leveraged the bank is. If the borrower defaults and the assets are sold at a discount 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. Often lending is 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. more secure the banks position) the less capital the bank is required to carry against the loan. Again, the less capital the better banks can price their loans.
For example, a bank may lend two businesses $1,000,000.00. One may be a strong business with a low risk of default and the debt could be secured by some property giving a low risk of loss. The bank for this business may be required to hold $200,000.00 capital (cash) against that loan. The other business may have a higher risk of default and no tangible security against the loan. The bank in that situation may be required to carry $300,000.00 of cash against that loan.
In very simple terms, if the bank were seeking a 25% return on their capital then the less risky loan would require an interest margin of 5% ($50,000.00 interest on $200,000.00 of capital). The riskier loan would require an interest margin of 7.50% ($75,000.00 interest on $300,000.00 of capital).
Per the above, whilst the OCR has been cut and we have the seen the cost of capital for banks fall steeply in the most recent few months (albeit the OCR is NOT the only cost of capital for banks) the risk in the market has risen and therefore a corresponding fall in price hasn’t been seen.
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 price slightly below competitors. Currently however each bank is more or less focussed internally (albeit KiwiBank are still seeking new business for good credits). The result of this is less competition which removes some downward pressure on rates and allows banks to retain strong margins.
Overall, we are in an environment where there is heightened default and loss risk (trading has been stunted by Covid-19 and asset values may fall) and therefore banks are pricing appropriately. They are also not being pressured by their peers to reduce this allowing the market rates to remain buoyant.
As the economy recovers, we should see this change, however, until then I would expect to see rates remain inflated (albeit at historic lows). As always, it is worth working with an adviser to help manage the risk of your project / business / investment and navigate that banking system to get a good price and facility.