Lending math: How banks make money on loans

Parth PandeCo-founder & CEO, Financebuddha.comLending is one of the primary functions of a bank; the bank takes deposits from customers and then lends them out to borrowers at a significantly higher interest rate than what is being paid to the customers as deposit rate. The cost at which the bank borrows money (the money can be from retail customers, institutions or even the government) is known as the cost of funds (COF) of the bank. The bank now starts loading all the cost structures that it has on top of the COF to arrive at the minimum hurdle rate at which it has to underwrite the loans at. The costs involved at the banks end are:-• Distribution, Marketing & Acquisition costs• Loan Processing and Underwriting costs• Loan Servicing and Maintenance costs• IT & Collections costs• Risk CostsBroadly, the overall operating costs of the bank are included in the above stated headings which also includes the cost of the people employed by the banks (their salaries and bonuses- this has been a contentious issue in the past, where regulators in many countries have clamped down on senior management bonuses at banks), the costs of the infrastructure of the bank (costs of branches, ATM’s etc) and other support costs of the bank (admin/HR costs etc).Let us now take each head of cost one by one, and see how each impacts the lending math, and how the changing banking and fintech landscape can have a positive impact on all of the above:-Distribution, Marketing & Acquisition Costs: This is perhaps the most significant cost for the bank, as getting customers is expensive. In addition, banks which are relatively newer and do not have the same existing customer base as an older bank may find the costs to be significantly higher, also banks have traditionally acquired customers through branches which have proven to be expensive in the long run. Now, the focus of a lot of banks is on direct customer acquisitions either digitally or through marketplaces and aggregators which can substantially lower the cost for the bank. In addition more data on consumers would increase the ability of the banks to run offers for the customers, thereby significantly reducing the costs of acquisition.Loan Processing & Underwriting Costs: This is the space which is seeing the maximum amount of disruption in the banking/fintech space. The premise of this argument is that technology platforms are now more nimble and effective, which require lower capital expenditure and the analytics piece for a bank has become important, which gives them more flavour on every customer sourced and thus can help in better and more efficient decision-making at lower costs. In addition, a lot of the credit underwriting processes are getting centralised and the digital methodologies being adopted by consumers and bankers will significantly lower the costs for the same, which can lead to lower costs of borrowings for the customers in the long-run.Loan Servicing & Maintenance Costs: These are costs for servicing and maintaining existing customers; the same is being significantly reduced by technology interventions and by creating self-service modules for customers to get details about loan payments, repayment schedules, etc.IT & Collection Costs: Lot of banks are still living with archaic technology systems, and have not kept pace with all the computational and technological advancements that have taken place; however, we are now seeing a shift in the philosophy of banks towards more nimble and more cost effective technology solutions. In addition, the costs of collections involves the monies spent on recovering delinquent accounts, by using more innovations and digital/mobile footprint mapping, better collections efficiency can be reached.Risk Costs: This is perhaps the most important piece which defines the pricing of a loan. It’s important for customers to understand that from a bank’s point of view every customer carries a different quantum of risk involved on the basis of their overall profiles. Traditionally, the banks have always looked at risk in a segmental fashion and hence priced customers on the basis of that point of view; however, we are now reaching a stage where consumers are being looked as individuals and not parts to a bigger segment and hence concepts like Risk Adjusted Rates (RAR) are coming to the forefront. It’s important for banks to move completely to risk-based pricing of loans as that will ensure that better customers benefit from lower rates.It’s also important for the customer to understand, that many factors go into the pricing of the loan which is not only about the rate of interest, but also the processing fees of the loan; other charges (part payment/pre closure), and any products being cross-sold by the bank. Lot of banks try to bundle other products like insurance/investment etc with loans; the same should be evaluated by the customer and only taken by them if they see a genuine merit in the product.In the end, it’s important to reiterate that the overall dynamics of the lending industry depends on its ability to lower costs through technology and digital disruption, and by customers becoming more aware and open to self service modes; this may result in much lower costs for the banks and hence lower costs for the customers.