Step 1: Calculate Net Interest Margin
The first step in evaluating a loan is arriving at loan level net income.
To get there, start with:
- Interest income from the loan, plus
- Other fees and charges, less
- Interest expense (the cost of funds from customer deposits or borrowing money from elsewhere)
That gets you Net Interest Margin – it is the equivalent of EBIT for non-financial companies.
Step 2: Calculate Loan Level Net Income
Next, you subtract an expense called loan loss provision, which refers to the estimate of money that needs to be set aside for any expected losses on the loan, or a contingency / provision.
Lastly, you need to subtract associated labor costs/salaries and allocated overhead as well as taxes.
This will get the corporate bank to a loan level net income. Here is a summary table for calculating the net income for a loan:
|add: Fee Income
|less: Cost of Funds
|Net Interest Margin
|less: Loan Loss Provisions
|less: Non-interest Expense
|Net Income before Tax
|less: Income Tax
Step 3: Determine Key Lending Ratios
With the loan level net income in hand, it is compared against the overall loan amount using a return on assets ratio (remember that the loan is an asset for the bank):
Return on Assets (ROA) = Net income / total assets
Understanding Return on Assets
ROA is used to calculate how profitable a potential loan is and whether or not they should extend the loan to a prospective borrower.
If these profitability calculations or ratios meet the hurdle for the lending product, the banks can approve the loan assuming other criteria are met from a risk perspective such as exposure to the same client, exposure to the industry at large and expected losses from the loan.
Note that return on assets is not directly comparable across lending products – so an ROA of 1% is not necessarily worse than an ROA of 3% if product A is less risky than product B. Therefore, the loan evaluation decision depends on different hurdles for different products.
Because of the differences across products, ROA has its limits. And one way to normalize for the differences in risks across products is to risk-adjust the loan amounts, using a return on risk-weighted assets ratio.
Return on Risk Weighted Assets (RORWA) = Net income1 / risk weighted assets
RORWA modifies ROA to capture the risks taken to achieve returns. For example, a $25 million loan with net income of $1 million would have a ROA of 4%.
But if that loan was a safe loan it might get risk-weighted down from $25 million to $20 million, bringing the RORWA to 5%.
As such, RoRWA is a good way to normalize how the corporate bank evaluates profitability on the loan. While ROA uses assets as the denominator in the formula, RoRWA will adjust the amount of assets based on their perceived risk.
Lastly, return on equity adjusts for the different amount of equity needed to cushion the loan:
Return on equity = Net income / Equity
When a bank makes a loan, it will take its safest asset (cash) and give that cash to a borrower, now creating a new (riskier) asset. If banks do this unchecked, their balance sheets will become riskier and riskier, endangering deposits.
To protect depositors, regulators require that banks must allocate a certain amount of capital at risk based on the credit profiles for a potential borrower that their risk rating models suggest.
Imagine the same $25 million loan generating $1 million in annual income requires the bank set aside $5 million in equity cushion. The ROE is therefore $1 million / $ 5 million = 20%.
Step 3: Adjust to reflect investment banking relationships
As we mentioned in our Ultimate Guide to Corporate Banking, Corporate Banking sits within the Investment Bank and will sometimes approve loans that wouldn’t be profitable on a standalone basis but make sense because they create opportunities for other parts of the investment bank to offer follow-on services like M&A, debt and equity underwriting, etc.
Revolving Credit Facilities As Loss Leader
Revolving credit facilities in particular are considered a loss leader product for corporate banks because they tend to run an economic loss for the bank as the bank sets aside capital for creditors, while borrowers instead of drawing on the revolver prefer the longer-dated capital of bonds and use cash and commercial paper for short term credit needs.
Let’s say that a corporate bank is lending to a large corporate client whose return on equity (ROE) is 13%, while the bank’s internal hurdle rate is 17%. As a standalone lending decision, this would not work. However, if they expect debt capital market refinancing over the next year and a potential M&A deal that could generate an all-in capital markets return of 22%, the bank may see this as a worthwhile decision.