Question

A banking institution has issued a 1 year loan commitment of $2 million for an upfront fee of 25 basis points. The back-end fee on the unused portion of the commitment is 10 basis points. The banking institution's cost of funds is 7%, and interest on the loan is 9%. The customer is expected to withdraw 60% of the commitment at the beginning of the year. What is the expected return on this loan? Discuss the take-down risk on the value of this banking institution.            

Answer 1

Upfront fees = 2*0.25% = 0.005 million

only 60% amount is called on the loan hence the interest and cost of funds needs to be calculated only on 60%

cost of funds on amount loaned = 2*0.6*7% = 0.084

interest on amount loaned = 2 * 0.6* 9% = 0.108 million

only 60% amount is called on the loan hence the back end fee needs to be calculated on rest 40%

back end fee = 2*0.4*0.1% = 0.0008 million

Epected return for the bank = ( Interest income + back end fee + upfront fee - cost of funds ) / amount of loan

= ( 0.108 + 0.005 + 0.0008-0.084) / 2 =

= 0.0298 / 2 = 1.49%

Takedown risk referes to the liquiidty risk fdace by the banks as they are unaware of the amount the client shall borrow during the commitment period. ie the client can borrow a percentage of commitment amount or the whole amount. This will lead to uncertainity regarding the amount the banks can have as surplus for other clients / borrowers. Also due to these banks are uncertain regarding the amount of return they shall get over the loan.