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Commerce Bank makes a $1,000,000 business term loan. All interest and principal will be paid after one year. The bank offers a 4% prime rate to its best customers. Based on the loan officer’s credit analysis, the appropriate risk premium for this business borrower is estimated to be 2%. The bank charges a 0.2% origination fee to cover costs incurred during the underwriting and some of the overhead expenses. The borrower is required to keep a 10% compensating balance according to the contract. The Federal Reserve imposes a 3% minimum reserve requirement on all banks.

Questions: 1). What is the return to the Bank on this loan?

2). If the borrower has 3% chance of defaulting and the loss given default is 40%, what is the expected return on this loan?

3) If the return is not large enough, what can this bank do to increase the return and expected return?

Answer 1

Loan	1000000
Risk Premium	2%
Prime Rate	4%	(Best customers)
Mimiumum Balance	10%	or	100000	$
Based on the above inputs we understand that from the bank's prime customers the return expected is 4%
Rprime = 4%
Risk premium for this specific client is 2% , hence returning		6.00%
1. Return to the bank on this loan	$ 60,000.00
2. Expected Return :
Chance of default	3%	Chance of no default	97%
Loss given default	40%	Interest		$      60,000.00
Return	$         4,00,000	Principal		$ 10,00,000.00
	$        4,00,000			$ 10,60,000.00
Expected amount	$            12,000	+		$ 10,28,200.00	(based on assigned Probabilities)
Expected Return	$ 10,40,200.00
2) Return	$      40,200.00	or	4.02%
3) if the return is not large enough the bank can do the following to recover better returns:
i. Reinvesting the margin money retained of 10% from the customer in other investments yielding a higher rate of interest
ii. Increasing the margin money retained to 15% from the customer to both safeguard itself, and also have a higher reinvestment opportunity