I was wondering how bank calculates in practice the amount of money it earns after granting a credit (I hope margin is the proper word).

Supposing, that the client took 3-year 10000 euros loan (36 equal monthly installments) with nominal rate equal to 10% (for the simplicity I assume no provision, no insurance required). Is the profit on such a product equal to 10000 minus present value of portfolio made from 36 zero-couponed bonds (I also assume for a while, there is no such thing like counterparty default risk)? That sounds like an answer from book, not practical solution since you should calculate PV of such portfolio each time. Moreover, what is more important, it isn't so simple (since bank have access to much cheaper source of funding = deposits, installments might vary, client may default, etc.)

  • $\begingroup$ Are you asking how banks accrue all of the various charges around loans? Or just are you asking the formula for PV'ing a cash loan? $\endgroup$ – JoshK May 5 '16 at 15:40
  • $\begingroup$ I know how to calculate PV of future cash flows, but it seems not feasible (from business perspective) to calculate margin of given indiviudal by subtracting present value of all discounted installments from total principle. As I said, installments may vary in the future (because they might be tied to LIBOR 3M), clients might default and, what is maybe more important, banks don't borrow money from other banks to replicate newly-granted loan. In most situations they have cheaper money from deposits, which is also a cost for the bank. $\endgroup$ – user2280549 May 5 '16 at 21:14
  • $\begingroup$ I guess I'm not getting your question. The LIBOR floating adjustment part isn't hard to deal with because the banks just have a big pile of fixed/floating obligations that they always are managing. $\endgroup$ – JoshK May 6 '16 at 1:12

Traditionally, banks did not particularly consider consumer loans as a source of profit, but rather as a source of credit risk to be mitigated (Thomas, 2000). Expected profit simply was (and I would guess, still is) not really something that comes into the loan decision at micro level.

As to your question as to how the profit is calculated in practice, I think it would be easier to understand my answer if we separate this into calculating the profit before (ex ante) and after (ex post) the contract expires.

The ex post profit is easy to calculate: it is simply the return of the loan minus the cost of capital of the bank over the loan period. The method you refer to would be an ex ante calculation, and it is simply the present value for of these variables. In other words, it's the expected return (adjusted for default risk) of the loan minus the prevailing interest rate.

Of course you are right that calculating the ex ante profit for a small individual loan seems unpractical. This is why I highly doubt that banks would do this for individual loans (even though the cited article argues that they should), but I do not know this for certain. It does seem likely that banks monitor the aggregate ex ante return on their consumer loans by region.


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