Question

A bank is considering a loan applicant for a $9,750,0004-year loan. The servicing fee is expected to be 55 basis points and the bank's cost of funds, its RAROC benchmark, is 9%. The estimated maximum change in the borrower's risk premium is 7.2%. The loan's duration is 3.4956 years and current market interest rates for similar loans is 9.8%. Based on the RAROC model, should the bank make the loan? Why or why not?

Answer 1

Based on the RAROC model, the bank should make the loan as the risk-adjusted return exceeds the total cost of funds.

Step-by-step explanation:

Based on the RAROC (Risk-Adjusted Return on Capital) model, the bank should evaluate whether the loan will generate a return that exceeds its cost of funds. To determine this, we need to calculate the risk-adjusted return and compare it to the bank's RAROC benchmark.

The risk-adjusted return is calculated by multiplying the estimated maximum change in the borrower's risk premium (7.2%) by the loan's duration (3.4956 years). This gives us a risk-adjusted return of 25.0944%.

Next, we calculate the total cost of funds for the bank by adding the servicing fee (0.55%) to the bank's cost of funds (9%). This gives us a total cost of funds of 9.55%.

Finally, we compare the risk-adjusted return (25.0944%) to the total cost of funds (9.55%). Since the risk-adjusted return is higher than the total cost of funds, it indicates that the loan is expected to generate a return that exceeds the bank's cost of funds. Therefore, based on the RAROC model, the bank should make the loan.