How are business and commercial loan interest rates calculated?
Before you negotiate your next business loan interest rate
How are interest rates determined
When it comes to your bank loan interest rates, its completely fair enough if you are sceptical. I’m sure your banker has assured you that you have the best interest rate you could possibly get but how did they come to this rate? Is it really the best interest rate you can get?
Well, sales pitches from your trustee banker aside, there are basically three parts to your interest rate:
Unlike what you may think, bank’s do not borrow at the RBA overnight rate. The RBA overnight rate is exactly that, the overnight rate – it’s the rate the RBA gives the banks for excess funds they deposit “overnight”. The interbank reference rate that banks borrow at are the 30, 60, 90, 120, 150 and 180 day BBSW rates. These rates are usually between 0.15% and 0.75% above the RBA rate. These rates move as per the market view of what the RBA will do over the next 1-6 months as well as demand and supply requirements for these periods.
The BBSW rate (or sometimes BBSY rate which is 0.05% higher than BBSW and represents the bid rate for BBSW) is sometimes stripped out for your commercial funding interest rate and so you can see your customer margin. For other facilities you only see an all up rate. Which ever way this is presented to you, you need to deduct the BBSW rate (usually the 30 day one since most people pay interest monthly) from your rate to work out your bank margin.
Cost of Funds
Bank’s get their money that they lend their customers from two places. One is the deposits that that their clients have in their accounts. Some of this money, they don’t pay any interest on but a lot of it, they do. If you look at typical term deposit rates or online bank deposit rates, they are usually higher than the current BBSY rate. This positive difference between the deposit rate and the current BBSY rate is a part of the banks cost of funds.
Banks in Australia fund about 50% of their loans from their balance sheet (ie the deposits). The rest they have to borrow from the international market. Banks don’t borrow for free, they have to pay a margin over BBSY to get their funds as well. This is the other part of their cost of funds. The iTraxx credit default swaps (CDS) is a great guide on what the banks are paying on their margins. Pre-GFC the index was consistently around 30bp. This indicates that the average five year credit spread (or cost of borrowing above the benchmark rate such as bank bill swap rate or BBSW) for investment grade issuers in Australia was around 0.30%, a margin that most people would agree was way too low. In the midst of the GFC when the risk of a banking system collapse was very real, the Aussie iTraxx reached a peak of 443bps (4.43%). This time a margin that was clearly too high. Ever since, the margin has been trending to as low as 0.78% in September 2014 to above 1% in mid 2016.
The capital requirement is the amount of capital a bank has to hold as required by APRA. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. The important point here is “risk-weighted”. This is the cost of holding the debt based on your (the client) risk profile and the type of debt you are being given. Client’s deemed riskier (based on security level and your business performance) have a higher capital requirement and hence their rate is higher. Lending products that are deemed riskier such the overdraft vs termed home loans also have a higher capital requirement.
Operating Costs and Profit
Like all companies, banks have many operating costs like your banker’s salary, the branches, the ATMs, technology and the list goes on but most importantly, the bank needs to make a profit and this of course is a part of your interest rate.
So in short:
Business Loan Interest rate = Wholesale rate + cost of funds + capital cost + operating costs and profit.
All too complicated?
Running a business is hard enough, if you want some advice on which Asset Finance provider is best for you, feel free to contact us.