Study on the Theory and Practice of Loan Pricing of Banks of Village and Town in China YU Lihong, LAN Qinggao School of Economics and Management, Shenyang Agricultural University, China, 110866 jane_yu2008@163.com Abstract: In the management and administration of banks of village and town, loan pricing is one of their key businesses, and it is essential to choose the appropriate loan pricing method for the normal running of banks of village and town. At the beginning of this article, the author introduces three kinds of major pricing methods of commercial banks cost-plus pricing method, price leadership loan pricing method and customer profitability analysis pricing method. On this basis, the author analyzes the basic principles which loan pricing of banks of village and town should follow, and the influencing factors of loan pricing. At last, the author discusses the selection of loan pricing models for China s banks of village and town. Keywords: Banks of village and town, Loan pricing, Cost-plus pricing method 1 Introduction There had been already more than 100 banks of village and town in China by the end of 2009 since the first one opened on March 1, 2007. The establishment of banks of village and town has brought a positive and far-reaching influence on promoting the rural financial structure effectively and strengthening the credit service of peasant household and rural small and medium-sized enterprises. Foreign researches on rural microfinance institutions are more mature, for example, the researches on microfinance institutions, such as the Grameen Bank in Bangladesh, microfinance department of People's Bank in Indonesia, Sunshine Bank in Bolivia, and mutual-aid team of Village Bank in Uganda are relatively successful. The researches are mainly on successful experience in respects such as their management ideas, institutional framework, loan pricing, incentive mechanism, regulatory mechanism, etc. At present, domestic scholars researches about banks of village and town are still in the initial stage of exploration. Some representative researches are in the following. Guo Jun(2008) analyzed the market positioning of banks of village and town. Zhang Leilei(2010)analyzed the operation problems of banks of village and town, and put forward suggestions. Hou Junhua (2009) studied the sustainable development of banks of village and town. Zhou Shuo(2009) and Zhang Jing (2009) had done related researches. Overall, the main researches of banks of village and town are focused on market positioning, the status introduction and sustainable development issues. There are few researches on the loan pricing of banks of village and town. In fact, the loan business is the key business and effective means for commercial banks to reach their profit goals; thus, loan pricing is essential to the management and administration of commercial banks. Loan pricing also influences credit risk management level, profit level and market competitiveness of commercial banks, therefore, analyzing loan pricing of banks of village and town has important realistic meanings for the healthy and sustainable development of China s banks of village and town. 2 Loan Pricing Methods of Commercial Banks At present, there are numerous loan pricing methods in the world. And the following three are the representative pricing methods now. 2.1 Cost-plus loan pricing method The leading thought of this method is that the loan price should remedy the cost of the bank offering the financial service and can obtain certain target profit from it, so the loan price includes four parts: (1) the cost of raising loan fund; (2) expenses related to loan, which are the non-interest costs caused by banks 226
issuance of loan and the maintenance of debtor-creditor relation with customers; (3) the risk premium of loan, namely the necessary compensation for the probable default risk of loan; (4) target profits of loan. Among them, each one can be expressed by the percentage of credit amount. The basic formula is as follow: Loan interest rate = fund cost rate of loan +administrative expenses rate of loan + risk premium rate of loan + target profit rate This is the comparatively traditional pricing method. This method is mainly from the banks' perspective, providing loan pricing by considering the banks own cost, risk and expected profit. This method can guarantee that the bank is lucrative on the loan, but it doesn t consider some factors, such as competition in the bank trade, relations with customers, customers' demand, etc., and it will lead to the fact that market share drops and the customer runs off easily and cause to bank passively. This method is suitable for loan market possessing the characteristics of seller, for instance loan of small and medium-sized enterprises, peasant household's loan, etc. 2.2 Price leadership loan pricing method The pricing method is a kind of pricing method which is widely used by international banking industry. Its core is the benchmark interest rate. This method chooses a widely influential benchmark interest rate as base price. On the basis of the benchmark interest rate, the bank gives different risk premium to customers who have different credit levels or risk levels so that commercial banks can make different loan interest rates according to various customers and loans. The formula is as follow: Loan interest rate= benchmark interest rate+ risk premium points Or Loan interest rate=benchmark interest rate risk premium multiplier In the formula above, the benchmark interest rate is the market interest rate or the prime rate set by the bank itself. The risk premium includes default risk premium and term premium. They can be regarded as the compensation for some risks. Compared with the cost-plus pricing, the price leadership loan pricing is based on the general interest rate and combined with the degree of risk of loan. It considers not only the risk of the market interest rate, but also the default risk. So, the price made through this method is more reasonable and can be accepted by the banks and the debtors easily, and it will also improve the market competitiveness. However, with the competition becoming fiercer, many commercial banks will select the money market interest rate as the benchmark interest rate. Of course, it may reduce the profit level of commercial banks. 2.3 Customer profitability analysis pricing method Customer profitability analysis pricing requires that the bank should take full consideration of the overall relationship between the banks and the customers and have a comprehensive analysis of the contribution of each debtor. These contributions can include the assets, the liabilities and intermediate businesses and so on. Based on calculating the cost and the profit of various businesses, the bank can give the appropriate loan pricing according to the bank s target profit and the customers' risk level. Its formula is as follow: Loan interest rate= (target profit+the total cost of providing service-the income other than loan interest)/the loan amount The total cost includes the interest cost of deposits, management cost, risk cost, transaction cost and all other expenses, and the income consists of interest income, service charge income and investment income. This kind of pricing method reflects the business philosophy of customer-centric. It attempts to find the optimal loan price from all the businesses between the bank and its customers in order to make loan pricing more competitive. Nonetheless, this method presents high requirements for cost accounting, and requires a perfect customer relationship and management system, so it is more suitable for the important customers who contact with the bank closely and can do great contribution to the bank. 3 The Principles and the Main Influencing Factors of Loan Pricing of Banks of Village and Town 227
3.1 The principles of loan pricing of banks of village and town 3.1.1 Symmetric principle on cost, risk and gains The basic requirement of loan pricing is that the gains from loan should offset the costs of loan, such as fund cost and management cost. And in addition, interest rate must show the credit conditions of different customers and risk level of specific loan. Just as, the less the risk is, the lower interest rate is. Therefore, banks of village and town must follow the symmetric principle on cost, risk and benefit while loan pricing. 3.1.2 The principle of earnings The principle of earnings is that loan price should reflect the profit goal of banks of village and town. Banks of village and town are also enterprise, so pursuing the profit is its main goal. Credit business is the main business of banks of village and town and the main source of acquisition of revenue. It is very important to have an appropriate loan interest, because it is helpful to increase the revenue of banks of village and town. Thus, banks of village and town should achieve the profit as much as possible while loan pricing. 3.1.3 Differentiation principle The differentiation principle requires the bank to make different loan prices according to different customers, loan variety and risk type and so on. It can ensure the safety and the profitability of loan of banks of village and town and lend limited loans to the right debtors with a reasonable price. 3.2 The main influencing factors of loan pricing of banks of village and town We can know that there are numerous influencing factors for the loan pricing of commercial banks from the above-mentioned loan pricing methods, because of the particularity of the rural financial market, banks of village and town should especially consider three following factors for the loan pricing: 3.2.1 Cost As the loan pricing of banks of village and town, the factor that we should consider primarily is the cost of bank offering the loan service, including fund cost and loan management expenses. The fund cost refers to the cost of raising loan fund, because banks of village and town are new financial institutions, its prestige is not widely recognized by people at present, banks of village and town have certain difficulty in absorbing the deposit, so the cost of raising fund for them is higher. Management expenses related to loan, which are the non-interest costs caused by banks issuance of loan and the maintenance of debtor-creditor relation with customers. The customers of banks of village and town are mainly peasant household and rural small and medium-sized enterprises, and they are disperses and their loan amount is small, so the loan management is more tedious and expenses should be obviously higher than the general commercial banks. 3.2.2 Risk Financial institutions have to face some risks when they operate the loan business, for example, the loan and interests can t be repaid on time. The expenses which banks cost for undertaking this kind of loan risk are called the risk cost of loan. On the rural financial market the customers of banks of village and town are mainly peasant household and rural small and medium-sized enterprises who obtain loan fund mostly put into agricultural economy such as crop farming and livestock breeding, and the weak quality of agriculture decides that their production is easy to be influenced by natural condition, so the risk is relatively high and their ability to resist risk is relatively weak. Meanwhile they are lack of effective collateral. All these factors increase the risk of loan. Thus, loan pricing of banks of village and town should pay close attention to the risk compensation and reflect its risk premium accurately. 3.2.3 Target gains The commercial banks are the financial institutions that operate independently and are responsible for their own profits and losses and pursue profits as goal. The loan business is the main business of commercial banks, so the loan income is the main goal which commercial bank pursues. Banks of village and town, as the small-scale commercial banks serving sannong, also pursue the profit. The loan pricing of banks of village and town must guarantee to realize profits. 228
4 Loan Pricing of Banks of Village and Town 4.1 The choice of loan pricing method of banks of village and town At present, among the popular pricing methods, I think the cost-plus pricing method is relatively suitable for applying to loan pricing of banks of village and town at present in China. Although the cost-plus pricing method belongs to the internally-oriented pricing method and mainly bases on financial institutions own costs and risk-taking while loan pricing and neglects the influence of the horizontal competition, customers' demand factor. However, banks of village and town are the new financial institutions which are still in pilot construction period, besides studying how to meet the rural financing demand at present, they will mainly consider their own sustainability, so, loan pricing must be from them own view to ensure the price to cover cost and risk of loan. In addition, on regards of the actual conditions of the rural financial market, the main problems are the insufficiency of rural finance supply and the difficulty of obtaining loan for rural economic agents, but not the problem of interest rate level. So loan pricing of banks of village and town needn't consider factors such as price competitiveness, market share too much, they should make the reasonable price for the loan mainly according to factors such as fund and business cost, risk compensation, customer credit and profit etc. Consider synthetically, the cost-plus pricing method is a more excellent choice of loan pricing under the present conditions for banks of village and town. After banks of village and town develop into a certain scale and the problem of obtaining loan difficultly in the rural financial market relieves, banks of village and town can choose other more suitable loan pricing modes. 4.2 Consummation of the groundwork of loan pricing of banks of village and town The loan pricing has a very high requirement on the technology and managerial ability of financial institutions, so banks of village and town must do basic work well and accumulate necessary technology and experience in order to set up effective loan pricing mechanism to lay a solid foundation. First of all, we should set up the defaults database of sannong loan progressively. Banks of village and town should calculate different kinds of loans and defaults of different credit grades debtors from now on, and set up the own defaults database of financial institution. Meanwhile, we should strengthen the dynamic accumulation of the database and pay attention to the change of various factors constantly in order to offer the overall and objective data for loan pricing of banks of village and town. Secondly, we should build a scientific evaluation system of credit risk. One of the core problems of loan pricing is how to measure the debtors credit risk and charge different risk premium according to the risk degree of different debtors, so establishing and perfecting the internal credit rating system of banks of village and town is the foundation of loan pricing and the basis of lending decisions, therefore banks of village and town should establish a scientific customer-risk evaluation system and make the customer risk evaluation results more objective and more effective. Finally, we should improve the management of cost accounting. If the financial institutions can accurately account and divide loan cost, the financial institutions can make loan pricing accurate to ensure the profits of loans sufficient to cover the costs. Therefore, banks of village and town should implement comprehensive cost management and set up a cost center to allocate bank s operation cost to the cost of departments, products and customers scientifically and reasonably in order to evaluate customer contribution and the profitability of products accurately. 5 Conclusion Loan pricing is essential to the management of banks of village and town, because it affects the level of credit risk management, the profitability and market competitiveness of banks of village and town, however,as newly-built banks, the loan pricing capacity of banks of village and town is weak generally, in order to adapt to the interest rate liberalization and competition, loan pricing has important practical significance for health and sustainable development of banks of village and town. 229
Author in brief: This paper is a phased achievement of the social science plan fund project of Liaoning Province (L09DJY098), the project of education department of Liaoning Province(W2010368), the young fund of Shenyang Agricultural University and the young fund of school of economic management of Shenyang Agricultural University(20081007) References [1]. HelmsB, Reille X. Interest rate ceilings and microfinance: the story so far[r].washington: World Bank, 2004. [2]. Zhou Zhenhao. Study on loan pricing of Rural Credit Cooperatives[J], Southern Finance. 2008 (4):76-78(in Chinese) [3]. Qi Youfa. Thinking of improving loan pricing of commercial banks in China[J], Productivity Study. 2009 (5):86-89(in Chinese) [4]. Fernando N A. Understanding and dealing with high interest rate son microfinance: a note to policymakers in the Asia and Pacific region[r]. Philippines: Asia Development Bank, 2006. 230