SA Affordable Housing January - February 2020 // ISSUE: 80 | Page 36

FINANCE MATTERS
Based on the example in Table 1, a bank expects to lose
R80 000 from a R400 000 balance, which is a 20% LGD
(R400 000 divided by R80 000).
In the above example, loan cover (the credit loss cover),
reduces the LGD by 17.5 %. Even though customers pay for
the credit loss cover, they receive a better interest rate than a
loan without this, as the LDG is lower. Such cover enables
banks to increase their risk appetite and still be able to offer
a more affordable interest rate.
QUICK EXPECTED LOSS CALCULATION EXAMPLE
that a bank will still be able to recover its costs if it offers a
lower interest rate on bigger loans.
Consider Figure 2 (page 33) which is a depiction of how
the interest rate decreases with a higher loan amount for a
240-month loan.
PROBABILITY OF DEFAULT (PD)
Banks use predictive models that are mostly based on the
customer’s historical credit behaviour, in order to assess a
customer’s propensity to repay the advanced loan diligently,
or for the customer to default in repayment (assuming that
affordability at inception is in order).
These probabilities vary across products, with unsecured
products generally reflecting riskier business than secured
loans, as banks can recover a portion of the debt for secured
loans from the security offered by the customer in support of
the loan (for example, a mortgage bond).
LOSS GIVEN DEFAULT (LGD)
Once a client has defaulted, a lender calculates the loss that
it expects to incur as a percentage of the balance at the point
of default. In the case of a mortgage loan, the loss incurred is
the final write-off amount after the property was repossessed
and a legal sale in execution was done, or the property was
voluntarily sold.
LGD is therefore based on the actual property, whereas
PD focuses on the probability of the client repaying the
loan.
Table 1: An example of calculating loss.
Balance at the point of Default R400 000
Value realised at the auction R250 000
Less Credit Loss Cover R70 000
WRITE-OFF R80 000
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JANUARY - FEBRUARY 2020
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The client defaults with a balance of R400 000. The Client’s
PD was 5% (over 12 Months) and the expected LGD through
previous experience is 20%. Thus, the expected loss is
R400 000 x 5% x 20%, which is
R4 000. Therefore, when modelling, a bank will need to
account for the fact that for this deal they may lose
R4 000. All deals are modelled on an individual basis and
such a loss will depend on the PD and LGD for that specific
client or deal.
Pricing is therefore done on the basis that the interest
income stream is adjusted so that the hurdle rate is achieved,
whilst taking the expected loss into account. Figure 3, below,
shows the effect of PD and LGD on expected loss and hence
the interest rate that is charged to a borrower.
COST OF FUNDS
As discussed earlier in this paper, the Cost of Funds is the
biggest expense when considering a loan or a mortgage loan.
Cost of Funds generally follows the Bank Repo Rate, as
published by the South African Reserve Bank (SARB). If a
lender cannot attract sufficient deposits or investments to
cover the loans it makes, then the SARB is the lender of
last resort for lenders. If a bank is sufficiently capitalised,
it will cover its loans from deposits or investments held
from the public, the cost of which is normally slightly
lower than the SARB Repo Rate.
COST OF CAPITAL
The Banks Act, 1990 and Amendments/Regulations
thereto, require banks to hold capital on each loan, which
is a predefined percentage depending on risk factors and a
bank’s ability to match the term of deposits or loans.
Capital holding is sloped in such a way that the higher the
PD and LGD, the more capital that is required to be held.
Thus, the higher the cost of capital, the higher the interest
rate quoted to a customer for the bank to make its required
return (hurdle rate).
OTHER INCOME
Apart from interest income, which forms the majority of the
income stream, banks may charge an initiation fee on a loan,
as well as a monthly service fee, and potentially any insurance
commissions earned. Such fee income formulas or ceilings are
prescribed within the National Credit Act, 34 of 2005. The
thinking behind an initiation fee is to offset the costs of
setting up the loan, including the valuation fee, to cover the
cost of valuing the property, and the monthly service fee is to
offset the ongoing cost of managing such a loan.
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