Dear Prof. Damodaran
I have a few questions related with banks which I would like to have your opinion.
1. What is the appropriate discount rate that a bank should use in pricing its loans? Should this be equal to her debt funding rates (a mixture from deposits, bonds and interbank markets, ECB funding rates, etc.) or the combination of equity and debt financing (the WACC) ? Is this rate the same with the interest rates the bank should charge for her clients?
2. If we use the wacc, then essentially we use average funding rates. Is this correct, or we should use the marginal transfer rates i
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You cannot compute cost of capital for a bank, because since you cannot get a precise definition of what really is debt for a bank therefore you cannot estimate a cost of debt .Instead of a WACC approach, try using a cost of equity approach,along with,of course, cashflows to equity.
1) in practice, larger financial institutions use a Funds Transfer Pricing curve (which is what you refer to as debt funding rates) as a base curve from which to price loans and deposits. Swap rates are also used. There is no fast and easy rule as to how exactly to construct a FTP curve, as various insitutuions can use different curves, and some institutions actually use more than one curve in house. However, they are always somehow referenced to market rates. BUT- this funding curve is not equal to the rate that the bank's clients should receive. The bank would adjust (build off of) this ftp rate due to the specifics of the client borrowing. Example, for a 5 year loan, a bank would look at the 5 year FTP rate, then it would have to factor in the risk of the client borrowing, and other factors.
2) I've personally never come across a fianancial insitution using a WACC for pricing loans. There is an inherent issue with using an average rate for pricing loans or deposits which is it would distort the profitability of loans or deposits along the curve. E.g. if the average funding rate is 3%, but the 1 year funding rate is 1%, then a 1 year loan at 2% would look profitable uing the FTP method, but would look unprofitable according to the average funding rate method.
Thank you for your reply. The FTP pricing curve with the matched maturity approach is indeed the way that banks estimate the rates they charge to their clients. Although, I do not doubt it is the correct way instead of a WACC approach, at the same time I cannot see why the CoE for a bank should not enter in the calculation of transfer rates. After all, equity (existing and retained earnings) is a major source of funding the new investment in loans according to the regulatory requirements and is cost should be priced. Is this against the finance theory or I am missing something?