Description:
In the last two decades, both internal and external risk management of banks have undergone significant developments. Banking supervision encourages banks to use a risk-based approach for computing minimum regulatory capital. Accounting rules have been tightened requiring more timely loss reserves for impaired loans. In this article, we propose a comprehensive scheme for calculating the profitability of a loan that could be used both for setting risk-based interest rates when originating a loan and for accurately determining the profitability of existing clients. The scheme utilizes the credit models developed for regulatory purposes and takes the impact of regulation on loan performance into account. We show that accounting loan loss provisions cannot be applied in a performance measurement scheme because they do not reflect the true economic loss. In addition, we demonstrate that it is crucial to measure loan performance over the full life cycle of a loan. Restricting profitability measurement to a time horizon of one year as often observed in practice could be misleading. Although our focus is on profitability measurement, the framework could be applied in a wider context, i.e., for macroeconomic stress tests, bank balance sheet projections, capital management, or evaluating the impact of securitizing parts of a bank's loan portfolio.