In the financial services industry, pricing loans at the current market rate only may seem like a straightforward practice, but it may not be the best way when all the risks are considered, especially interest rate risk. Interest rate risk (IRR) is the threat that changes in interest rates will negatively impact the value of financial instruments or a financial institution’s earnings. In this context, pricing loans at the current market rate may not adequately reflect the risk associated with lending activities. When pricing loans solely based on current market rates, financial institutions may not be accounting for the potential for rates to change.
A recent LinkedIn survey conducted by Kohl Analytics in 2022 suggested that around 50% of market participants do not use an interest rate risk adjusted process, such as funds transfer pricing (FTP). If an institution were to utilize this process, they would be assured that they are pricing loans in a way that adequately reflects the IRR associated with lending.
Market participants not taking interest rate risk into account may be more focused on securing the lowest interest rate possible. If they do not consider the possibility of rates rising over time, this can lead to a situation where financial institutions are competing solely on price, rather than the overall IRR associated with lending activities. To address these issues, FTP can be used to account for the IRR and should be used to set a minimum price, with lenders still allowed to set pricing above this level.
In conclusion, pricing loans solely based on the current market rate is no longer considered a good practice due to all the risks, especially IRR. Without taking the IRR into consideration, market participants may set an improper market price, highlighting the importance of financial institutions taking a holistic approach to pricing loans.