How Banks Price a Business Loan
A margin is five costs added up. The borrower's grade decides two of them.
BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED
// THE SHORT ANSWER
A bank prices a business loan by adding up what the loan costs it to hold: funding for the loan's term, the loss it expects on average from loans like it, a return on the capital it must keep against worse-than-expected losses, the cost of assessing and watching the loan, and a profit. The borrower's risk grade decides two of those — expected loss and capital — which is why a weaker grade pays more, and why the grade matters more than the negotiation. Competition and the rest of the relationship decide how close to that build-up the price lands.
BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.
// MAKE THE CALL
Issue 09 — The Tuesday List. Eight dashboards. Two intensive-care slots. Portfolio triage, Tuesday 8:30am. Your call first, then the senior banker's.
// WHAT A MARGIN IS MADE OF
A business loan's rate is a base rate, which the market sets, plus a margin, which the bank builds. Every bank builds it from the same pieces, whatever its own spreadsheet calls them.
Funding for the term. Inside the bank, the treasury charges the lending desk for the money it lends, for as long as it lends it. Money promised for five years costs more than money for one, so a longer loan carries a larger charge before anything is said about the borrower.
Expected loss. Across many loans like this one, some will fail. How likely this borrower is to fail in a year, how much of the loan would be lost after the security if it did, and how much would be owed at that moment together give an average loss the bank expects to bear. It is priced like an insurance premium: collected on every loan to pay for the few that fail.
A return on the capital held. Some years the losses are much worse than average. Those are absorbed by the bank's own capital, which regulators require it to hold against every loan, more against riskier ones. Shareholders expect a return on that capital, so each loan carries a charge for the capital it ties up.
Running the loan. Assessing it, documenting it, reviewing it every year and watching it in between. That work costs much the same for a small loan as a large one, which is why small loans carry more of it per dollar.
Profit. What is left is the bank's reason to make the loan at all.
// 01 — ONE LOAN, TWO GRADES
An illustration, not market levels: the same five-year loan to two businesses the bank grades differently.
| Dimension | A STRONGER GRADE | A WEAKER GRADE |
|---|---|---|
| FUNDING FOR THE TERM | A STRONGER GRADE0.40% | A WEAKER GRADE0.40% |
| EXPECTED LOSS | A STRONGER GRADE0.20% | A WEAKER GRADE0.90% |
| RETURN ON CAPITAL HELD | A STRONGER GRADE0.70% | A WEAKER GRADE1.40% |
| RUNNING THE LOAN | A STRONGER GRADE0.50% | A WEAKER GRADE0.60% |
| PROFIT | A STRONGER GRADE0.30% | A WEAKER GRADE0.30% |
| THE MARGIN | A STRONGER GRADE2.10% | A WEAKER GRADE3.60% |
The two pieces that move are the two that measure risk. The weaker borrower is more likely to fail, so its expected loss is higher; and the capital held against it is larger, because the bank must be able to survive a bad year in which borrowers like it fail together. Running the loan costs a little more, because a weaker borrower is watched more closely. The funding and the profit are the same, because neither is about the borrower.
That is why the grade matters more than the negotiation. A borrower who argues about the margin is arguing about the last two pieces; a borrower who improves what the grade is built on — steadier cover, less debt, better security, accounts that arrive on time — moves the first ones. The borrower's guide to pricing and fees takes it from there.
// 02 — WHERE THE GRADE COMES FROM
A grade is the bank's estimate of how likely a borrower is to fail over the next year, on its own scale. It is built from the financial statements — cover, leverage, the cash cycle — and from what they do not show: the industry, the people running the business, how good the information is, how the account has been run. Many banks then grade separately how much they would lose if the borrower did fail, which turns mostly on the security and where the bank ranks.
A grade is reset at every annual review and should move whenever something important changes, which is where most of the judgment in pricing actually sits. In Issue 09, a borrower whose cover is a clean 1.8× is sending its monthly accounts later every month and has just lost its CFO. Its numbers support its grade. Its behaviour does not, and a bank that prices off the numbers alone is charging yesterday's price for today's risk.
// 03 — WHY PRICE DOES NOT ALWAYS FOLLOW RISK
The build-up says what a loan should cost the borrower. What it actually costs is set by three things beside it. The rest of the relationship: deposits, transaction banking and other business can earn part of the return the bank wants from a customer, so a loan may be priced below its own build-up because the whole relationship clears it — provided the rest of the relationship is measured, not assumed. Competition: a lender growing its book in an industry this year prices to win. And strategy: a bank that has decided to grow a kind of lending will pay for the growth in margin.
None of that is wrong, and all of it has a cost that arrives later. A loan priced below its expected loss and capital is paid for when the cycle turns, years after the price was agreed, by whoever holds the book then. Price can be competed away in a quarter. The loss that follows a mispriced book cannot.
// 04 — WHAT A GOOD PRICE DOES NOT PROVE
A loan that earns its full margin can still be a bad loan. The price covers the average loss across many loans like it; it does nothing for this one if this one fails. That is why pricing comes second. The first question is whether the bank will be repaid at all, and the answer to that is in the cash flow, the structure and the people — the coverage, the leverage and the security — not in the rate.
// STANDARDS THIS SITS BESIDE
The recognised ground this page sits beside. Each was opened and checked when cited; none is a source for the framework itself.
- Basel Committee on Banking Supervision, An Explanatory Note on the Basel II IRB Risk Weight Functions (July 2005) — sections 2 and 4.4 — Expected loss is a cost of doing business, managed through pricing and provisions; unexpected loss cannot be priced in and is what capital is held for — the distinction in section 01 and the FAQ.
- European Banking Authority, Guidelines on loan origination and monitoring, EBA/GL/2020/06 — Section 6, Pricing, paragraphs 199–205 — Says a loan's price should reflect the cost of capital, the cost of funding for its expected life, operating costs, credit risk costs and competition, and that loans priced below cost should be reported — the build-up on this page.
- Basel Committee on Banking Supervision, Basel Framework, CRE32 (IRB risk components) and CRE35 (expected losses and provisions) — Defines the three parts of expected loss described in words here: the probability of default for a grade, the loss given default, and the exposure at default.
- Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision (September 2008) — Principle 4 — Banks should build liquidity costs into internal pricing, charged to the activity that uses the funding — the supervisory basis for funds transfer pricing.
- Office of the Comptroller of the Currency, Comptroller's Handbook: Rating Credit Risk (April 2001, updated 2017 and 2025) — Uses of risk ratings: loan pricing, page 2 — Risk ratings should guide price setting, and mispriced credit risk leads to adverse selection — sections 02 and 03.
// QUESTIONS PEOPLE ASK
- How do banks decide the interest rate on a business loan?
- The rate is a base rate, set by the wholesale market, plus a margin the bank builds up from what the loan costs it to hold: funding for the loan's term, the loss it expects on average from loans like it, a return on the capital it must hold against worse-than-expected losses, the cost of arranging and monitoring the loan, and a profit. The borrower's risk grade drives the expected loss and the capital; competition and the rest of the relationship decide how close to that build-up the final price lands.
- What is a credit risk grade?
- A bank's rating of how likely a borrower is to fail to repay over a period, usually a year, on the bank's own scale. It is built from the financial statements, the industry, the quality of management and information, and how the account has been run, and it is reviewed at least once a year and whenever something important changes. Many banks also grade separately how much they would lose if the borrower did fail, which depends mainly on security.
- What is expected loss in banking?
- The average loss a bank expects across many loans like this one, treated as a cost of doing business and priced in like an insurance premium. It depends on how likely the borrower is to fail, how much of the loan would be lost after the security if it did, and how much would be owed at that moment. Losses above that average — unexpected losses — are not priced in the same way; they are what the bank's capital is for.
- Why do banks hold capital against loans?
- Because some years losses are much worse than average, and a bank must be able to absorb them without failing. Regulators set minimum amounts of capital — the bank's own funds, mainly shareholders' equity — that must be held against each kind of exposure, more for riskier ones. Shareholders expect a return on that capital, so every loan carries a charge for the capital it ties up, and a riskier loan ties up more.
- What is funds transfer pricing?
- The internal price a bank's treasury charges its lending desks for the money they lend, and pays its deposit desks for the money they raise. It separates the profit from lending well from the profit or loss on interest rates and funding, and it charges longer loans for the cost of funding them for longer. It is why two loans to the same borrower for different terms can carry different margins.