Why is my business loan margin higher than another company's?

Because the bank has graded the two loans differently. It estimates how likely each borrower is to fail and how much it would lose if that happened, and each estimate feeds the price directly. Size matters too, since running costs fall on a smaller balance, and so does the term, because money promised for longer costs more. A competitor may also hold deposits or other business that earn the bank part of its return.

How does a risk grade affect the interest rate on a business loan?

The grade is the bank's estimate of how likely the borrower is to fail over the next year. A weaker grade raises the expected loss built into the margin and, at a bank using internal ratings, raises the capital held and so the charge for it. Grades are usually revisited at each annual review. A changed grade reaches the margin only at a refinancing or if the facility agreement provides for a review or a ratchet.

Can you negotiate a risk-based price?

Yes, within limits. A bank can often give ground on fees, on the margin where the relationship earns it, and on structure. It has less room below the cost the loan imposes on it, and a discount beyond that comes out of its return on capital. The arguments that move a price furthest change the inputs: better security, a shorter term, lower debt, or evidence that the grade is too harsh. Competing offers help most when the borrower is one the bank wants.

Does better security lower the margin on a business loan?

Security lowers the loss if the borrower fails, so it reduces the expected-loss part of the price, and at some banks the capital as well. It does not change how likely the borrower is to fail. How much reaches the margin depends on what the asset would fetch in a forced sale, how well the bank ranks, and how much competition there is for the loan. Security of doubtful value may earn little reduction.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Risk-Based Pricing: a Worked Example

A better grade moves the floor. A haggle only goes below it.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

Risk-based pricing is the reason a business can be quoted a higher margin than its competitor down the road for a loan of the same size. The lender starts from what this particular loan is likely to cost it, by grade and by security: the average loss, and a return on the capital held for worse years. Funding and running costs are added, and the sum gives a floor. In the example here the floor is 1.91% for one borrower and 3.34% for another, and a good negotiation moves either by a fraction of that gap.

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.

// BEFORE THE BANK READS IT

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PART OF How Banks Price a Business Loan

// 01 — WHAT THE PRICE IS PAYING FOR

A lender does not know which of its borrowers will fail, but across a book it knows roughly how many will. Pricing every loan the same would mean the safest customers paying for the riskiest, and the safest customers would leave for a lender that charged them less. What remained would be a book of weaker loans at a price set for stronger ones. Pricing by risk is how a bank avoids being left with only the borrowers its rate card undercharges.

Two of the pieces in the price measure risk, and they do different jobs. Expected loss is the average cost of borrowers like this one failing. The capital charge pays shareholders for standing behind the years when losses run well above average. This page covers business lending; consumer credit has its own rules in each market.

// 02 — HOW THE FLOOR IS BUILT

Expected loss = probability of default × loss given default

Capital charge = capital as a share of the loan × return required

Floor margin = expected loss + capital charge

+ funding cost above the base rate

+ running costs

The grade sets the first input. Security and ranking set the second, which is why many lenders grade the borrower and the loan separately. Capital depends on the regulatory approach. A bank approved for internal ratings holds more against a weaker grade. A bank on the standardised approach may hold the same against both: Australia's APS 112 gives unrated companies a single weight unless the bank has an approved method to split them into investment grade and below. Such a bank may still use an internal capital measure for pricing, or let the difference fall on expected loss.

For small loans, the same logic is often packed into scorecard bands rather than worked deal by deal. The borrower sees a band, not a build-up.

// 03 — THE EXAMPLE

Two dry-cleaning chains, constructed for this page like every figure on it, each ask for a US$5m four-year term loan. The first has steady cover and low debt. The second is more heavily borrowed and has less steady earnings. Then the second offers a mortgage over its main plant. All the inputs, and the 12% required return, belong to the example and are not market levels.

Stronger Weaker Weaker + mortgage

Probability of default 0.50% 2.50% 2.50%

Loss given default 40% 40% 20%

Expected loss 0.20% 1.00% 0.50%

Capital, share of loan 8% 12% 10%

Capital charge at 12% 0.96% 1.44% 1.20%

Funding above base 0.35% 0.35% 0.35%

Running costs 0.40% 0.55% 0.55%

Floor margin 1.91% 3.34% 2.60%

Weaker − stronger: 1.43 points × US$5m = US$71,500 a year

Value of the mortgage: 0.74 points × US$5m = US$37,000 a year

Funding is the same in all three columns, because it has nothing to do with the borrower. Nearly all of the gap is expected loss and capital. The mortgage halves the expected loss without changing the chance of failure; what changes is how much the bank would lose if failure came.

Now suppose the weaker chain negotiates 0.25 points off its floor, to 3.09%. That is worth US$12,500 a year to the borrower, and it comes straight out of the return on capital:

Return left for capital: 1.44 − 0.25 = 1.19 points

Return on capital: 1.19 ÷ 12 = 9.9%, against 12% required

// 04 — HOW IT DIFFERS FROM THE PRICE ACTUALLY PAID

The build-up gives a floor. The margin in the letter of offer also reflects things outside it. Deposits and transaction business can earn part of the return the bank wants, and competition can force a price below what the loan alone would justify. A bank growing in a sector may accept less for a time, and one whose sector limit is full may not bid at all.

Risk-based pricing is the calculation that sets the price going in. RAROC runs the same inputs the other way, and tells the bank what return a given margin earns. A margin ratchet applies the same idea after signing, moving the margin as leverage or another agreed measure moves.

DEFINED IN ONE PARAGRAPH → · HOW BANKS PRICE A LOAN → · RAROC, WORKED →

// 05 — WHERE IT DECIDES A FILE

A borrower who wants a lower margin has two kinds of argument. One is about competition and the rest of the relationship, and leaves the build-up where it was. The other addresses its first lines: steadier cover, less debt, better security, accounts delivered on time. Only the second kind changes what the loan costs the bank to hold, and in the example it is worth several times the first.

For the lender, the discipline runs the other way. A loan priced under its floor is paid for later, when the expected losses arrive and the margin that should have covered them was given away to win the deal. Pricing also comes second: a loan that earns its full margin can still fail, and the price does nothing to recover this one if it does. The credit margin is where the result appears in the facility, and the annual review is where a changed grade can reach it, if the document allows.

PRICING AND FEES → · WHY BANKS REPRICE →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Basel Committee on Banking Supervision, Basel Framework, CRE30 IRB approach: overview and asset class definitions (version effective 1 January 2023) — paragraphs 30.1 and 30.2 — IRB banks may use their own estimates of PD and LGD, and the risk-weight functions set capital for unexpected loss with expected loss treated separately — sections 01 and 02.
Australian Prudential Regulation Authority, Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk — Attachment B — Unrated general corporates take a 100% weight unless the bank has an approved method to apply 85% and 110% by investment grade — section 02.

// QUESTIONS PEOPLE ASK

Why is my business loan margin higher than another company's?: Because the bank has graded the two loans differently. It estimates how likely each borrower is to fail and how much it would lose if that happened, and each estimate feeds the price directly. Size matters too, since running costs fall on a smaller balance, and so does the term, because money promised for longer costs more. A competitor may also hold deposits or other business that earn the bank part of its return.
How does a risk grade affect the interest rate on a business loan?: The grade is the bank's estimate of how likely the borrower is to fail over the next year. A weaker grade raises the expected loss built into the margin and, at a bank using internal ratings, raises the capital held and so the charge for it. Grades are usually revisited at each annual review. A changed grade reaches the margin only at a refinancing or if the facility agreement provides for a review or a ratchet.
Can you negotiate a risk-based price?: Yes, within limits. A bank can often give ground on fees, on the margin where the relationship earns it, and on structure. It has less room below the cost the loan imposes on it, and a discount beyond that comes out of its return on capital. The arguments that move a price furthest change the inputs: better security, a shorter term, lower debt, or evidence that the grade is too harsh. Competing offers help most when the borrower is one the bank wants.
Does better security lower the margin on a business loan?: Security lowers the loss if the borrower fails, so it reduces the expected-loss part of the price, and at some banks the capital as well. It does not change how likely the borrower is to fail. How much reaches the margin depends on what the asset would fetch in a forced sale, how well the bank ranks, and how much competition there is for the loan. Security of doubtful value may earn little reduction.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Treasury analystFunds the bank and manages the interest rate and liquidity risk created by its own balance sheet.
Product managerOwns what the bank sells rather than who it sells to — the design, pricing, terms and lifecycle of a lending, deposit or payments product.
Business relationship managerCarries a book of trading businesses — wins them, keeps them, and is the bank's voice when the answer is no.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE NUMBER · THE LOAN · PRICE

A US$10m loan. The bank estimates a 2% chance the borrower defaults within a year, and expects to lose 40% of what is owed if it does.

What is the expected annual loss?

5 MORE ON THE LOAN · PRICE →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHRisk-based pricing What is risk-based pricing on a business loan?