Return on Asset or Return on Equity Measurements for Commercial Loan Pricing
Whether the profitability of a specific commercial loan should be measured as a percent of the loan (return on asset) or as a percent of equity (return on equity) is an often asked question when using a loan pricing system. If the same amount of equity is allocated to all loans being priced, it doesn’t matter simply because the mathematics makes them equal. What does matter is if different loans have different amounts of equity allocated to them. The question then becomes as to how much equity should be assigned each type of loan. Because this becomes a highly debated question, it is often best to assign each loan the same amount of capital, unless there is a solid justification to assign something different. As a matter of fact if different amounts of equity are assigned each loan, the underlying premise is that the amount of credit risk assigned the individual loan is not sufficient in the model, hence a different level of equity should be assigned. However, if the user is confident of the risk cost, using return on equity or return on assets is a not an issue, as either can be used since the same amount of equity would be assigned all loans.
Phill Rowley