Response to the following problem:
An FI is planning to give a loan of $5,000,000 to a firm in the steel industry. It expects to charge an up-front fee of 0.10 percent and a service fee of 5 basis points. The loan has a maturity of 8 years. The cost of funds (and the RAROC benchmark) for the FI is 10 percent. The FI has estimated the risk premium on the steel manufacturing sector to be approximately 0.18 percent, based on two years of historical data. The current market interest rate for loans in this sector is 10.1 percent.
The 99th (extreme case) loss rate for borrowers of this type has historically run at 3 percent, and the dollar proportion of loans of this type that cannot be recaptured on default has historically been 90 percent. Using the RAROC model, should the FI make the loan?