Lesson 16 of 25 · 7 min

How the rate is built: index plus spread

One leg is the lender's own cost of money passed straight through; the other is the only part it actually chooses.

Track 1 lesson 13 set out how index plus spread works on a statement. The lender's version of the same structure is a question of what each leg is being asked to cover.

The index leg covers the lender's own cost of money. An institution funds a loan from deposits, from borrowing, or from its own balance sheet, and that cost moves with a short-term policy-linked rate. Tying the loan to the same kind of index makes the funding cost a pass-through: when the lender's cost rises, the charge rises with it, and the margin is untouched. The index leg is not a profit centre. It is an insulation layer.

spread = expected loss + capital cost + operating cost + liquidity cost + margin

spread: The fixed increment added to the index. The whole of the lender's discretion over price lives here.
expected loss: The provision for losses the portfolio is expected to produce, from lesson 1's arithmetic.
capital cost: The return required on the capital the institution must hold against the exposure.
operating cost: Servicing, monitoring, collateral systems and the people who work the exception queue.
liquidity cost: The cost of standing ready to fund, which is larger where the lender has committed to lend.
margin: What is left. The only part that is a choice rather than a cost.

Decomposing a spread this way explains why secured lending spreads are thin and why they are not thinner. Expected loss is genuinely tiny against liquid collateral — a handful of basis points. Capital and operating costs are not tiny, and they do not fall just because the collateral is good. A large part of what looks like profit is the fixed cost of running a collateral monitoring operation at all.

One more consequence follows from the split. Because the index leg is a pass-through, a rise in short-term rates does not widen the institution's margin, and a fall does not narrow it. A rate increase on a facility structured this way is not the lender earning more; it is earning the same 220 basis points it earned before, on money that now costs it more to obtain. What moved was the input, not the price of the service.

Key terms

Cost of funds: What the institution pays to obtain the money it lends. Tracked by the index leg so that changes pass through rather than eroding margin.
Capital charge: The return the institution must earn on capital it is required to hold against an exposure. Usually the largest component of a secured spread.
Basis point: One hundredth of a percentage point. Spreads are built and revised in these units, which is why they look small and are not.

Worked example

Taking a 220 basis point spread apart

A $1,250,000 drawn balance. Illustrative decomposition; the components are not published anywhere.

Expected credit loss, 14 bp: $1,750
Cost of regulatory capital, 62 bp: $7,750
Operating and servicing cost, 31 bp: $3,875
Liquidity cost of standing ready, 18 bp: $2,250
Residual margin, 95 bp: $11,875
Total spread, 220 bp: $27,500

Credit loss is 14 of the 220 basis points. The collateral did its job; almost everything else in the spread is the cost of running the machine that watches it.

Check yourself

A facility is priced at a short-term index of 4.68 percent plus a spread of 185 basis points. The balance is $815,000, flat for a 31-day month, on an Act/360 basis. What is the interest charge?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.