Many loan contracts contain a prepayment option, allowing the customer the option of early repayment or even of complete early redemption of the remaining debt. If the bank does not consider the possibility of prepayment at the initial recognition of the loan and prepayment occurs, it will cause volatility in the profit and loss account (P&L).
In general, every unanticipated early payment causes a rupture in the amortisation path and a ‘shock’ in the P&L. It is therefore highly recommended to consider prepayment beforehand and to incorporate it into the original calculation for the effective interest rate (EIR); this is a vital tool to control P&L volatility.
Moreover, the definition of the EIR urges financial institutions to consider prepayment estimates. According to IAS 39.9 ‘The effective interest rate is the rate that exactly discounts estimated future payments or receipts over the expected life of the financial instrument.’ Because prepayment is an estimated future payment that influences the expected life of the instrument, it must be taken into account in order to ensure proper calculation of the EIR.
The Solution of Prepayment Estimation
The best way to avoid P&L volatility is to estimate prepayment at initial recognition and to incorporate it as additional cash flows into the effective interest rate calculation, which in turn is used for amortisation. FlexFinance takes the prepayment estimate into account. It can derive estimated prepayment behaviour from historical data or can work with prepayment curves delivered from an external risk management system.
Consideration of Prepayment Behaviour
The EIR calculation of a loan is based on a cash flow plan (i.e. a list/plan of the expected future cash flows) on the individual deal level. The estimated prepayment cash flows have to be added to the cash flow plan in order to incorporate them into a more accurate EIR calculation.
The Way FlexFinance Deals with P&L Volatility
- FlexFinance analyses prepayment behaviour on the portfolio level: financial instruments are organised in portfolios with similar prepayment behaviour characteristics (e.g. based on loan type, customer type, location).
- The estimated impact of the prepayment option is measured on a portfolio level in terms of a prepayment curve, which shows the relationship between the time elapsed since the start of the loan and the percentage of the estimated prepayment. Each point on a prepayment curve answers the question: Which amount is estimated to be prepaid at that point in time during the life span of the financial instrument? (In a more simplified approach, a ‘constant prepayment rate’ (CPR) can be supplied as one fixed percentage to be applied to the entire lifecycle of a deal within a specific portfolio.)
- This prepayment curve can be delivered by the bank’s risk management system, based on historical prepayment behaviour. It can also be calculated by FlexFinance Analytix using real payment data delivered to FlexFinance by the source system(s).
- Subsequently, estimated prepayment cash flows are added to the cash flow plans of all deals in that portfolio in addition to the contractual cash flows for each individual instrument in the portfolio. As such, at initial recognition, the EIR will be calculated taking estimated prepayment into account. This will result in a more accurate estimate of the real EIR on the portfolio level with fewer shocks/volatility in the amortisation plan and the P&L.
- FlexFinance provides multiple views of the cash flow plan: in addition to the ‘contractual cash flow’ view and the ‘real payment cash flow’ view, there is also an ‘estimated cash flow’ view which includes the estimated prepayment.
Tax Benefit
The steps FlexFinance takes for the estimation of the real EIR not only decrease volatility, they also lead to a tax benefit: If the financial valuation is the basis for the bank's tax return, then the anticipation of prepayment behaviour could lead to faster amortisation of transaction costs with a positive impact on tax liabilities.
