Modelling of Prepayment on Fixed Rate Residential Mortgages: A Logistic Regression Approach

Roberto Baccaglini

Loans prepayment deeply affects the risk profile of the banking book of a financial institution as, on one side, it alters the timing of the expected principal cashflows of outstanding loans and, on the other side, it considerably reduces the interest rate margin. From the liquidity risk point of view, neglecting this phenomenon exposes the bank to the risk of overestimating its funding cost, since it would rely on an additional source of funding for the future without the need to renew part of its liabilities. From the interest rate risk perspective, the bank would over-hedge its loan portfolio amortisation profile, with the consequence of having to unwind the excess of hedging positions, often at the price of locking a negative margin. This particularly affects fixed rate loans and, partly, floating rate loans with embedded optionalities, such as caps and floors.

After the origination of a loan, the customer has the possibility to reduce or fully repay the principal amount of the loan at any time before the contractual maturity of the deal. This option can either be exercised or not upon the payment of a penalty,¹¹ In Italy, for instance, the approval of the Bersani law in