Risk-based pricing is the alignment of loan pricing with its expected risk. Typically, a borrower’s credit risk is used to determine acceptance or denial of the loan application. It may also be used to drive the loan price. Borrowers whose risk is high will be charged a higher interest rate. Risk-based pricing builds on the net interest margins calculations by adding to the cost of funds (cost of transactions and account maintenance, cost of expected loss and of capital for the unexpected loss due to the risk of default).
A risk-based pricing framework should guide a firm’s growth strategy by clearly defining within which market segments to compete and which represent a hedge. This strategy would balance the risk and reward ratio during credit on-boarding. One of the major factors in the latest credit crisis was the lack of risk-adjusted pricing when defining which credit to on-board or pass over. This approach – pursued in a race for growth – led to large provision, which will end in large losses that have yet to be documented as charge-offs.
Risk-based pricing allows the bank to price the risk of issuing credit according to its cost by closely aligning the cost structure with real costs. The components of the equation include cost of funds, transactions and account maintenance, as well as the cost of collections and cost of unexpected and expected loss (expected is the reserve capital and unexpected is the cost of capital set aside for each credit exposure).
Risk-based pricing isn’t new. It has evolved from a partially risk-based methodology to the current fully risk-based pricing strategy. During the partially risk-based era, banks were using a tier- or segment-based pricing framework that evaluated a category of exposures rather than the individual profile of an exposure.
Other methods used to approximate the risk component costs include looking at historical charge-off rates, historical delinquencies and other proxies, which, in certain cases, can be fairly accurate. In the post-Basel world, however, banks should leverage the work done for regulatory compliance in processes like risk-based pricing. Basel provides some guidance with respect to LGD (loss given default) for product types and borrower profile as well as ready-made formulas for the computation of unexpected loss at the exposure level that should help smaller banks in setting up a risk-based pricing framework. The computation of PD (probability of default) at the obligor level may be the single best thing to come out of the Basel framework, thereby providing a good analytic approximation for less sophisticated banks.
Segmentation and risk driver identification are the foremost issues that can cause problems with a risk-based pricing process. If you allocate cost along the wrong segments or use the wrong risk drivers to apply costs, over time the portfolio risk will differ significantly from its original forecast.
Two other significant elements that may affect systemic risk are acceptance and exceptions. It’s important to gain acceptance from affected business units (BU) from the beginning. Without acceptance of the framework, compliance to the process will be spotty and ineffective. In the case of exceptions, it is often unrealistic to think that a risk-based pricing framework can be followed implicitly from the start. If the BUs negotiate exceptions, it is important to track and report the exception’s performance. Exception tracking will validate that risk-based pricing is working as it should. If a risk-based price is right but the BU has created exceptions to get lower rates for customers, the risk-adjusted return (return less loan losses) for that BU will be lower than expected because the spread is too low for the customer risk profile. This further validates the risk-based price.
The acceptance rate concept allows a BU executive to evaluate the trade-off between levels of return at given risk-based prices. BUs will also want to know how many deals are being lost because of the increased spread and if their units will be required to adjust sales strategies to compete in a segment where the risk-based price is closer to market rates (i.e., where they have a competitive advantage). A full understanding of risk-based pricing allows the BUs the flexibility to choose between making 10 deals with a 20 percent risk-adjusted return or 15 deals with a 16 percent risk-adjusted return. These exceptions represent the bank’s additional risk. Performance of the exceptions signals that the bank’s sales instincts are on the mark or need to be adjusted. Tracking performance is an important element to ensure success of the risk-based pricing framework. When complemented by comparison of acceptance rates, market rates and portfolio performance, performance tracking can help drive growth strategy on a risk-adjusted basis.
For more information on developing and implementing a risk-based pricing framework, read the full white paper.