Introducing risk-adjusted debt pricing strategy

All over the world, risk-adjusted loan/debt pricing (RLP) is a widely-used mechanism to assess borrower's creditworthiness and to provide differential loan offerings. In the simplest form, risk-adjusted loan pricing allows the higher creditworthy borrowers to get the lower interest rates and fees and vice versa. Typically, banks or financial institutions (FIs) need three basic components to establish risk-adjusted pricing strategy - credit quality, profitability and growth.
Risk-adjusted loan pricing is the alignment of expected default risk of a particular borrower and the loan offerings and covenants provided to that borrower. Risk-adjusted 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). In other ways, risk-adjusted pricing can be determined through deriving cost of fund, operating costs, risk costs, capital costs and additional margin or expected return on equity.
In USA, until the mid-1960s, companies relied on loan officers to use their individual judgments in determining creditworthiness and one-size-fits-all interest rates that treated low-risk borrowers the same as higher-risk ones. But this couldn't scale with a growing economy of consumers hungry to buy new cars and household goods on credit or expand their businesses. In response, innovators began collecting credit and financial data and developing statistical models to determine individuals' levels of risk. These credit scores allowed consumer lenders to tailor lending prices (interest rates) to individual risk profiles. Credit card issuers in USA started using risk-adjusted loan pricing in 1988, auto-lenders in 1992 and mortgage lenders in the mid-1990s.
The major advantages of risk-adjusted loan pricing are:
* Compared to flat-rate pricing adapted by most banks and FIs, RLP allows a fair borrower to be characterised as low risk and let him avoid costs imposed by higher-risk borrowers who have more difficulty making their payments. Because of risk-adjusted pricing, consumers' access to credit and financial services doesn't depend on social connections or the reputation of their family's name. Instead, objective data of an individual's financial situation and payment history expressed as a credit score is used to determine a consumer's credit risk and interest rate.
* Risk-adjusted pricing expands access to credit for previously credit-constrained populations, as creditors are better able to evaluate credit risk, and, by pricing it appropriately, offer credit to higher-risk individuals. Banks and FIs can tailor their prices and offerings to reach to benefit the low risk borrowers.
* Improved data analysis, statistical modelling, and risk-adjusted pricing become a competitive edge.
* In the broadest sense, by adapting risk-adjusted loan pricing model would enable the loanable funds in the economy to be allocated among the deficit group in efficient manner.
* It enables the banks and FIs to know early enough what kind of price/fees will satisfy their risk/return preferences. It also enhances shareholders' value by ensuring that credit risk associated with the transaction is appropriately measured and priced.
Most of the banks and FIs follow flat-rate pricing method where all the customers receive the same rate of interest irrespective of their creditworthiness. Due to lack of technology, superior MIS (management information system) and database management, banks apply flat-rate pricing to "keep it simple". The inherent problem with this method is the low risk or highly creditable customers are underrated and they pay the same as the high-risk borrowers.
So what do the banks and FIs need to do to apply RLP? First, as pricing models are dynamic and need to be updated episodically, a robust database to record, assess and monitor the individual client's repayment pattern and history is required. The bank must be able to assess how they predicted the loan would perform against how the loan actually performed. Secondly, introducing an internal credit scoring model to assess retail, SME and corporate clients to determine the individual offerings is imperative. Financial, behavioural, macroeconomic and sector exposures are to be considered as parameters to develop the scoring model. Analysing the infection ratios of different segments or sectors where the banks have faced unfavourable recovery would help to build the categories of the clients. Banks and FIs may use a tier- or segment-based pricing framework that evaluates a category of exposures rather than the individual profile of an exposure. FICO, VantageScore, PLUS Score, Trans Risk, Equifax etc. are the widely-used credit score models in the world.
Segmentation and risk parameters identification are the keyhole issues that can cause problems with a risk-adjusted pricing process. Allocating additional cost of lending to the wrong segment or industries or less-affected areas of portfolio may result in a paradox; or setting the risk parameters in an improper manner while underestimating the risky ventures would drive the portfolio risk and differ significantly from the original forecast. For establishing an accurate RLP framework, the policy-makers, risk analysts, MIS team and the business units' managers need to be combined. It is important to gain acceptance from business units (BU) to identify the affected ventures or segments of the portfolio to determine the sales strategies of the organisation.
There might be some exceptions regarding the "bad investments" which would need to be tracked and negotiated with the BUs to monitor the performance over time. If a risk-adjusted price is right but the BU has created exceptions to get lower rates for customers, the risk-adjusted return for that BU will be lower than expected because the spread is too low for the customer risk profile. For an example, RLP framework allows the business units (BU) to choose between making 10 deals with a 14 per cent risk-adjusted return or 15 deals with a 13 per cent risk-adjusted return. On the other hand, exceptions land banks in additional risk exposures. Performance of the exceptions indicates that the bank's sales instincts are on the mark or need to be adjusted.
In the era of financial uncertainty and moral unpredictability, risk-adjusted loan pricing (RLP) methodology can lead the banks and FIs from risk-avoidance mindset to risk-return mindset. To generate ample level of profit and gain capital adequacy, these organisations can start differential price offerings of credit products to stay top of the competition and deliver adequate returns.
Adnaan Jamilee Financial Services Professional
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