SAS: Risk-Based Pricing: The Steps to Initiate a Risk-Adjusted Framework
Posted: 9 September 2009 | Source: SAS
There are some factors that require careful consideration before the development and implementation of a risk-based pricing framework. This paper outlines those factors and provides a quick methodology to begin instantiating risk-based pricing when other processes, such as an economic capital framework, have not yet been implemented. This methodology makes it possible for institutions with a less sophisticated enterprise risk management (ERM) framework to differentiate customers based on their risk profile; institute a process by which the bank can affect its risk profile; and determine a level of risk to actively pursue.
What is Risk-Based Pricing?
Risk-based pricing, in its simplest terms, is the alignment of loan pricing with the expected loan risk. Typically, a borrower’s credit risk is used to determine whether a loan application will be accepted or declined. That same risk may also be used to drive the loan price. This means charging a higher interest rate for a higher-risk transaction and a lower rate for a lower-risk transaction. Additionally, risk-based pricing builds on the net interest margin 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).