Risk Based Loan Pricing – Is Yours the Real Thing?

Much press in the past decade has been devoted to the concept referred to as Risk Based Loan Pricing (RBL).  Most financial institutions claim they are engaged in some form of Risk Based Loan Pricing.  Turns out that most of these institutions could well be fooling themselves at their peril.

Risk Based Loan Pricing when done properly has measurable positive returns on investment (as much as 35 basis points improvement in ROA).  And there lies the crux of the debate – not many RBL models actually use measurable, stochastic methods to price consumer loans.  This paper looks at the elements necessary for an RBL program to:

• Improve  the ability to profitably offer loans to borrowers across the full spectrum of FICO scores;
• Decrease subsidies high FICO score borrowers typically provide low FICO score borrowers thereby improving the ability to provide competitive rates to all borrowers regardless of FICO;
• Assure receipt of interest sufficient to cover the increased risk in making lower FICO grade loans;
• Provide for increased interest income to significantly enhance ROA

Almost all financial institutions have attempted some sort of pricing system that adequately prices loans according credit grade (risk).  Most of these models lack accurate measurement of the costs distinct to each credit grade.  Since these models are absent accurate cost identification, at best they could be referred to as tiered pricing.  Empirical, stochastic methods are necessary to assure a return adequate to truly offset the risk and costs associated with lower grade loans and to assure the higher grade borrowers are not subsidizing riskier loans.  Pricing loans using tested empirical methods assures all costs associated with lending are identified and allocated according to the unique risks and costs each grade poses.

To assure accurate pricing of loans according to risk, stochastic methods need to be utilized that assure:

• All costs associated with loan programs are quantified and applied to rates;
• Costs are accurately measured and assigned to each credit grade independently to assure risk is quantified;
• The replacement cost of money is measured and assigned to appropriate loan terms;
• Profit margins (in excess of costs) are measured accordingly as rates are set and evaluated;
• Potential losses and cross grade subsidies are identified and corrected.

By identifying, quantifying, and applying costs unique to each credit grade, loan performance and earnings will be maximized.  The four key costs associated with lending are:

• Cost of funds (consistent across grades);
• Loan processing and management (mostly consistent across grades) ;
• Collection expenses (variable across grades);
• Charge-offs (variable across grades).

Since the crux of accurately pricing loans according to risk is dependent on distributing costs meticulously, the following process is necessary for each key cost:

Cost of funds
COF (deposits and borrowed funds) is calculated as a blended rate.  COF is the starting point for RBL.

Processing and management
Activity Based Costing (ABC) or some equivalent method should be used to identify costs, both direct and indirect associated with the lending process.  With costs identified by loan type, a statistical process can be used to convert costs into an effective interest rate.

Collections
Again using ABC, a statistical model using past experience and data is developed to identify collections costs incurred according to each credit grade at the time of loan origination.  These costs are also converted to an interest rate.

Charge-offs
Using a three year average, a statistical model is used to divide charge-off costs among credit grades (credit grade at origination).  These costs are then converted to interest rates that can be applied to each unique credit grade.

Once it has been established what the interest rate needs to be to breakeven on each credit grade and type of loan, the financial institution next needs to establish what margin they want to add to the breakeven point.  This cost + margin is the starting point for setting rates on each grade and type of loan.  Financial institutions can then use a well designed, robust spreadsheet using this data to perform “what if” pricing strategies.

Finally, it would be well to bear in mind the direction given by regulatory agencies regarding risk based lending processes.  They use a concept referred to as “reasonableness” in determining the validity of a financial institution’s RBL and its adherence to regulations.  Besides frequent testing to determine the accuracy of original assumptions that were used to establish an institution’s RBL, it must be shown that credit pricing and decisions are supported by:

• Actual experience with loans having similar characteristics;
• An empirically derived, demonstrably sound statistical analysis;
• Industry-wide data available from outside credit reporting services;
• A well documented estimate of the servicing, counseling and collection costs.

Financial institutions may learn too late that setting loan interest rates according to Risk Based Loan Pricing schemes using any methods other than those that are stochastic and statistically validated, could well face legions of risks and problems.