Leveraging regulatory investments with portfolio risk-based pricing

Abstract

In preparing to comply with the new International Financial Reporting Standards and the Basel II Accord's capital adequacy standards, leading banks are leveraging investments in these regulations by applying risk management and capital allocation best practices to adjust pricing decisions. Among the dizzying array of pricing models, risk-based pricing can most effectively help turn regulatory compliance into a competitive advantage and ultimately, transform lenders into high performance businesses. Risk-based pricing is an underwriting method by which a credit application is evaluated based on how much risk it contributes to a reference portfolio of the bank. Taking concentration risk into account allows banks to identify deals with (good) and (bad) structure, relative to portfolio pricing. In today's sluggish growth environment, the struggle to improve shareholder returns is slowly pushing banks towards commodity pricing, resulting in widespread margin and fee discounts. The traditional process of assessing loan applications is burdensome, costly, and unable to incorporate the impact of portfolio diversification. Risk-based pricing, in contrast, can improve shareholder value by driving banks to differentiate pricing based on individual customer and transaction risk as well as portfolio risk characteristics. Correct pricing can be leveraged to (cherry pick) the most profitable transactions, increase price on certain segments, and target the portion of the customer base which is destroying value. With proper training and buy-in of bank personnel, plus the right technology tools, most banks can implement riskbased pricing in less than one year. Banks that have adopted this approach have seen dramatic increases in their lending margins while maintaining, and even growing, market share.