Risk-Based Pricing

When acquiring assets, banks and NBFCs use a pricing mechanism commensurate to the product, geography, and tenor limits. For lending assets that may be unattractive for the bank’s or the NBFC’s portfolio, the lender can offer these at a higher price to disincentivize the borrowers. This Marginal-Cost Pricing compensates the lender for the marginal cost associated with each borrower on a risk-adjusted basis. However, this strategy would not yield maximized returns in situations of large idle capacity and capital, where it is in the commercial interest of the lender to generate even small positive spreads on idle capital. In situations where risk grading amongst borrowers is not granular, risk differentiation may not truly result in price differentiation, as borrowers are segregated on a smaller risk-scale.

In another illustration of risk-based pricing, banks use Cost-plus-Profit Pricing strategy, where the lender has an advantage of multiple offerings and does not engage in price war. Such a lender is a market leader and sets the rules for pricing of assets for other smaller market players. This simplistic approach to credit pricing is based on computing a capital charge for each borrower’s risk rating, tenor, collateral, guarantees and covenants and historic loan loss rates, over and above a hurdle rate. However, this implicit approach to pricing, only incorporates expected losses in computation of capital charge, and assumes only two scenarios, of default or no default, and does not consider risk premiums adequate to factor in the gradually improving or declining credit profile of a borrower across the spectrum between default and no-default.

Banks and NBFCs have long transformed their credit pricing decisions to be able to allocate sufficient capital consistent with risks taken across the portfolio. From allocating capital to business units based on size of the lending assets, to using blanket regulatory capital across asset classes, to incorporating unexpected losses at sub-portfolio level (where sub-portfolios exhibit default correlations resulting in one line of business subsidizing the other), the search for the most optimal capital charge computation and credit pricing decision has led us to the evolution of Risk-Adjusted Return on Capital (RAROC).

Large sized banks across the world have already put in place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans, which calls for data on portfolio behavior and allocation of capital corresponding with credit risk inherent in loan proposals. Risk Adjusted Return on Capital or RAROC is a risk-based pricing tool that is used for transaction approval and pricing. It  is a unique risk adjusted profitability measuring tool representing a risk-oriented view for revenues, in perspective of the magnitude of risks taken to generate those revenues. It signifies the buffer from the Economic Capital that can be provided for Unexpected Losses.  Based on business needs and judgements, RAROC can be used for approval or rejection decision, pricing of loans, structuring or collateral coverage, and measure of profitability across various business segments.

The underlying fundamental risk management principle used in RAROC suggests that the higher the Probability of Default (PD) of a borrower, the higher the price charged for the lending product. Borrowers that are Public Sector Enterprises (PSEs) or equivalent, are charged low as they are believed to have a low likelihood of default given the implicit sovereign support.

RAROC framework helps banks and NBFCs in making better credit decisions when approving, structuring, and pricing deals. Risk adjusted returns are arrived at after adjusting income for all expenses, expected losses, return on economic capital. The denominator could either be Economic   Capital or Regulatory Capital.

The framework primarily takes into consideration probability of default, loss given default, unexpected loss – it takes into account expected loss-pl check, and risk capital, to compute RAROC.

RAROC is a modification of the traditional return generated from a transaction, after accounting for the riskiness of the transaction. 

RAROC = (Return Generated) / (Regulatory Capital Required)

• ·    Return Generated on Capital

Return Generated on capital is the amount which the bank intends to make from the loan transaction after deducting all the cost involved.

Return Generated = Interest Income + Fee Income + Return on Capital invested – Cost of fund –Operating cost & other overhead cost – Expected Loss

• ·    Regulatory Capital

The amount of capital a financial institution is to maintain for every lending asset, as mandated by the RBI.

Regulatory Capital = Exposure * Risk Weight * Regulatory Capital Amount

• ·    Risk Adjusted return on Capital

Risk adjusted return on capital or RAROC is the return generated on capital as a percentage of the capital required for the transaction.

RAROC = [(Interest Income + Fee Income + Return on Capital invested – Cost of fund – Operating cost & other overhead cost – Expected Loss) / (Regulatory Capital)] * (1-Tax Rate).

Since any transaction priced as per RAROC will be acceptable only if it at least matches the hurdle rate, the effective return generated from the transaction should be equal to the Hurdle Rate * Capital Required for the transaction. A higher volatility of returns essentially necessitates more capital allocation which suggests that the transaction has to generate cash flows large enough to offset the volatility of returns (arising from credit risk, market risk and other risks).