Credit Pricing

From Open Risk Manual

Definition

Credit Pricing is the method by which a lender (or a counterparty that assumes the Credit Risk) in a new contract sets terms such as fees or the Margin on top of a reference rate that is required as compensation for the assumed credit risk. This approach is usually termed Risk Based Pricing (non-risk based pricing policies have also been used historically)

Credit pricing may be part of the overall pricing method that may involve other costs and risk elements (funding costs, pre-payment risk, other operational costs). A profit margin (or discount) will connect the ex-ante calculated components with the actual agreed pricing.

Methodology

In typical modern usage pricing methodologies decompose the task into distinct risk and cost components that are (for simplicity) assumed independent.

In turn, the specifically credit linked pricing component can be conceptually split into the main contributing risk factors:


In the context of holding a credit risky contract as part of a portfolio that must be funded in part by Risk Capital the above calculation would be referred to as an Expected Credit Loss calculation. In addition, credit pricing would be techniques from Economic Capital management (such as the incremental capital required to support the transaction) to incoporate the Cost of Capital.


EBA Requirements[1]

Pricing frameworks should reflect institutions’ credit risk appetite and business strategies, including profitability and risk perspective. Loan pricing should also be linked to the characteristics of the loan product and consider competition and prevailing market conditions. Institutions should also define their approach to pricing by borrower type and credit quality, and riskiness of the borrower (in the case of individual pricing) when appropriate. Institutions should ensure that the pricing framework is well documented and supported by appropriate governance structures, such as a pricing committee, that are responsible for the maintenance of the overall pricing framework and for individual pricing decisions when relevant.

Institutions should consider differentiating between their pricing frameworks, depending on the types of loans and borrowers. For consumers and micro and small enterprises, the pricing should be more portfolio and product based, whereas for medium-sized and large enterprises the pricing should be more transaction and loan specific.

Institutions should set out specific approaches to pricing promotional loans, when risk- based and performance considerations specified in this section do not fully apply.

Institutions should consider, and reflect in loan pricing, all relevant costs until the next repricing date or maturity, including:

  • the cost of capital (considering both Regulatory Capital and Economic Capital), which should result from the Capital Allocation in place, according to the established breakdowns, e.g. geography, business line and product;
  • the cost of funding, which should match the key features of the loan, e.g. the expected duration of the loan, taking into account not only contractual terms but also behavioural assumptions, e.g. pre-payment risk;
  • operating and administrative costs, which should result from cost allocation;
  • credit risk costs calculated for different homogeneous risk groups, taking into account historical experience of recognising credit risk losses and when relevant using expected loss models;
  • any other real costs associated with the loan in question, including tax considerations, when relevant;
  • competition and prevailing market conditions, in particular lending segments and for particular loan products.


For the purposes of pricing and measuring profitability, including cross-subsidisation between loans or business units/lines, institutions should consider and account for risk- adjusted performance measures in a manner that is proportionate to the size, nature and complexity of the loan and the risk profile of the borrower. Such performance measures could include


Risk-adjusted performance measures may also depend on and reflect institutions’ capital-planning strategies and policies.

Institutions should transparently document and review the underlying cost allocation framework. Institutions should establish a fair distribution of costs within the organisation in order to ensure that business lines, and as far as possible individual loans, reflect the correct expected return corresponding to the risk assumed.

Institutions should implement ex ante transaction tools and regular ex post monitoring, linking together transaction risk, pricing and expected overall profitability at an appropriate level, including business lines and product lines. All material transactions below costs should be reported and properly justified, in line with the policies and procedures established by the institution. The monitoring process should provide an input for the review of the adequacy of overall pricing from a business and risk perspective. If needed, institutions should take actions in order to ensure compliance with targets and risk appetite.

See Also

References

  1. EBA, Guidelines on loan origination and monitoring EBA/GL/2020/06



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