CREDIT PRICING

Risk based pricing

Components of cost of lending
Base rate and its calculations
Credit risk premiums
Cost of capital

PRICING OF DIFFERENT BANK PRODUCTS AND SERVICES

1.Deposits ROI on Savings and Term Deposits
2.Fund Based Credit facilities ROI on Term Loans, Cash Credit,
Overdraft, Bills discounting/purchase (backed by LC or not),
Export / Import finance
3.Non-Fund

Based

Credit

facilities

(Domestic/Foreign)

Commission on Bank Guarantee (Performance/Financial), Letters

of Credit (DP/DA)

TYPES OF PRICING OF PRODUCTS - STRATEGIES

Value for money pricing ( Parle G biscuits, Britannia Marie, Maruti Car,
McDonalds, Vada Pav)
Skimming pricing High prices for new novelty products introduced eg iphone6
Penetration pricing Opposite of skimming pricing for new products to
capture market share
Perceived Value pricing e.g. ATM Banking cash dispensation 24X7X36
Relationship pricing Bunching group of products and services eg. Mobile
voice call charges + data
Behaviour Modification pricing eg Charge if you visit the branch or charge if
you issue large no of cheques
Cost + pricing
Variable cost pricing
Break even pricing
Rate of return pricing (ROCE)

OBJECTIVES AND IMPACT OF PRICING FUNCTION

Match and / or counter competition
Recovery of cost including risk premium
Improve earnings and profitability
Influence demand by influencing the customers improve market share, attract good customers
and avoid attrition
Improve Capital adequacy in Banks
Capacity utilisation of resources eg Lockers, IT investments
ALM RSA & RSL
Achieve Customer satisfaction Restaurants
Optimise risk and return and avoid lower risk customers subsidising high risk customers
Avoid adverse loan selection

INPUTS NEEDED FOR PRICING

Regulatory prescriptions / restrictions on pricing
Cost of all inputs fixed and variable
Allocation of cost to different products and services
Cost analysis of competitors and their pricing
Estimate price elasticity of demand
Demand analysis

CONCEPT OF RISK BASED PRICING

1. Risk based pricing involves the alignment of loan pricing with the expected credit risk.
2. Typically, the credit risk of a borrower is used to determine the accept/reject decision
of a loan and to drive loan pricing. This means charging a higher interest rate for a
higher risk transaction and a lower rate for a lower risk transaction.
3. The practice of risk based pricing has beneficial impact on an economy. First, scarce
loanable funds will be allocated in a more efficient manner, as businesses with better
prospects and associated lower risk would find credits to be less expensive.
4. Secondly, more accurate measurement of and pricing for risk would reduce the
sometimes disruptive rationing of credit than can occur, especially during economic
downturn.

BENEFITS OF RISK BASED PRICING

Enables an institution to know early enough what kind of price/fees will
satisfy its risk/return preferences
Enhances shareholders value by ensuring that credit risk associated with
the transaction is appropriately measured and priced
Improves loan and profitability relationship
Enhances the achievement of credit portfolio goals and objectives
Satisfies regulatory requirements that the risks inherent in loan products
and services have been adequately accounted for in the pricing of loan

COMPONENTS OF RISK BASED PRICING METHODOLOGY

Additional Margin

Capital
Costs

Risk Costs (RC

Operating Costs (OC)

Funding Costs (FC)

FUNDING COSTS
1.Cost of Deposits Savings, Current, Term Deposits, CD
2.Cost of Borrowing and funds Refinance, Inter-Bank
borrowings, Euro-Dollar Borrowings, Tier 1 & 2 Bonds
3.Cost of CRR Negative Carry of CRR
4.Cost of excess SLR maintained
5.Weighted Average cost of Funds Historical Cost or
Marginal Cost can be used for pricing decisions

OPERATING COSTS
1. Deposit Insurance premium
2. Staff Costs
3. IT Costs
4. All other overheads
Operating costs have to be allocated to different products and services
scientifically

RISK COST TENOR PREMIUM AND CREDIT RISK PREMIUM

1.Tenor premium arises from loan commitments with longer
tenor. Longer the tenor of a loan, higher the risk and therefore
higher the premium. The change in tenor premium will not be
borrower specific or loan class specific. In other words, the tenor
premium will be uniform for all types of loans for a given residual
tenor.
2.The credit risk premium charged to the customer showing
default risk is based on credit risk rating and scoring model and
after taking into consideration customer relationship, expected
losses and collaterals. Under Basel 2 guidelines Banks have to
categorise borrowers into rating classes showing similar
characteristics for default relationship. Thereafter credit risk
rating of each borrower is to be undertaken using credit rating

CAPITAL COST:
This is a product of hurdle rate and economic capital.
Economic capital is a function of PD, LGD, EAD and default
correlation of the asset portfolio.
The hurdle rate figure is a board decision and can be
determined from the capital asset pricing model (CAPM) or
through appropriate benchmarking.
Economic capital represents the capital required to cover
unexpected losses in the institution, given the risk-specific
time horizon and the desired target rating of the institution.

ADDITIONAL MARGIN:

1. This represents the target return on

equity, i.e. the rate of return expected
by shareholders.
2. This expectation is guided by economic
fundamentals and the long term

CASE STUDY FOR DISCUSSION ON RISK PRICING

Given below are eight different types of Export Bills to be discounted by Mera Bank Ltd.
You have to
identify the type of risk in each bill to be discounted
the level of risk identified by you in terms of low, medium or high
indicate the pricing effect in terms of premium to be added on base rate in terms of +
0, 1, 2, 3 or more basis points based on level of risk for the Bank

Bill Name of
No. Customer

Country
Item Sold Billing
to which
done in
exported

Tenor of Whether DP or DA
Bill
LC
available

1.

Toyota

Japan

Horns

Yen

Sight

No

Ford

Thailand

Bakht

60 days

Maruti

India

Rupees

90 days

LC
Available
No

Piaggio

Angola

Wheel
Rims
Gear box
parts
Scooter
parts

General Motors USA

Axle

Local
120 days
Angolan
Currency
US $
180 days

Honda

Brazil

B Lining

US $

Sight

Volkswagon

Germany

Euro

Sight

Bajaj Auto Ltd.

India

Piston
Rings
Plastic
parts

Rupees

270 days

LC
Available

Name
Bank

DP

of

Not
applicable
DA
Bank
of
Thailand
Receipted Not
challans
applicable
DA
Bank
of
Angola

LC
Available
No

DA

Citi Bank

DP

LC
Available
No

DP

Not
applicable
SBI

Receipted Not
challans
applicable

SOLUTION TO CASE STUDY

Bill
No.
1
2
3
4
5
6
7
8

Name of
Customer

Tenor Risk

Credit Risk
(LC
&
Bank
Strength)
Toyota
Low Risk
High Risk
Sight
No LC available
Ford
Low Risk
Medium Risk
60 days DA
LC of Bank of
Thailand available
Maruti
Medium Risk
High Risk
90 days DA
No LC available
Piaggio
Medium Risk - 120 High Risk
days DA
LC of Bank of
Angola available
General
High Risk Low Risk
Motors
180 days DA
LC
of
Citibank
available
Honda
Low Risk
High Risk
Sight
No LC available
Volkswagon Low Risk
Low Risk
Sight
LC of SBI available
Bajaj
Auto High Risk
High Risk
Ltd.
270 days DA
No LC available

Credit Risk
(Drawee)

Currency Risk

Country Risk

Low Risk

Low Risk

Low Risk

Medium Risk

High Risk

High Risk

Low Risk

NIL

NIL

High Risk

High Risk

High Risk

Medium Risk

Low Risk

Low Risk

Low Risk

Low Risk

Medium Risk

Low Risk

Low Risk

Low Risk

Low Risk

NIL

NIL