Risk-based loan pricing model
For many years, we have been involved with developing, maintaining and supporting a risk-based loan pricing model for one of our banking clients. This helps them to determine the optimum interest rate for a loan to ensure that it provides a return commensurate with the risk to the bank.
Under international banking regulations, banks must have adequate capital to underwrite their loan book – with the amount of capital required being determined by the perceived risk. Since capital is a limited resource, it is essential that it should be allocated to those areas that deliver the best return: this tool helped the bank to ensure that this could be done reliably and easily.
The model takes as inputs loan details such as borrower risk grade, term, margin, fees/costs, collateral, and payment structure and calculates the capital requirement and risk-adjusted cash flows for each month of the term (adjusted for anticipated losses). It then carries out a discounted cash flow analysis of these monthly figures to calculate an overall risk-adjusted return on capital (RAROC) and net present value (NPV) for the loan. This provides the bank with the necessary information to decide whether or not the loan meets its lending criteria. To assist the lending officers, our model also provided sensitivity and scenario tools, to allow them to experiment with changing the terms of the loan to see how those changes affected its profitability.