Risk Adjusted Return on Capital Employed

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Cost heads considered in pricing as % of exposureCost of FundsDirect and Indirect CostsProvisionsOpportunity Cost of Regulatory Capital Loan origination and servicing cost + Other overheadsMaximum of Existing provisions apportioned Expected loss computed as PD * LGD * ExposureCost of borrowing Hurdle rate based on RoE * Regulatory capital

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Risk based pricing an example8.50%1.00%0.50%0.90%0.00%2.00%4.00%6.00%8.00%10.00%12.00%Cost of fundsOverhead costCredit risk premiumCost of capitalProcessing feeLending rate0.10%10.90%

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Credit risk premium depends on the rating of the borrower*LGD is assumed as 10% as per Basel guidelinesAssumptionsProcessing fee is amortised over 10 years

Quality of borrowerCredit riskPDLGDExpected loss = PD* LGDRisk based pricingExcellentNegligible0.30%10%0.03%10.43%GoodLow1.00%10%0.10%10.50%ModerateMedium2.00%10%0.20%10.60%PoorHigh5.00%10%0.50%10.90%

a.Cost of funds8.50%b.Overhead cost1.00%c.Processing Fee1.00%d.Regulatory capital12%e.Return on Capital10%f.Risk weight for home loans50%, 75%g.Cost of capital = d * e * f0.60%, 0.90%

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Benefits of a rating modelDecision to lend reduce adverse selection problemIn case of lending for a poor credit worthy borrower, what additional collateral to be soughtMeasure risk and price loans in a scientific mannerAchieve consistency across the organisationPerform analysis of portfolio using risk scores, drivers of risk in the rating model

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Explanatory Variables in the Home Loan ModelFixed Obligation / Income IncomeLoan AmountEMI/NWQuality of Borrower Cost of Living AgeSkill levelYears of ExperienceOthersFamily structureJoint/NuclearYears of BankingMarital StatusNo. of dependentsResidence typeLoan to ValueQualitativeQuantitative

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Quantitative IndicatorsFixed Obligation to Income Ratio (FOIR)Higher the FOIR, lower is the capacity of the applicant to absorb the negative shock in net income. Hence, higher the FOIR, lower is the ability of the applicant to meet unforeseen expenses.From the data it is observed that if FOIR exceeds 60%-80%, default increasesThe optimum range for lending in terms of most favorable default experience is the 40%-60%

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Quantitative IndicatorsLoan to Value Ratio (LTV) Lower the LTV, greater is the applicants contribution towards the asset i.e. loss in event of default increases for the applicant.

The optimum range in terms of most favorable default experience is the 60-70%Default rates increase sharply when LTV is greater than 80%

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Quantitative IndicatorsAge of the Borrower The lower age bracket and the higher age brackets appear more prone to default

The 40 -50 years age bracket seems to be the safest

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Other important factors which should be considered for appraisalCredit Track RecordPast credit record depicts the attitude of the person in honouring his credit obligation. Wilful default are one of the causes for a number of defaults.Nature of Asset In Housing Segment, assets gradually appreciate with time unlike many other assets [Cars, white goods, etc.]. The chance of negative equity will be lesser and Loan to Value ratio will improve over the period of time.Collateral SecurityAdditional collateral security lowers the net exposure of the bank. It increases the applicants contribution in the asset thus effectively reducing loan to value ratioIf the Collateral Security is high, in case of default by the applicant, the Loss Given Default will be lower

Rating models Does it really work ? 6967 out of 9092 customers correctly classified -77% accuracy (73% accuracy within first 3 grades refer blue color last column)

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Balance business flexibility with asset quality improvement The objective is to strike a balance between business objectives (so that not too many cases are rejected) and potential NPA reduction.

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Formation of pools cost effective way of managing risks

Pool 1Pool 2Pool 3Pool 4Source of IncomeSalariedSelf EmployedSalariedSelf EmployedLTV50% - 75%50% - 75%>75%>75%FOIR< 40%40% - 60%40% - 60%> 60%Expected Loss0.1%0.2%0.25%0.3%Interest Rate11%11.10%11.15%11.45%

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Risk based pricing of mortgage loans USAInterest rates are determined based on a number of factors like Loan Type, Loan AmountProperty Type, Property Use, Property LocationCredit Score and History one of the most important factorsDebt to Income Ratio Appraised Value/Purchase Price Loan to Value/Purchase Price Documentation TypeExample: FICO score >=760 score can fetch 0.375% rebate FICO score 680-719 will have no fee/rebate FICO score 660-679 will incur 0.25% costIllustration source: http://www.thetruthaboutmortgage.com/mortgage-dictionary/risk-based-pricing-loan/

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Risk based pricing system in various countries

USA/ CanadaUKAustraliaInterest Rates are linked to credit scores and internal rating models

FICO score is widely used in US

Equifax's ScorePower and TransUnion's credit score are popular in Canada

Risk based pricing notice to be given to consumers - mandated by regulationInterest rates are linked to credit scores and internal rating models

Internal rating models and scorecards are used widely than external credit scores to calculate credit risk and interest rates

Experian and Delphi scores are also referred to

Interest rates are linked to internal rating models

Internal rating models and scorecards are used widely than external credit scores to calculate credit risk and interest rates

External credit scores used to decide whether loan to be approved or not and set limits

Discussions

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