LO 33.8: Discuss the benefits o f risk-based pricing o f financial services.
Recognizing that charging a single price for a product to all customers regardless of risk levels may lead to adverse selection (i.e., high-risk customers attracted to a relatively low price relative to their risk profile and low-risk customers pushed away by the higher price relative to their risk profile), lenders have been moving toward risk-based pricing (RBP). RBP involves lenders charging different customers different prices based on their associated risks. Although RBP is still in the early stages of implementation in the financial retail sector, it has been utilized more frequently in credit card, home mortgage, and auto loan lines.
Key external and internal factors which account for risk and play into the interest rates and prices charged by lenders include:
The probability of take-up (i.e., acceptance by the customer of the offered product). The probability of default (PD). The loss given default (LGD). The exposure at default (EAD). The cost of equity capital to the lender. Capital allocated to the transaction. Operating expenses of the lender.
Prices may be set on a tiered level based on score bands allocating risks from high to low. The lender can then map pricing strategies to metrics such as profit/loss, revenue, market share, and risk-adjusted return at the various score bands. Utilizing RBP effectively allows management to evaluate the inevitable tradeoffs among profitability, market share, and risk with the short and long-term goal of increasing shareholder value.
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Topic 33 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 9
K e y C o n c e p t s
LO 33.1
Retail banking involves the acceptance of deposits and lending of money to customers. Credit risk (the probability that a borrower will default on debt obligations) represents the biggest risk in retail banking. Other risks include operational risks, business risks, reputation risks, interest-rate risks, and asset valuation risk.
LO 33.2
Retail credit risk differs from corporate credit risk in the following significant ways:
Retail exposures are relatively small such that one default has minimal impact, whereas commercial exposures are much larger and single defaults can have a significant impact. Losses exceeding expected thresholds can have a much greater impact for corporate portfolios than retail portfolios. Lenders can take preemptive actions to reduce retail credit risks, whereas commercial portfolios often send warning signals after it is too late.
LO 33.3
The dark side of retail credit risk occurs when a large scale risk factor causes a decline in asset values coupled with an increase in default rates. The end result is losses which exceed an estimated threshold. Lenders offering mortgage loans must evaluate customers ability to pay as well as determining whether a mortgage is qualified. In addition, banks must segment their portfolios and set aside risk capital as well as assess exposures and probabilities of default along with potential losses.
LO 33.4
A credit risk scoring model assigns (to each credit applicant) a score which serves as a measure of borrower risk; the higher (lower) the score, the lower (higher) the risk that the borrower wont be able to pay the debt obligation. Models include credit bureau scores, pooled models, and custom models which all use applicant data and weight them based on their historical relationship to potential defaults.
LO 33.3
Key variables associated with mortgage credit applications include FICO scores, loan-to- value ratios, debt-to-income ratios, payment types, and documentation types. Cutoff scores are thresholds set by lenders which dictate whether credit will or will not be extended, as well as terms associated with the loans. Probability of default and loss given default metrics are critical to assessing the risk associated with various lender portfolios.
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Topic 33 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 9
LO 33.6
The cumulative accuracy profile (CAP) and the accuracy ratio (AR) are used to assess the performance of a credit scorecard. The closer the accuracy ratio is to 1, the more accurate the CAP model is at predicting the distribution of defaults relative to the risk levels of the associated population.
LO 33.7
For new and existing credit applicants, lenders may use a variety of scorecards to evaluate both creditworthiness and potential profitability. The customer relationship cycle involves marketing products, screening applicants, managing customer accounts, and eventual cross- selling to an existing customer base.
LO 33.8
Risk-based pricing (RBP) involves charging different prices for the same product such that higher (lower) prices can be charged to higher (lower) risk customers. Several external and internal factors are used to determine the prices charged, which are then evaluated in conjunction with various key performance metrics at each score (risk) band in order to maximize the tradeoff between risk and profitability.
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Topic 33 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 9
C o n c e p t C h e c k e r s
1.
2.
3.
4.
5.
Which of the following statements is most accurate regarding risks incurred by retail lenders? A. Reputation risk is more of a concern for the borrower rather than the lender. B. Business risk relates to the day-to-day operational risks of the business. C. Credit risk relates to the potential for a lender to default on their obligation. D. Refinancing a mortgage when rates decrease is an example of asset valuation risk.
The dark side of retail credit risk is perpetuated by all of the following factors except: A. capital set aside to protect a bank in the event of default. B. process flaws resulting in high risk applicants receiving credit. C. new products which do not have sufficient historical loss data. D. a social acceptance of bankruptcy and borrowers walking away from their
obligations.
Which of the following statements is correct regarding credit risk scoring models? A. A pooled model will result in scores ranging from 300 to 830. B. A custom model is cheaper to implement than credit bureau scores. C. Multiple requests for new credit will reduce an applicants credit score. D. An example of a characteristic in a scoring model is the applicants current gross
salary of $30,000.
In assessing the key variables associated with a potential mortgage loan, a bank will charge a higher interest rate if the borrower has a relatively: A. high FICO score. B. high loan-to-value ratio. C. low debt-to-assets ratio. D. low debt-to-income ratio.
By implementing risk-based pricing on its mortgage products, a bank will likely charge a: A. higher interest rate to a customer with a higher FICO score. B. C. higher interest rate to a customer with a higher probability of default. D. lower interest rate to a customer positioned on a lower relative score band.
lower interest rate to a customer with a lower credit bureau score.
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C o n c e p t C h e c k e r An s w e r s
1. D Refinancing a mortgage is considered a prepayment risk to the lender, which is a component
of asset valuation risk. When rates decrease, borrowers are more likely to refinance their existing (higher rate) mortgage into a lower rate obligation. The lender then earns less in interest on the debt obligation than they would have previously. Reputation risk is primarily a concern for the lender. Business risk relates to strategic risks tied to new products and volume, while credit risk is the risk that the borrower (rather than the lender) will default.
2. A Capital must be set aside to protect banks in the event of default, but this is a response to the
dark side of retail credit risk rather than a perpetuating factor. A process flaw which grants credit to high risk individuals, a new product which doesnt have historical loss data, and the social acceptance of failing to meet debt payments are all considered perpetuating factors of retail credit risk.
3. C An individuals credit file will show a history of credit requests, with multiple requests
causing an applicants credit score to decline. A credit bureau score model (rather than pooled model) will result in scores ranging from 300 to 850. A custom model is more expensive to implement than credit bureau scores. Gross salary with current employer is an example of a characteristic, with the actual salary number itself representing an attribute.
4. B The loan-to-value ratio represents the amount of the mortgage versus the appraised value of the property. The higher this ratio is for a property and an associated borrower, the more risk there is to the lender. In order to protect their position, a lender will charge a higher interest rate. Each of the other scenarios will result in a lower interest rate.
5. C The more likely it is that a customer will default, the higher the interest rate the bank will charge. A customer with a higher (lower) FICO/credit bureau score will be offered a lower (higher) interest rate. A customer positioned on a lower relative score band will be offered a higher interest rate.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
T h e C r e d i t T r a n s f e r M a r k e t s a n d T h e i r Im p l ic a t io n s
Topic 34
E x a m F o c u s
Securitized financial products became very popular prior to the 20072009 financial crisis. Although it is important for investors to understand the inner workings and risk potential inherent in any investment before adding it to a portfolio, more complex assets such as securitized products demand even more scrutiny. For the exam, be able to identify flaws in the securitization of subprime mortgages, and be able to explain the different techniques used to mitigate credit risk. Also, be able to describe the different types and structures of credit derivatives, including credit default swaps (CDSs), first-to-default puts, total return swaps (TRSs), and asset-backed credit-linked notes (CLNs). It is also important to be familiar with the structures of collateralized debt obligations (CD Os), synthetic CD Os, and single-tranche CDOs.
F l a w s i n t h e S e c u r i t i z a t i o n o f S u b p r i m e M o r t g a g e s