Risk Based Pricing

A Model for Credit Unions

Developed by Randy C Thompson, Ph.D.
President, TCT, Inc.

Introduction

One of the more innovative practices introduced into Credit Union credit programs is risk-based lending (RBL). RBL employs tools, such as the Fair-Isaac (FICO) credit scoring system, to identify the relative risk of loan repayment by different borrowers. Through FICO, a score is generated for each borrower, which indicates the relative risk of loan default by that borrower. In RBL the scores are used to create ranges into which potential borrowers are assigned. As the scores decrease, the risk of loan default increases.

The use of RBL offers two, somewhat dichotomous advantages to credit managers. First, it helps to identify, and perhaps avoid, high risk loans, thereby reducing, at least in theory, the risk associated with the loan portfolio. Second, it allows the credit union to create products to better serve a larger pool of members.

The key to achieving the second advantage is the ability of the credit union to adequately price loans of distinct grades, thus, assuring a return that compensates for the risk associated with each grade of loan.

Almost all credit unions have attempted to create such a pricing scheme. In these schemes the best, or A+, grade gets the best rate available. Each decreasing grade (A through E) receives a higher interest rate. This strategy appears to answer the pricing question; however, it does so in the absence of accurate measurement of the costs associated with each grade of loan. In the absence of accurate cost identification, this pricing approach would best be identified as tiered pricing and does not assure a return that is adequate to offset the risk of loans with lower FICO scores.

A superior alternative to tiered pricing is Risk-Based Pricing (RBP). In RBP all costs associated with RBL are identified, and allocated to the different loan grades. By allocating the full risk, as measured by cost and return, a credit union may extend its lending practices to an expanded segment of the membership and protect itself from non-funded losses, thus supporting a healthy ROA.

This paper provides a clear definition of RBP and outlines the elements that are included in the TCT Risk-Based Pricing model. The paper does not provide an extensive review of the research techniques employed in the development of RBP, but instead focuses on its implementation, to support RBL.

Risk-Based Pricing

Definition

RBP is a system of loan pricing that allocates risk to each grade of loan through a systematic pricing strategy. To allocate risk, RBP identifies all costs associated with the lending process, including underwriting, repayment and risk of loss. It then assigns those costs, and a fair return, to each grade of paper through a computed interest rate.

Advantages/Benefits

Implementation of the Risk-Based Pricing model offers the following specific advantages to a credit union:

Increases the ability to offer loans to members across the spectrum of FICO scores,
Decreases subsidies from high FICO score loans to low FICO score loans thereby increasing the ability to provide competitive rates for all grades of paper,
Assures receipt of interest revenues to provide for loan loss reserves, and
Provides for increased interest rates spreads to enhance ROA.

Implementation Steps

Implementation of the RBP model is accomplished in a step-wise manner using the following steps:

Identification of costs, both direct and indirect, that are incurred in the lending process,
Calculation of cost contribution from each grade of paper,
Conversion of costs to interest rates, and
Application of interest rates to each grade of paper.

Costs Associated with Risk-Based Lending

Product/service pricing typically requires pinpointing production costs and then adding a margin to provide a return on investment. RBP is consistent with this process. The starting point in the implementation of RBP is the identification of all costs incurred in the lending process. A thorough analysis indicates that the lending function in a credit union includes four distinct categories of costs that must be included in the pricing model. These categories are:

Cost of Funds
Deposits held at the credit union are the primary source of loan funds. The blended Cost of Funds is used as the foundation of RBP pricing. This cost represents the interest paid to members for the deposits held in member accounts.
Processing
The next cost category includes those costs, both direct and indirect, that are incurred by the credit union in the issuing of loans. This category includes costs associated with attracting borrowers, processing applications, underwriting and maintenance. Collection costs are not included in this category, but are broken out separately for reason that is explained below.
Collections
The costs of collecting loans, that are not performing as agreed in the loan documents, is the third cost category. As will be shown later in this paper, this category of cost varies across the different grades of paper and so must be isolated for accurate application of interest rates.
Loan Charge-Offs
The fourth category of cost is the charge-offs that result from defaulting loans. In RBP charge-offs are included as a cost of the lending function. Including this category allows the credit union to price for risk and build any future loan loss allowance into the loan rates.

The following graph illustrates the differentiation of these costs.

Distribution of Costs

Before discussing the calculation of interest rates through the RBP model, it is necessary to discuss a difference in the application of the four cost categories. Costs may be applied either equally or proportionally across the different grades of loans. If the cost is consistent for each grade then equal application is indicated. If the costs differ, based on the grade of paper, a proportional application is indicated. In this RBP model both equal and proportional applications are used.

Consistent across Grades
The following two cost categories are applied equally across the grades of loans:
Cost of Funds
The cost of funds is based on the blended interest rate paid on deposits. The same source of deposits is used to fund all loans issued by the credit union. For this reason cost of funds is equally applied to all grades of loans.
Processing
Laws and regulations governing the extension of credit, as well as prudent lending practices, require that all loan applications be handled in a consistent manner. Some loans may require minimal additional work, such as preparing a co-signer document, but these differences are not significant across the grades of loans. For this reason processing costs are equally applied to all grades of loans.
Variable across Grades
The following two cost categories are applied proportionally across the grades of loans:
Collection
Practice shows that loans in the higher risk grades (lower FICO scores) consume significantly more collection time and expense than those in the lower risk grades. For this reason, collection expenses are applied proportionally across the grades of loans. This proportion is calculated using a statistical model developed by TCT.
Loan Charge-Offs
By definition loan risk implies the potential for loss associated with loan grades. For this reason, loan charge-offs are applied proportionally across the grades of loans. This proportion is calculated using a statistical model developed by TCT

Calculation of Costs

Once the costs are identified, both by source and distribution, a logical process is applied to calculate the costs in each category. The process is distinct for each category of cost. (See graph below)

Cost of Funds
As part of their reporting requirements, credit unions regularly compile the cost of interest paid on deposits. This amount is then computed into an interest rate called the Cost of Funds. This rate, as currently calculated, is used as the foundation of RBP.
Processing
Activity-Based Costing (ABC), an innovative cost accounting model, is used to identify all costs, both direct and indirect, that are associated with the lending process. ABC eliminates the problem of subsidies, between loan grades, that are associated with more traditional cost accounting methods. Lending costs are divided into loan types (i.e., consumer, mortgage and commercial). With the costs identified by loan type, a statistical process is applied to calculate an interest rate to compensate for this cost. This interest rate is applied equally to each grade of loan.
Collections
Collection costs are derived from the ABC model but broken out for a distinct application. As mentioned earlier, this cost is not incurred equally by all grades of paper. The higher risk loans, identified by a lower FICO score, incur a proportionally higher share of this expense. Accordingly, a statistical model is used to apply this cost according to the relative collection risk associated with each grade of loans. This rate is then converted to an interest rate and applied proportionally across the grades of loans.
Loan Charge-Offs
A three year rolling average of charge-offs is used in the RBP model. Use of a three year model, provides a more consistent basis for analyzing this cost category, by normalizing the amount of charge-offs. Again, a statistical model is used to divide the costs among the grades of loans. This cost is then converted to an interest rate and applied proportionally across the grades of loans.

Applications

Each of the four cost category calculations yields an interest rate that can be applied to each grade of loan (as shown above). Cost of funds and processing calculations yield a consistent interest rate for each loan grade. Collection and charge-off calculations yield an interest rate that increases as the risk increases. The rates for each cost category are summed, by loan grade, to arrive at a base rate.

Once the base rate is calculated a margin of 2% is added to the cost to provide a starting point for pricing loans. The 2% margin may be reduced in response to competitive rates, but at no time would a credit union be advised to reduce its rates below the 2% margin. Below this point, the loan would cause the credit union to lose money, negatively impacting ROA. (See graph below)

The TCT model includes a pricing spreadsheet that is divided into three sections. The first section includes the recommended rates for each grade of loan, by term. In the second section, the credit union lending manager, inserts the suggested loan rates. The third section calculates the yield and the net effect of the rates on earnings. By applying this model, credit managers can assure that all loans are contributing positively to ROA.