Why financial institutions are updating loan pricing strategies

Learn more about loan pricing — including how to assess the relative profitability of loans and how to use the output of loan pricing models — during the webinar, “Loan Pricing: A Key Driver of Success.”

Progressive banks are increasingly turning to stronger pricing models that incorporate loan risk, borrower profitability and bank strategy to ensure that the customer always sees the bank’s best rate. This rate may not be the lowest rate, but it will be its best rate that aligns with the strategic goals of the bank. These pricing models incorporate not only the likelihood of payment default but also an estimate of how much could be lost in the event a borrower fails to fulfill financial obligations.

Pricing the Potential Loss

All loans have some risk that they will default. Whether the loan has a AAA rating, a perfect FICO score or a risk rating of 1, there is always a slight mathematical chance it will not be repaid as promised. Those perfect borrowers are very hard to find because there are not that many of them. Most borrowers have some risk, and so do their loans. Bank portfolios reflect this. A typical loan portfolio utilizing a risk rating scale of 1 to 9 will generally look like a bell curve, with most of the loans showing a risk rating of 3, 4 or 5. 

Risk ratings, of course, attempt to label the relative possibility of default using a bank’s interpretation of a borrower’s financial situation, as seen through the lens of its underwriting guidelines. Regardless of individual bank underwriting guidelines, a risk rating of 5 is riskier than a 3. But how much riskier? That is what the Probability of Default (PD) attempts to assess, providing a means for pricing the relative risk into the loan.

What is the Probability of Default?

Each risk rating has an inherent percentage chance of payment default based on a bank’s own default experience. A risk rating of 1 likely has a PD close to 0 percent, but not 0 percent. A risk rating of 3 could be 0.9 percent, meaning that the average percentage of obligors that default on a loan with that rating is 0.9 percent. A risk rating of 8 is likely to have a PD of close to 100 percent.

If risk ratings and the PD establish the chance of payment default, what about the likely amount of a loss in the event of a default? Losses in the event of a default can be estimated based on what percentage of repayment sources have historically been unrecoverable, whether those sources are secured deposits, corporate cash, equipment or real estate. This Loss Given Default (LGD) ratio provides what percentage of the exposure could be expected to be lost, net of recoveries, should a borrower default. Real estate loans may see LGDs of around 35 percent; equipment loans could see much higher LGDs.

When PD and LGD are combined, they give a picture of the likely loss, and the likely loan risk, for that loan. Using the examples above, imagine a new commercial real estate loan for $1 million with a risk rating of 3. It is known that risk rating 3 loans have a PD of .9 percent and commercial real estate loans tend to lose 30 percent post-default. If the $1 million is multiplied by both the PD of .9 percent and the LGD of 35 percent, an expected loss, or risk, of $3,150 is the result. This potential risk should be accounted for in the pricing process. This is done by multiplying the risk rating PD by the LGD percentage and adding that to both the cost of funds and the spread.

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