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Pricing Decisions in Credit Risk Management

Date: July 10, 2015 Author: Ramzi Watfa
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In line with the Basel accords, it is imperative that credit risk is balanced by rewards. Without the rewards, credit risk could not be sufficiently covered, and the impact on capital would be detrimental to the bank’s well-being. So how are we to combine the two to ensure that we are charging sufficiently to cover credit risk and are banks doing it properly? Let’s go through the logic first.Credit Risk Management Icon

Credit Risk is normally measured through the credit review process. Rewards are measured from the profit and loss of a relationship with an obligor, or a set of obligors. So how are we combine the two to ensure that we are charging sufficiently to cover credit risk?

Profit and Loss Put simply, the profitability of any relationship is measured through the following formula:

  • Net Revenues (spreads plus fees)
  • Minus Operating Expenses. This is normally a percentage of the Net Revenues, and is derived by dividing the overall Total Net Revenues by Total Operating Expenses.
  • Minus Expected Losses (EL) as per the risk rating of the obligor or portfolio.

The resultant profitability is better known as Risk Adjusted Return on Capital or RAROC. At the level of each obligor, it has to be:

  1. Positive to compensate for the Operating Expenses plus Expected Losses, and
  2. Adequate to provide the bank’s shareholders with sufficient return on their Economic Capital (aka Unexpected Loss of UL) as set by the Board of Directors every year.

The ratio of Profitability to Economic Capital is known as the Return On Risk Adjusted Capital or RORAC and is normally compared with the Return on Economic Capital (ROEC) that is set by the Board. Obviously RORAC has to be equal to or above this threshold. A more informative methodology on how all this is calculated can be had in our Credit Risk module.

Accountability In an effort to introduce credit accountability, some banks started assessing their relationship officers on the level of RORAC their particular portfolios generate. Those that had lower than the threshold had much to answer for. Those that exceeded the threshold shared in this extra return through bonuses. Perhaps after the debacle of the sub-prime, this practice can be made common amongst all banks.

Ideal Spreads As ELs and ULs are fixed in value for each obligor or portfolio, obviously there is a minimum spread that is sufficient to cover the underlying credit risk. If we were to use the above equation starting with Net Revenue = Spread x Facility Limit, then to arrive at the ideal spread for any given Revenue to Expense ratio, Risk Rating and ROEC, the spread would be:

Spread = CCF x (EL + (UL x ROEC)) x RE ratio / (RE ratio – 1) / 10,000

So the minimum spread charged on a particular facility for a given Facility Risk Rating is equal to its type (CCF being Credit Conversion Factor), its Expected Loss of that facility rating, plus the Return on Economic Capital that the shareholder expects for its capital, multiplied by a Revenue to Expense factor. The division by 10,000 is used when the EL and UL are expressed in basis points. The ROEC is determined by the Board (fixed every year), and the Revenue to Expense or RE ratio is a function of the amount of net revenue the bank makes versus its operating expenses. The RE ratio is also calculated on an annual basis.

If we were to use:

  • Revenue to Expense ratio of, say, 2 (happens to be an average for most banks)
  • A Return on Economic Capital (ROEC) of 25%
  • A risk scale of 1-10 with 1-6 being acceptable obligors.

For a risk-rated 6 obligor with no collateral security associated with its direct facilities, the minimum spread one should charge is 7.59% pa to cover all the credit risks associated with the obligor, and provide a return to the bank’s shareholders. Similarly the charge for a sight LC should be 1.52% pa and 3.8% for Performance Guarantees. These levels are certainly onerous, but unless the bank is willing to lose profit on a relationship (and it would be very unwise to do so), these have to be charged. If the bank were not to charge these seemingly uncompetitive rates, then the bank’s shareholders would have to cough up the shortfall, either by way of additional provisions or increased capital (either way reducing returns on shareholder equity). Under the circumstances, a bank has several options up its sleeve to manage such a seeming, loss-making proposition:

  1. Deal with better rated obligors (improve the Target Market).
  2. Acquire cash collateral or margin against a facility.
  3. Deal mostly with indirect facilities whose CCF is much lower than those for direct (Cross Sell).
  4. Increasing the Revenue to Expense ratio. The higher this ratio, the lower the spreads charged to clients as the extra revenues of the bank automatically compensate it for the credit risks it is taking. If the RE ratio were to increase from 1.2 to 4, then for a risk rated 6 obligor and an ROEC of 20%, spreads to be charged reduces from 23% to 5%.

Revenue to Expense Ratio Increasing the Revenue to Expense ratio requires particular effort on behalf of a bank. Banks on average have an RE ratio of 2:1 (or as the accountants would have it Expense to Revenue ratio of 50%). Those in the emerging markets tend to have lower ratios of 1.6:1, and those in developed markets higher than 2:1.

One of the most critical factors impacting the RE ratio is the bank’s ability to cross-sell its products. The better the cross sell, the higher the RE ratio. Due to the limitation of facilities offered in emerging markets (mostly limited to overdrafts, LCs, LGs, and some FX) cross-sells are low, and RE ratios are hardly above 1.6:1.

What banks need most is the ability to create new products to improve on this ratio, particularly those with high fee structures. Banks that are willing to change to comply with IRB also have to be able to change from within, to be able to think out of the box and create new businesses for themselves, within and outside their immediate markets. This will create the efficiencies needed to manage credit risk. We seem to go back to the issue of talent within a bank, the need to train, and the need to hire the right caliber people, and so on.

Changes to Current Status Quo Hang on a second. Are we stating that the fees and spreads that are charged to obligors across most markets are way below what should be charged given the above. How come?

Using Basel’s Standardized Approach methodologies, it is assumed that the 10.5% (and now 12% in most Emerging Markets) was sufficient to cover VAR exposure. Based on this, there is no direct link between charges and risk; capital is fixed and whatever the banks charged over and above cost of funding and operating expenses was extra profit. Bonuses were paid not on RAROC basis but on number of obligors booked and revenue growth. The more one booked, the more revenues were expected, and the more bonuses were paid. Under these circumstances, for any obligor, based on an RE ratio of 2:1 and ROEC of 20%, the spread on direct lines would be 4.2%. This is the equivalent of a risk rated 5 under IRB for the same business characteristics, and explains why inefficient banks have shied from dealing with large companies (risk rated better than 5) and instead are focusing on SMEs where they can get away with higher charges. However with the onset of IFRS9 where you would be obliged estimate probability of default, you will soon discover that the model for charging falls far short of what it should be.

If you are interested to learn more about how credit risk, subscribe to our modules on http://credit-risk-store.com/online-courses/credit-risk-management/

© 2014 6 Sigma Group

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