Advanced Credit Risk Analysis and Management

21

Pricing Methods

What method should be adopted while pricing a credit? If the price is too high, good quality credit would be hard to come by. On the other hand, if the credit risk is underpriced, not only does the value addition suffer but it also means that the risk underwritten is not appropriately compensated for.

Pursuing risk-adjusted profitability is a tough job. Nowhere is this harder than in large corporate lending, where, by most accounts, adequate risk-adjusted returns are hard to achieve, given the competition in the market for creditworthy accounts. To control credit risk exposures while ensuring adequate return to shareholders who have risked their capital (in creating credit assets), institutions must accurately measure the value delivered by a loan, bond or any other credit contract. Credit providers who are deficient in this vital capability are essentially trying to run a business without knowing how to price credit commensurately with the underlying credit risk. Most institutions today use rudimentary credit risk pricing procedures. The consequence is that the credit providers originate or acquire many credit assets that they should not, while turning down those they should have accepted. The basic pricing model, described in the previous chapter, that stresses the recovery of costs and a reasonable profit for the shareholders, can be applied by different methods discussed below, starting with RORAC:

21.1 RORAC (RETURN ON RISK-ADJUSTED CAPITAL) BASED PRICING ...