RISK MANAGEMENT IN PRICING A FINANCIAL

PRODUCT
James B. Bexley
Sam Houston State University
Joe James
Sam Houston State University
ABSTRACT
Product pricing is one of the most critical decisions facing financial institution managers.
Management has been forced to continuously review pricing with a "sharper pencil" in
light of stiffer competition for a share of the market. If the institution is to be successful
and ensure continued profitable existence, there must be a balance between loss control
and pricing to generate profitability. This study looks specifically at the loan pricing
dilemma from a risk management perspective that minimizes the number of calculations
to arrive at the risk factor.
THE DELICATE BALANCE BETWEEN RISK AND PRICING
In the past, substantial lip service has been given to the impact of poor loan decisions
upon a bank's profitability. This lip service obviously was not heeded in light of the
substantial number of bank failures and declining bank earnings across the nation
suffered during the 1980s and 1990s. Perhaps, when we talk of a one percent loan default
rate, there is a notion that "only" one percent is not statistically significant. However, the
reality of a $100 million bank with a 65% loan-to-deposit ratio and a one percent loan
loss equates to a $650,000 impact. Further assume a $ 100 million bank earning a return
on average assets of 1.2% would return $1.2 million annually. Now should we have that
one percent loan loss in the $100 million bank which earned $1.2 million, it would be
necessary to either look at the impact of a reduction in the loan loss reserve or the charge
to earnings to replenish the loss to the reserve. In either case, the result would be an
impact on net earnings reducing it from $1.2 million to $550,000. In this example, only a
one percent loss from loans could cost the bank over 50% of its normal earnings!
DEALING WITH THE FOUR CATEGORIES OF RISK
In looking at the loan pricing aspect of a bank from an asset/liability standpoint or risk
scenario several concepts should be instantly considered by the bank practitioner. First,
and foremost is the consideration of the various means of measuring risks that the
management of a bank should consider prior to establishing a strategy for developing a
pricing model. Hempel, et al (1994, pp. 67-68) has developed an excellent concept of
measuring risk based upon four categories of risk which the author identifies as liquidity
risk, interest rate risk, capital risk and credit risk.

The element of liquidity risk addresses the bank's ability to consciously deal with
shortfalls in the supply of money either through excess withdrawals or substantial
commitments of the bank's funds for loans and other income producing devices.
Therefore, the liquidity of the bank is paramount to being able to stay in business given
the approximate 14 to 1 leverage to capital in the average bank. In considering liquidity,
the following formula will give you the liquidity risk:
Liquidity risk = Short term securities/Bank deposits
In recent years, most banks have purchased or developed sophisticated modeling
packages that give a detailed picture of the various scenarios that would exist for a bank
given differing economic conditions. So to look at the interest rate risk, we are concerned
with the assets of the bank that are subject to interest sensitivity as opposed to a balancing
of these elements with the liabilities which are also interest sensitive. In a perfect world
assets and liabilities would be balanced at an equal level. Needless to say in most banks
we do not have a perfect world, and as a result we find the need to constantly look at the
bank's position in such a scenario. To measure interest rate risk, the following formula
should be utilized:
Interest rate risk = Interest sensitive assets/Interest sensitive liabilities
The desired number for balance is one. In determining the make-up of interest sensitive
assets, you should include short-term securities and all variable rate loans. Transaction
deposits, short-term time and savings deposits, and short-term borrowings should be
treated as interest sensitive liabilities.
A risk that is often taken for granted which is critical to the foundation integrity of a bank
is that of credit risk. In looking at credit risk, we are seeking to determine the basic
exposure of the bank in all areas of credit extension. In the above example of the bank
with a one percent loan loss, it becomes very clear that credit risk evaluation is essential
to the viability of the bank. The formula for credit risk is arrived at as follows:
Credit risk = Medium loans/Assets
Medium loans would be those loans having average loss potential as opposed to those
loans of extremely high or extremely low quality. Yes, there is an element of judgement
in determining what are medium loans; however, most banks have classified their levels
of risk on their loan portfolio so it should not be too difficult to establish those loans with
average loss potential.
Capital risk addresses how much the bank's assets may decline before the depositors,
creditors, and shareholders are put at risk. The more capital the bank has the better the
cushion to absorb loss to the bank's assets at risk. The formula associated with capital risk
is as follows:
Capital risk = Capital/Risk assets

RETURN OBJECTIVE
Banks have in the past traditionally priced based upon either what the competition was
doing or what the market would bear. It has become obvious to the writers that in the
current competitive environment, those old methods will not work. Before setting pricing
parameters, the bank should set some basic return objectives such as return on average
assets, return on average equity, and net interest margin. Equally important to meeting the
objectives is the establishment of a loan-to-deposit ratio.
Why should the bank be concerned with return on average assets and return on average
equity since these are in reality end-result or "big picture" considerations? The answer is
very simple. If you are not focused upon the desired end-result, you cannot be reasonably
assured of having a sufficient volume of loans priced at the desired rate to reach your
goal until it is too late to do anything about the results. Additionally, if you have
established the desired goal, it gives the bank a yardstick against which to measure
results. The formulas for return on average assets and return on average equity are as
follows:
Return on average assets = Net income/Average assets
Return on average equity = Net income/Average equity
The net interest margin continues to be impacted by the competition for good loans. The
net interest margin considers the interest earned on loans less the interest paid for the
money. The formula for net interest margin is as follows:
Net interest margin = (Interest income - Interest expense)/Earning assets
It is obvious that as rates become more competitive, there are only so many loans to be
divided up among all of the banks and the other entities that have invaded what was for
years a market dominated by banks. At the same time, the investor has more options than
ever before concerning where to invest his/her money for optimum return. What we see
with this picture is the bank being squeezed to pay more for its deposits and charge less
for its loans. This equates to a reduced net interest margin. The only way to avoid the
impact of such a problem is to competitively price your loan with deposit or fee
requirements and strategically price your deposits in such a way that will avoid being the
highest bidder. For example, look at deposit pricing in the market and place your bank at
approximately 10% above the average price paid for deposits.
COMPETITION AND PRICING
For years, the small to mid-sized bank escaped the competitive pricing challenges facing
the large regional banks. Given the competition for quality loans from within the banking
community as well as the non-banking entities, bankers everywhere must now be creative
and price loans off of LIBOR as well as their time-tested base or prime rates if they have
any hope of staying competitive. Gone are the days when a bank in some small market

can assume that it has a "lock" on a loan merely because there is not another bank within
miles. Mass communications, computer banking, and the Internet have brought Wall
Street and the world to every Main Street, U.S.A.
Koch (1995, p. 763) stated, "The fact that loan losses were so high during the 1980s
revealed that loans were not priced high enough to compensate for default risk as well as
other risks and the cost of operating the bank." The authors certainly agree with Koch and
would point out since the 1980s, competition has increased. Should banks and other
financial institutions fail to price their loans in such a way as to insure compensation for
all of the known risks, then they stand to repeat the errors of the 1980s.
HISTORICAL PRICING METHODS
Banks have historically priced their loans utilizing several traditional methods. For years,
the primary method for loan product pricing was a variation off of a bank's prime lending
rate or a regional money center bank's prime rate usually quoted in one of the daily
financial journals. This method implied that the bank's best customer (whether judged by
risk or deposit balances) was given the prime lending rate. All other customers were
priced either at prime or some variation of prime plus a given percentage rate. This
method dominated loan pricing until the mid to late 1970s when several occurrences
caused the method to lose popularity. First, the competition for quality loans drove the
money center banks to look to more exotic pricing methods to attract the large, blue-chip
companies. This new methodology based off of LIBOR (London Interbank Offer Rate)
was then embraced by banks in middle-America. The second occurrence was a series of
law suits challenging banks' use of prime rate as the principal method for pricing loans.
Today, in lieu of prime rate, banks are utilizing the term "base rate" as the rate off of
which they price their loans. While many banks continue to use the base rate or prime
rate (disavowing that it is the best or lowest rate), banks continue to search for a method
of loan pricing that incorporates risk and at the same time allows the bank to obtain a
reasonable profit.
CUSTOMER PROFITABILITY ANALYSIS
In the quest for a method of lending money that would price the product being sold by the
bank similar to an industrial product, large money center banks and regional banks turned
to customer profitability analysis as a means to accurately include all the costs for bank
loans and services and a profit margin. Smaller community banks for the most part stayed
with a base rate pricing due to the cost and complexity of establishing and maintaining
accurate costs for all of their products and services. This method required an accurate
costing of all the bank's products, which were then applied to individual customers on an
activity or volume basis. At the same time, the customers were given credit for balances
maintained and charged for the cost of reserves and several other items.

COMPENSATING BALANCES
For years, bankers have tried to recognize the deposit balances maintained by their
commercial loan customers and give credit, either formally or informally, for those
balances when setting a rate for a loan to the customers who maintain deposit balances.
This method has been utilized by more community banks than the large money center
banks or regional banks. Banks utilizing this method would usually establish a peg or
base rate and depending upon how large a balance the customer maintained, the bank
would make the loan at the peg or base rate or at a rate or some percentage over the peg
or base rate. Some banks would also try to allow for risk as they set the rate, but the
calculation was less than scientific.
FEE BASED LENDING
As competition for loans heated up, corporate financial officers saw an opportunity to
play one bank against another. These corporate financiers told the banks in ever
increasing numbers that they preferred to pay a fee rather than be required to maintain
what to them amounted to unproductive compensating balances. As Koch (1995, p. 771)
pointed out in his discussion of fee income for banks, banks developed three distinct
methods of utilizing special fees in the pricing of loans. Those methods (usually some
amount less than 1%) were facility fees, commitment fees, and conversion fees. Facility
fees were utilized to charge the customer a fee for making funds available, whether they
were utilized or not. On the other hand, a commitment fee is charged only on that portion
of the committed funds that are not drawn down. Conversion fees were charged on those
loans which were converted to another type of loan.
In practice, the fee based lending concept has met with substantial resistance from many
smaller companies and some larger firms. Like wise, competition has caused this practice
to be very limited in scope.
RISK MANAGEMENT BASED PRICING
With the concentration by both regulators and bankers on risk management, we believe
that the time has come for banks to price their loans based upon some measure of risk
related to loan price or reward to the bank. Several authors support this position, although
they arrive at the concept in differing ways. Sinkey (1998 pp. 420-422) believes that you
should score the credit predicting creditworthiness of the borrower using a statistical
model. Koch (1995, p. 778) is of the opinion that banks have generally underpriced loans
because they have understated risk, and therefore, they should identify both expected and
unexpected losses, incorporating both in the risk charge for a loan. While we certainly
agree that both Sinkey and Koch have developed scholarly and workable approaches to
the incorporation of risk, the authors are more concerned with developing a pricing
mechanism that can be utilized equally well by the small community bank and the large
regional bank. Our method would assign a numeric value to the various segments of the
loan portfolio which would be converted to a pricing factor that would be added to a
preestablished loan rate that was based upon conventional pricing methods.

Possible risk categories to implement the start-up of a risk pricing scenario are as follows:
Categories Risk Price

Defined Risk Within Categories

Base + 0

Cash or CD secured, or Government

Guaranteed Loan

Base + 0.25%

Loans Secured By Stock, Cash Value

Life Insurance, or Corporate Bonds

Base + 0.45%

(Average Risk) Loans Secured By Real

Estate, Receivables, etc.

(Above Average Risk) Loans To

Base + 0.75% Companies With Slightly Deteriorating
Profitability, etc.

We would then adjust the risk rates on a historical moving average basis that would be
gathered from loss experience in the various grade categories. After several years, using a
migration analysis or historical moving average much like Banking Circular 201 requires
to calculate historical loan loss reserve, you would have good historical data for
evaluating pricing risk.
For example, let's assume that the bank had previously set a rate of base +0.50% for a
loan with a risk category 2. In our risk pricing scenario, we would add an additional
0.25% to the conventional pricing. If instead of category 2 the risk were category 4, then
you would add 0.75% which would make the loan price out at base rate plus 1.25%.
SUMMARY
Regardless of the method chosen, risk must be an integral part of the loan pricing
scenario to adequately compensate the bank for credit exposure.
Utilizing our pricing method, a bank over several years time would have a reasonably
accurate means of pricing to incorporate risk.
REFERENCES
Hempel, G., Simonson, D., & Coleman, A. (1994) Bank Management Text and Cases; 4th
Edition. New York: John Wiley & Sons, Inc.
Koch, T. (1995) Bank Management, 3rd Edition. Austin: The Dryden Press; Harcourt
Brace College Publishers.
Sinkey, Jr., J. (1998) Commercial Bank Financial Management: 5th Edition. Upper
Saddle River, NJ: Prentice Hall.