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Managing Risks in Commercial and Retail Banking by AMALENDU GHOSH

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CHAPTER 15

Risk-Based Loan Pricing

15.1 LOAN PRICING CONCEPT

The risk-based loan price reflects the return on a risk-free asset, plus a risk margin, which should be adequate to compensate the bank for the entire gamut of risks assumed by it. Risk-based loan prices take into account different elements of risks, including default risk, rating migration risk, credit correlation risk, credit concentration risk, collateral risk, and recovery risk. The most dominant factors that influence the loan price are the probability of default and the loss rate given default that reflect the probable loss from credit risk.

The key factor that determines the risk-based loan price is the quantum of potential loss that can arise from the exposures to a counterparty. The default characteristics of loans and the varying scales of recovery when default occurs set the platform for discriminating between counterparties in fixing the lending rates. Prior to default, it is not possible to say with certainty which borrowers will default, but we can make an inference about the possibility of a borrower committing default by looking at its current risk rating and fix the lending rate accordingly.

15.2 LOAN PRICING PRINCIPLES

The general principles that can be followed in determining the risk-based loan prices are explained here:

1. Rating grades assigned to borrowers should be the basis for fixing lending rates on loans and advances. The bank may rely on its own internal risk rating framework for fixing ...

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