Published on: 2024-08-10 19:01:13
Lenders set interest rates in two ways. Product-driven pricing, or a risk-based rate for each customer.
Product-driven pricing gives every customer the same rate for a given product. You can estimate product profitability as the average expected risk cost per loan in that portfolio.
Risk-based pricing sets a rate for each customer based on the probability of default.
This approach lets you differentiate rates to improve profitability and remain competitive. It is harder to execute because you need to understand each customer's risk.
Risk-Adjusted Return on Capital
Some lenders calculate Risk-Adjusted Return on Capital (RAROC) for each customer and set the rate from that result. RAROC can also include customer lifetime value, including potential cross-sell and upsell.
Risk-based pricing is complex because the formulas used to calculate RAROC can change and may include multiple models.
The models used in RAROC can include
- Anti-fraud model: the probability of fraud
- Credit risk model: the probability of credit risk
- Cross-sell and upsell propensity model: the probability of accepting an offer
Complexity also comes from different customer segmentation by demographics.
In practice, full risk-based pricing can sit as a sub-flow within the underwriting decision flow.
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