In an ideal world, good begets good. Good deeds are lauded, and good behaviour is rewarded. Lending often works the same way. Borrowers with high credit scores are rewarded with low-interest rates, and conversely, those with low credit scores must pay higher interest on their loans.
This is a rather simplistic explanation of risk-based pricing, i.e. a process by which lenders offer different interest rates to different borrowers based on their creditworthiness. Aside from their credit scores, this may also involve assessing the borrower’s employment status, current debt, if any, assets, and so on. As a result, all borrowers for a single credit product will not be offered the same terms and rates.
The concept is by no means new – back in 2018, then deputy governor of the Reserve Bank of India, N S Vishwanathan, said, “Risk-based pricing of loans would need fair assessment and understanding of the risk involved, rather than merely relying on collateral and/or guarantees obtained from stakeholders including equity holders. Banks should charge interest rates that are commensurate with the risk involved in the projects that are being financed.”
What are the benefits of risk-based pricing of loans?
- First and foremost, risk-based pricing models offer an extra layer of protection for
financial institutions lending to non-prime borrower cohorts. - Flexible risk pricing models allow lenders to set interest rates that align with their
financial goals. The financial security offered by risk pricing gives the lender more leeway
for product and process innovation.
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- Research has shown that risk-based pricing can improve loan performance by bringing
down delinquency rates. - Risk-based pricing offers lenders the ability to tailor loan rates and terms so that they
can lend to more borrowers, even if they don’t have the required credit scores and
history. The higher risk level is offset by the higher interest rates, and subprime
borrowers have a shot at accessing the credit they need.
Even as recently as 2016, risk-based pricing was almost an alien concept in India. Less than a decade on, most leading lenders are on their way to working with these pricing models. It wouldn’t be a stretch to say that the rise of risk-based pricing has a lot to do with credit expansion to thin-file and new-to-credit (NTC) customers in recent years – 35 million borrowers opted for their first credit product in 2021, and well over 30 million did the same in the following year.
The rise of alternate data-driven underwriting is helping lenders fine-tune their scoring models by adding depth and texture to existing data sources. This adds further nuance to traditional indicators and, hence, enables progressive, risk-based bucketing of borrower cohorts and dynamic pricing.
As lending goes beyond typical borrowers with strong credit histories and high scores, lenders face the challenge of enabling access while protecting their business interests – and risk-based pricing comes in as a win-win in this situation. With the Reserve Bank of India’s recent move to increase risk weights for unsecured loans, lenders must focus heavily on pricing risk accurately while ensuring adequate risk capital in their books.
The growth of risk-based pricing has for long been a slow burn, but all signs point to it getting into its stride sooner rather than later.
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