Pricing Basics

One of the most basic matters in finance is how the market compensates investors for bearing credit risk. Establishing credit worthiness of borrowers/assets is imperative for financial and non financial institutions alike. The important question here is establishing the cost of credit through interest rate charged on credit. After assessing the satisfactoriness of creditworthiness, the next step is to understand how much return can be generated from the credit risk underwritten. After the 2008 Global Financial Crisis, pricing of credit risk has started receivng more focus. Moreover, pricing of credit is vital for the sustenance of businesses depending on credit assets. This is because the benefits derived from extending credit should surpass its costs.

Credit Pricing in Non-Financial Institutions

As there are various kinds of financial institutions ranging from banking related, insurance related, investment related the pricing of credit in non- financial institutions is not as complex as that of in financial organizations.  Nonetheless, unless the credit facility is appropriately priced, the business will suffer because the credit assets (viz. receivables/debtors) are created by deploying capital, which, in turn has a cost. Accordingly the cost of capital plays a major role in influencing the pricing of credit in a non-financial enterprise. If higher credit periods are involved then companies usually load the cost of capital into the sales price and offer discounts.  These discounts offered by the businesses, which at times speed up collection can be viewed as forgoing of interest factor already loaded in billing. Similarly, sometimes, where collection risk is high, the companies tend to quote a higher selling price, which tend to reflect the pricing of credit involved therein. The driving force to quote higher price emanates from the higher credit risk involved.

Credit Pricing in Financial Institutions

The very survival of institutions depends on adequate pricing of credit. The concept of credit risk pricing in banks depend on the level of capital deployed i.e. the capital adequacy norms. The capital adequacy norms for each bank may differ in policy. In practice higher capital should be deployed for higher credit risks underwritten. Additional when raised to take in risky assets, will translate into additional efforts to improve/maintain shareholder returns. The financial decisions of management of maximizing returns on possible credit assets with the existing capital or raise more capital/credit/loan to do more business, invariably depends on pricing. Pricing must commensurate with the risks. It is imperative for financial institutions to ensure that the credit risks are not only thoroughly analysed and mitigated, but also priced adequately.

Pricing Structure

As Interest on credit is the main source of financial institution’s revenue, the credit executives must ensure that the rate of interest on credit provides satisfactory return. The following are the major sources of income which determine the pricing:

Interest Rates

Interest rates represent the time value of money, and interest is a compensation that banks receive for lending out capital to borrowers. Banks apply interest on all credit facilities while non-financial entities load the interest factor in the price of goods/services, if they are sold on credit. Banks and FI’s charge interest, based on the base rate of the country they are operating in. Base rate is a rate that is normally the minimum rate at which a bank would lend out its money or discount bills of exchange. Base rates are usually determined by a countries money supply, central bank policy, demand for credit and internal factors among others. Therefore rate are exposed to fluctuations. Usually a margin is added to arrive at an appropriate interest rate for the credit at hand. The margin varies primarily depending upon the credit risk. A lower margin is fixed for less risky credit and a higher margin for risky credit. International credit by multinational banks and similar institutions is often quoted by reference to LIBOR (London Interbank Offer Rate), which reflects the general level of interest rates in the global market.

There are two kinds of applied interest rates:-

• Fixed rate of interest:– An interest rate that does not change over the life of a loan or other form of credit. If one borrows money at a fixed interest rate of 15% p.a , then 15% p.a is calculated over the principal balance each time the interest compounds.
• Variable Interest rate:- An interest rate on a loan or convertible security that changes periodically. For example, a variable rate mortgage has a certain interest rate that changes with varying frequency. The frequency of the change is called the variable rate. Usually, the variable rate is set according to some outside benchmark; for example, a loan might set the interest rate at LIBOR + 2%. An advantage of variable rate loans is the fact that one’s interest rate might fall over time; this is a particular advantage if prevailing interest rates are high at the time of the loan. A disadvantage to adjustable rates is the uncertainty associated with them: one’s payments on the loan generally rise or fall.

Commission

Commission is the charge collected on services rendered to customers. It is computed either as a percentage of the total amount or on the basis of total value of the services provided. For instance, when the bank negotiates a bill or collects a cheque, the commission is charged for the services, although no actual credit is extended. Normally the commission or fee covers the administration cost involved in the transaction, plus an element of profit.

Fees

Fees are charged to customers for the services rendered or facilities provided. Fee is usually charged by the bank to compensate the efforts and earmarking of funds for the customer. Fees may be charged upfront on the full amount for the full period or it may be charged in arrears on any unutilised portion of the facilities extended.

Fees at various creditor enterprises may take forms of processing fees, management fees, extension fees, amendment fees, etc.

Other Factors in Pricing A Credit

Cost of Capital: Both financial and non-financial institutions deploy capital while extending credit, and the capital raised either from shareholders or otherwise, has a cost. The cost of capital deployed in credit ought to be covered by the pricing of the credit.

Overheads: Institutions have to spend time, effort and resources to appraise, monitor and control the credit and related operations. The overheads are usually classified into two direct costs and indirect costs. Direct costs are those which can be easily identified with credit asset. Indirect costs are those which are more general in nature.

Sector: Pricing should reflect the underlying risk associated with the sector. Certain sectors are more risky than others, and as a consequence of constituents of such sectors may become defaulters while the constituents of a stable sector will continue to perform as well.

Borrower’s past performance: The past performance, immediate past performance and current performance is usually considered for pricing.

Security: If appropriate and adequate security is offered as the mitigant to the credit risk, downward adjustments in pricing can be considered. Pricing should be negotiated upward in consideration of the discharge of an existing security or dilution of the bank’s security position.

Inflation: Inflation eats into the value of a credit asset and hence it should be compensated through pricing.

Exit Strategy: Often, higher pricing of facilities is used as a strategy to cease dealings with a particular customer. Realizing that the price is higher than what is offered by competitors in the market, the customer prefers other suppliers. However, one important aspect to be remembered is that this strategy should be applied well in advance, before sharp deterioration in credit worthiness.