Credit pricing in the light of IFRS 9 regulations
The impact of the IFRS 9 impairment model on the financial statement will be correlated to the adequacy of the pricing assessment at the time of disbursement.
The IFRS9 accounting standard presents an impairment model where the coverage of expected losses, through provisioning, is a dynamic process which starts right from the time when credit is granted. This requires the adoption of a differentiated pricing policy based on the risk profile of the borrower, incorporating a lifetime aspect to the risk assessment. In fact, the pricing algorithms can incorporate the multi-period probability of default curves necessary to implement the IFRS9 rules for loss assessment.
Logically, the impact of the IFRS9 impairment model on the financial statement will be correlated to the adequacy of the pricing assessment at the time of disbursement. Pricing which is sensitive to borrower risk can in fact lead to adequate coverage of losses and risk costs, minimizing the negative impacts of the new accounting standard.
Pricing is an important factor in the credit value chain, since, together with credit policies and the definition of approval levels, it effectively translates the strategies set out in the Risk Appetite Framework (“RAF”) into operating practices to support lending and credit review activities.
Risk-based credit pricing enables the bank to:
- customize the lending process based on its cost structure and profitability targets in line with the RAF;
- optimize the commercial offering, preventing internal phenomena which subsidize riskier clients at the expense of less risky ones.
A pricing model identifies the minimum interest rate which makes the loan costs equal to the revenues, where expected revenues evolve according to a stochastic process, and where the management and financial costs, on the other hand, are predominantly deterministic in nature. This perspective is completely in line with the fair value assessment approach.
Analysis also shows that the highest risk bands of clients cannot be financed, whereas a broad portion of clients with a low-risk profile can be financed at lower rates. Managing credit without the help of a pricing system results in the serious risk of both a rise in capital requirements and the selection of risky creditors.
In other words, clients with the best creditworthiness assessments may be attracted by the most competitive offer from the competition, whereas less reliable clients may view conditions which are applied in a general way to all clients as very favorable.
One implication underlying the new regulatory scenario relates to the impact of forward looking assessments, which can also be extended to pricing. According to the new regulations, provision allowances must be calculated on the basis of a forecast of lifetime risk and loss given default, which incorporate expectations regarding the economic cycle.
A pricing strategy can therefore be designed which incorporates expectations regarding economic trends both according to the most likely expected scenario, known as the “baseline”, and according to one or more alternative scenarios, less likely and decisively less favorable, known as “stressed” scenarios.