- Every business needs to price its products. What is so exotic about banks? Other businesses may view increased volumes as a success of their pricing strategy. But for a bank, a spurt in volumes may merely mean that is pricing model is broken, and that others are taking advantage of that till the bug is fixed! Hence, risk pricing is error prone, yet important.
- How is risk priced in? We do not have(yet) that one universal calculator which will spit out an integrated figure for all risks. So often the systems are fragmented. Credit risk calculations are often bifurcated into counterparty(interbank/other FIs) and client risk(normal corporate transactions). And there are many ways to splice other transactions. So finally, an excel/other manual systems are needed to make sense of this mess of figures
- But why does not some one automate it? It is a control issue. Given the high sensitivity of prices, and the subjective adjustments needed, there is a limit to everything-even for flow trading!
- We learn this in marketing 101. Do those principles apply here? Yes and no. Yes because the exact pricing decision will depend on how well the pricer knows the client, which is again related to marketing. But no because the performance management system of banks ensure that the cost of funds charged to the trader, is often determined post facto, and so there need to be relatively accurate and robust models available for trade negotiation and evaluation. And while geeks/quants can design it, the end users need to know the ins and outs of the model, including its limitations, so that for extreme cases they can use modifications. For example, while executing a large trade which will move the ALM curve and the market, the liquidity adjustments among others would need to be made upfront.
- Floating or fixed rate? Depends totally on the risk appetite of the bank and the relationship/focus on that client. For example, Indian banks give fixed rate education loans to IIT/IIM/other top colleges students, while the ordinary student is exposed to floating rate risk.
Saturday, September 17, 2011
How banks price their loans and products
When I googled this title, guess how many results I got? Zero.zilch.nada. That in itself spurred me on to write something on which there is little organized information. I am not(yet!) an expert on pricing but from what I have seen of the structuring, trading and risk sides of banks, I think I can venture some informed views on this manner. More knowledgeable readers are welcome to comment on this primer in FAQ form.