Relationship of pricing with expected risk

As explained earlier, expected risk or loss is not an unknown factor but can be well-estimated taking into consideration the statistics and performance of the previous year, or better still the previous three years. Banks consider such a loss as part of the risk they have to take in order to do business and earn profits. The bank can account for expected losses by taking them into account in the pricing of its products.

Pricing Risk

Product pricing is a very sensitive part of the retail banking process as it has a direct impact on product profitability, and hence the success of such products. When pricing retail banking credit products, factors to be taken into consideration include:

  • The bank’s cost of funds
  • Direct overhead costs
  • An appropriate share of indirect overheads
  • The targeted profit margin
  • Expected losses.

Example of pricing a $100,000 loan:

  • the bank’s cost of funds is 5%,
  • direct and indirect operations cost 1%,
  • the expected loss factor is 1.5%, and
  • the bank is aiming to make a profit margin of 2%:

Here the calculation would be:

5% (COF) + 1% (OPEX) + 1.5% (EL) + 2% (P) =9.5%

Accordingly, the rate offered to the borrower is 9.5%.

Risk and provisions

Provisions (which are called reserves in the US) are the amount calculated to cover a certain amount of loss that is expected to happen. Since it is known to the organization, it is required to be calculated and kept as a provision to cover such loss if or when it occurs.  

Bad debt provisions are deducted from the loans shown in the bank’s balance sheet. For example, if the amount of auto loans shown on the assets side of the balance sheet is showing $600 million and the expected loss provision is 2%, then the amount of the loan loss provision will be $12 million. The assets side of the balance sheet will show as follows:

Auto Loans                     $600,000,000
Less: Bad debts provision      $ 12,000,000


Net Auto Loans                 $588,000,000

In accordance with the new international accounting standard (IFRS 9 – Financial Instruments) , credit losses under the expected credit loss (ECL) model are measured at expected values. As a result, this new model is more subjective in nature when compared to an incurred loss model since it relies significantly on the cashflow estimates prepared by the bank, which is inherently subjective.

To work out credit losses, the bank needs to consider the probability-weighted outcome, the time value of money, and other reasonable and supportable information that is available. Credit losses and related provisions have to be updated at each reporting date to reflect changes in credit quality. As the ECL model is more forward-looking, the new requirements are expected to increase credit losses of reporting entities with substantial long-term financial assets. The impact for short-term financial assets such as trade receivables is likely to be relatively small.