Research & Thoughts

Risk Based Pricing

Risk: The price is right

Risk, just like opportunity, will always be with us. But if institutions are going to assume risk successfully in the future, their assumptions have to be replaced by a more robust and, literally, accountable approach. They must alter, deeply and lastingly, the basis on which they acquire their understanding of risk exposure. They must understand what their funding models are really telling them, especially in an environment where capital is a finite commodity. They must arrive at the right price for risk (based on an accurate, non-siloed, holistic approach).

The present downturn has highlighted some serious flaws in traditional accounting-based metrics used to assess performance (ROE, ROIC, etc.). Although widely applied in the industry, these measures fail to consider the degree of risk borne by the activities under consideration. They thus neglect a fundamental component of assessing the real quality of a return on capital.

It is true that a number of metrics and models have been introduced to help incorporate risk analysis within pricing and capital allocation decision-making. However, these methods have not been able to adequately protect banks from losses or defaults. In fact, they have proven highly ineffective in distressed and illiquid markets.

Three questions you have to ask
In the post-recession world of scarce capital, lower risk appetite and reduced leverage, three questions should underlie banks’ business strategy decisions and drive thinking around optimal business models:

• What are the future growth areas?
• What risk do these areas carry?
• What will really be the impact of regulatory changes?

First movers will, as ever, gain a significant competitive advantage. But a critical pre-condition of success will be deep understanding of the bank’s own risk positions and projections. This understanding will go beyond the purely intellectual or even technical. It will be structurally integrated within the operating and decision-making framework.

Given the failings of traditional methods, we believe that a fundamental re-assessment of the purpose and application of risk-adjustment metrics is called for, if financial services institutions are to survive and prosper.