How to (mis)manage risk-based pricing: Some do’s and don’ts

How do you determine the best interest rate?

When it comes to loan pricing, banking industry analysts need to make sure they're taking advantage of real-time insights in order to determine the best interest rate – one that will net the bank the greatest possible return on investment. 

But understanding this concept and putting into practice are two very different things. To get risk-based pricing right, you need to follow key best practices – and avoid common missteps. Let's take a look at some do's and don'ts that financial lenders need to keep in mind during their risk-based pricing activities:

Don't: Lower rates just to get the sale

Taking your sales team's word when they say you need to lower the rate might not be the best way to accurately price your loans. Are they using actual data to corroborate their claims? How did they come to that conclusion? There could be too much risk involved in allowing the sales team to dictate the interest rates based solely on what would make the sale.

Credit Union Times contributor Dennis Child cautioned that the best way to price loans is to conduct measurable analysis in order to get the best return on investment possible. The problem is that most methods of risk-based pricing don't include this measurable component. In order to elicit the desired positive ROI, empirical data and stochastic loan pricing methods are essential.

"Using advanced analytics tools and techniques is a surefire way to get the best ROI possible."

Do: Trust the analytics

The use of real-time data to determine loan prices is gaining ground among financial institutions around the globe. According to McKinsey researchers, the utilization of data and analytics in managing risk allows banks to drive revenue and make better risk decisions during the loan pricing process. Using advanced analytics tools and techniques is a surefire way to get the best ROI possible.

"Empirical, stochastic methods are necessary to assure a return adequate to truly offset the risk and costs associated with lower-grade loans and to assure the higher-grade borrowers are not subsidizing riskier loans," Child wrote. "Pricing loans using tested empirical methods assures all costs associated with lending are identified and allocated according to the unique risks and costs each grade poses."

In addition, Financial Executives International noted that predictive analytics allows banking professionals to detect risk before assigning interest rates and forecast how well and how often customers will pay back what they're borrowing. In other words, banks can trust data analytics to give them the best rates when conducting risk-based pricing activities.

Don't: Use spreadsheets

Financial lenders should be wary of the pitfalls of using spreadsheets. Eighty-eight percent of spreadsheets contain errors, according to Forbes contributor Stuart Leung, which can have devastating financial consequences for banks. Because spreadsheets rely on the manual input of information, they can fall victim to human error – resulting in losses for financial services organizations in the worst-case scenario.

"For families and small businesses, miscalculations may only have a minor effect on balance sheets, but these errors can have a much greater financial and professional impact for larger organizations," Leung wrote. "Even small spreadsheet mistakes can cost companies billions of dollars or ruin a professional's career and reputation."

Spreadsheets are useful - but may contain costly errors.Spreadsheets are useful – but may contain costly errors.

Do: Invest in DealPoint

In order to deliver these key insights that can help improve pricing strategies and decrease the amount of risk associated with any one customer, banks need to have the right tools at their disposal. DealPoint software from Brilliance Financial Technology allows organizations to automate the loan pricing process by collecting, analyzing and leveraging customer data to evaluate decisions. DealPoint makes it so that banks can create a transparent process so that they can make decisions more quickly and with more data than they've ever had before: no more spreadsheets, no more costly errors.

Contact the risk-based pricing professionals at Brilliance today for more information about DealPoint.