Risk-Based Pricing of Loans in India: The Shape of Things to Come?

Narendra Kumar

09 Dec, 2020

All the leading Indian Bank announced plans to price retail loans based on consumer’s credit scores. This means that loan seekers with strong financial services and a good loan repayment track record should get loans at lower rates.

However, mutual in other parts of the world, and common in corporate lending the move is innovative for retail lending in India. At present, credit scores – whether driven from external credit bureaus or internal bank models – are only used to decide whether to approve or reject the loan application. The interest rate charged on the retail loan has not been driven by the score. Why have banks used it for corporate lending and not for retail lending? Perhaps it is because of power after all big corporates seeking large loans have much stronger negotiating positions than retail consumers. Perhaps it has been driven by market segmentation strategies where lower margin corporate loans have been subsidized by higher-margin retail loans.

However, over the last couple of years, with the sluggishness in corporate lending banks has shifted focus to the retail segment to drive growth. The retail banking is rapidly changing, presenting a new set of challenges and opportunities. The opportunity is big. As per an estimate by Credit Suisse, India’s retail loan assets, including SME credit, will grow to $3 trillion by 2026, five times the size of the market now. At the same time, the levels of competitive intensity are constantly increasing – banks versus banks as well as aggressive Non-Banking Financial Services (NBFCs). As digitization accelerates, the battle to acquire customers is expected to further heat up with peer-to-peer lenders and Fin-Tech start-ups making life even more challenging for banks. In the headlong dash for growth, banks need to exercise caution as delinquencies can soon pile up, especially if growth is not backed by robust credit practices & the risk-based pricing of loans can play a very strongest role.

Research suggests that a risk-based pricing environment based on accurate credit information can improve loan performance by reducing delinquency rates. Also, with the ability to tailor prices, lenders can extend credit to more consumers, profitably. Instead of rejecting applicants who pose a default risk of say 5%, lenders could accept them and charge an appropriately higher price for the loan to cover the additional risk. High-risk borrowers are therefore no longer subsidized by lower-risk consumers. Lenders who tailor their pricing to match the costs for each segment can compete much more effectively by offering each segment the lowest price in line with the costs of providing the loans.

Differential loan pricing based on the creditworthiness of loan applicants is commonplace in countries such as the US and UK, where consumers actively use credit scores to seek out better deals. Their credit score dictates the interest they pay on credit cards and loans; so every consumer is conscious of their credit score. Moreover, unlike in India, only the most glaring defaulters get shut out of the credit system; the rest simply pay higher interest rates. The fact that good borrowers get better credit rates has probably been responsible for widespread awareness about credit information reports, especially since lenders aggressively market their loan offerings on this basis.

Since a bank determines a reasonable default probability and provisions for it based on past credit history, borrowers with good credit histories can be rewarded for their responsible financial behavior. Expanding risk-based pricing, the borrower with better credit can get a lower rate of interest on a loan as a reflection of the expected lower losses the bank will incur. Risk-based pricing of loans is a scheme of offering credit at a rate depending on the customer’s credit score. For instance, lenders may offer a higher rate of interest to you if you are viewed as a higher risk borrower, i.e. your credit score is low as per the banks’ lending policies. For the same loan amount, lenders are likely to offer a lower rate of interest if your score is high. Since the CIBIL score^[1] ranges from 300 to 900, the higher the score, the better are the chances of getting cheaper loans and credit instruments.

Based on CIBIL data analysis, we have observed that most banks are lending to individuals with a credit score of 750 and above. In more developed markets like the US, customers with different credit scores are categorized as prime, subprime, and Alt-A borrowers. The lenders there charge varying interest rates as per the risk category of such borrowers. Typically, a credit bureau in the US defines those with credit scores below 660 as subprime borrowers, and such borrowers are often charged a higher rate than prime ones. Such classification and provision of risk-based pricing have yet to evolve in India.

However, some progressive institutions like Bank of Baroda^[2] have started offering credit score-based lending to retail mortgage loan seekers, which involves providing the differential rate of interest-based on the borrower’s CIBIL score. Customers with a good loan repayment track record and strong financials may get loans that are at least 50-75 basis points cheaper than a customer with a bad credit score. It shall provide an incentive to the customer to sustain constant credit behavior and increase his/her CIBIL score to get the benefit of lower rates. This is also likely to boost the growth of the retail loan portfolios of banks, thus making it a win-win situation for both parties.

However, risk-based pricing of loans aids both the lenders & borrowers alike as the lenders can assess the risk value of a customer before deciding to offer a loan at a particular rate, while customers with a higher CIBIL score benefit by getting lower rates as compared to customers with a low score. The benefits thus ensure that the customers work towards keeping their scores and creditworthiness high.