Risk-Based Pricing For Financial Products

Fact:

a) Approximately 5 million people in China are barred from flight travel because of their very poor Credit Score (from outstanding debts). 

b) Approximately 1.65 million people in China cannot take trains as they have credit defaults (as train tickets purchase require identification proof).

Whoa! Those are some facts to digest. Extending it a bit further, Sesame Credit, a subsidiary of the e-commerce giant Alibaba, runs a Credit Score system wherein customers are provided a score based on their behaviour on the e-commerce sites, inter alia,

i)       Frequency of purchase
ii)      Items of purchase
iii)     Defaults etc.

Orwellian or Experian Approach?

Based on this Credit Score, customers are profiled, judged and therefore, incentivised/punished. The downside risks may range from a more thorough frisking of low Credit Score customers at the Chinese airports to losing social security and welfare. Those with high rankings can rent bikes or cars without leaving a deposit, and skip lines at hospitals, government institutions etc.

The Credit Score-based programs have seen a phenomenal increase in China in the recent past, with more and more firms adopting Big Data to draw, profile, judge and provide benefits to customers based on their Credit Score.

While most of us debate whether this is more of an Orwellian or an Experian approach, let us look at the landscape in India restricting our scope to financial products.

Risk-Based Pricing for Financial Products

India, as on date, has four Credit Information Companies – CIBIL, Experian, Equifax and Highmark, that give Credit Scores to customers based on financial behaviour taking into consideration various factors, inter alia, credit defaults, credit limits, utilisation etc. India is pretty nascent to this setup considering that this industry is approximately a decade and a half old. Although all financial institutions in India use Credit Scores (from one of the aforementioned CICs), however, this is only as a measure for acceptance or sanctioning a loan faster and not as a tool for rewarding good customers or providing incentives.

In a Corporate Loan / Project Finance context, Corporates / SPVs are rated by External Credit Rating agencies (including CARE, CRISIL, ICRA, Fitch etc.) and the corporates are provided differential pricing based on the external credit rating obtained (which is a measure of the risk of the borrower).

However, in the retail loan context, the concept of providing incentives (which include differential pricing) to customers based on Credit Score (which in turn is a proxy for the risk of the borrower) is yet to take off significantly. In developed economies, incentives are provided to customers who have a higher Credit Score by way of lower priced loans etc. However, Credit Scores in India are used more like a benchmark on your credit history, thereby used only as one of the measures for just granting credit – more as an entry barrier.

For example, today, a customer with a CIBIL score of 780 and a customer with a CIBIL score of 680 get almost the same pricing for a credit product, ceteris paribus. So as long as a customer’s loan is approved, CIBIL score becomes irrelevant to the customer and therefore, there is no incentive for the customer to even take note of it, let alone improve it.

From a Credit Cards’ perspective, basis their Credit Score, the interest charges on late payment can be differentiated, providing incentives to higher Credit Score customers.

Key Advantages

However, if you look at the interest rates of the various financial institutions in the market, it is very evident that there is a thin margin available. Providing differential pricing/incentives (for both loans and Credit Cards) based on Credit Score will have the following key advantages:

• Customer Cognizance and Conformance Behaviour: Customers will have more cognizance of their Credit Score and those with relatively poorer Credit Scores will have strong incentives to improve their credit profiles, while still availing of higher cost loans in the short term vis-a-vis in the current scenario, where they just need to cross the borderline.
• Cross subsidisation of high-risk (low Credit Score) borrowers by low-risk (high Credit Score) customers will no longer be required.
• The industry also stands to gain by adopting a mature retail lending practice, thereby driving business growth, increasing credit penetration and enhancing financial inclusion.
• Pricing Transparency – It may be noted that the same has been implemented successfully in both the corporate context and in developing countries in the retail context.

The Way Forward

Bank of Baroda has started to lead the way in terms of introducing risk-based pricing for Home Loans. Based on the CIBIL score of customers, the interest rates offered vary with a maximum benefit of 100 bps.

Considering the above points, there is a strong case for the financial institutions to explore providing incentives (including differential pricing) for credit products to customers based on their Credit Score.

Additional Reading: 5 Simple Rules To Improve A Bad CIBIL Score.

The views expressed here are solely those of the blogger in his private capacity and do not in any way represent the views of the legal enforcement authority or any other entity. The user of this information is advised to consult experts in the domain for concluding any opinion or course of action. All trademarks and logos, mentioned or used in this blog are the property of their respective owners.