The Role of Risk in Pricing Retail Loans

An objective method of pricing, where the cost of each component of a product is determined separately, is relevant to the pricing of loans in banking. Relevant factors in this case are a “real rate” of interest, an inflation premium, administrative expenses, a maturity factor and an allowance for credit risk. All these can be accounted for in the pricing of retail loans. This systematic approach enhances the loan pricing procedure and offers an objective way for an institution to establish and monitor the risk level of its portfolio of earning assets. From data it is clear that banking has priced its retail loans well and this brings the evolution of new pricing techniques into question.