Risk Based pricing of loans to corporate borrowers based on economic capital allocation and migration matrixes

The article is dedicated to the problem of loan risk-based pricing within commercial banks. Proposed Approach is based on Monte-Carlo simulations. The Approach allows to take into account several important factors: rating migration process and changes in economic capital allocation (within the time horizont equal to loan maturity). As the result, the Approach leads to more accurate risk-based pricing system in terms of achieving target ROE (established by shareholders), than under the common simplified approaches. Proposed backtesting algorithm for the Approach could be used for verification of correctness of the Monte-Carlo simulations. The necessity of credit covenants for borrowers within unstable rating classes has been justified. The results are illustrated by examples based on public S&P default statistics.

risk-based pricing, economic capital, credit risk, return on equity, quantitative risk assessment