Is a loan to a baker in Hampden County, MA as risky as a loan to a baker in Orange County, CA? Is a loan to a plumber in AZ as risky as a loan to a dentist in AZ? Intuitively, the answer is no. The point of Localizing Risk is that the intuition can be easily operationalized by comparing the segments’ credit quality. Follow-up question: Can we price loans to these businesses differentially? The answer is yes. And the solution is easy.
A simplified pricing framework
And we really mean simple as we will not use Greek letters or subscripts. To price a loan, we need to know three things – the return we want; the losses we expect; and what it costs us to lend.
Interest rate = (Desired return + Loss rate + Lending cost) / (1- Loss rate)
So, if we want to make 12%; expect 4% in losses and it costs us 2% to lend, then we should charge an interest rate of 18.75%. What we want to make and what it costs us to lend is independent of the borrower. They are business constraints. However, the losses we expect are determined by the borrower we select. And that’s the lever for mass customizing loan pricing.
Per the September 2014 WAIN Street Credit Quality Map, LA Accommodation & Food Services segment default rate is less than 1% and NV Accommodation & Food Services default rate is over 12%. That’s quite a range. And plugging it into our simplified loan pricing formula gives us an interest rate range of 15% to 30%. Same industry sector but different states. Consider another example. CA Information industry sector has a default rate of under 6% whereas CA Wholesale Trade sector has a default rate of over 9%. Same state but different industry sector. In terms of interest rate, the difference is 21% versus 25%. 4% percent doesn’t sound like much till you remember that putting your money in a 12-month bank CD gets you about 2%.
For lenders, the message is simple: you can price loans more advantageously by paying a little attention to the borrower’s segment without getting bogged down in the minutiae of a specific borrower. That’s mass customization!