Module: | MODULE B: RISK MANAGEMENT
Q263: Scenario: A corporate client approaches XYZ Bank for a working capital facility. The bank's internal treasury determines the current macroeconomic risk-free rate is 6.50%. The credit risk assessment of the corporate client indicates a higher probability of default compared to prime sovereign borrowers. Based on the fundamental risk pricing framework, consider the following statements regarding the correct regulatory actions:
1. The bank must charge a risk premium strictly above the 6.50% risk-free rate to logically compensate for the elevated probability of default.
2. The bank must ignore the probability of default and offer the exact risk-free rate to ensure competitive market acquisition and rapid credit growth.
3. The risk premium charged must be mathematically sufficient to cover the exact Expected Loss associated with the client's internal credit rating.
Which of the statements given above is/are correct?
2. The bank must ignore the probability of default and offer the exact risk-free rate to ensure competitive market acquisition and rapid credit growth.
3. The risk premium charged must be mathematically sufficient to cover the exact Expected Loss associated with the client's internal credit rating.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is correct: The fundamental principle of risk-based pricing requires that any exposure carrying a higher risk than a sovereign/risk-free asset must be priced higher.
The bank must charge the 6.50% base rate plus a "Risk Premium" to compensate for the corporate client's probability of default.
Statement 2 is incorrect: Ignoring the probability of default to acquire market share is a catastrophic violation of risk management principles and RBI guidelines.
Banks cannot lend commercial, unsecured, or corporate loans at the risk-free rate.
Statement 3 is correct: The mathematical purpose of the risk premium within the interest rate is to directly fund the provisions needed to cover the Expected Loss (EL) specific to that client's credit rating.
The premium must be scientifically calculated to ensure EL is completely absorbed upfront.
The bank must charge the 6.50% base rate plus a "Risk Premium" to compensate for the corporate client's probability of default.
Statement 2 is incorrect: Ignoring the probability of default to acquire market share is a catastrophic violation of risk management principles and RBI guidelines.
Banks cannot lend commercial, unsecured, or corporate loans at the risk-free rate.
Statement 3 is correct: The mathematical purpose of the risk premium within the interest rate is to directly fund the provisions needed to cover the Expected Loss (EL) specific to that client's credit rating.
The premium must be scientifically calculated to ensure EL is completely absorbed upfront.