Module: | MODULE B: RISK MANAGEMENT
Q268: Consider the following statements regarding the implementation of risk-based pricing strategies within the basic risk management framework:
1. Risk-based pricing ensures that borrowers with lower credit ratings are logically charged a higher interest rate to cover the increased Expected Loss.
2. The fundamental goal of risk management is to uniformly apply a flat interest rate across all retail asset products to prevent any form of customer discrimination.
3. Proper implementation of risk-based pricing directly protects the bank's profitability by aligning the cost of assumed credit risk with the revenue generated.
Which of the statements given above is/are correct?
2. The fundamental goal of risk management is to uniformly apply a flat interest rate across all retail asset products to prevent any form of customer discrimination.
3. Proper implementation of risk-based pricing directly protects the bank's profitability by aligning the cost of assumed credit risk with the revenue generated.
Which of the statements given above is/are correct?
✅ Correct Answer: C
The correct answer is C. Statement 1 is correct: This is the core definition of risk-based pricing.
A borrower with a low credit score (subprime) poses a higher probability of default, leading to a higher Expected Loss (EL). To compensate, the bank must increase the risk premium, resulting in a higher overall interest rate for that borrower.
Statement 2 is incorrect: Applying a "flat interest rate" uniformly across all borrowers is completely contrary to risk management principles.
It penalizes low-risk borrowers (who would subsidize high-risk ones) and leads to adverse selection, where the bank only attracts the riskiest customers.
Statement 3 is correct: Risk-based pricing ensures that the revenue generated from a loan is mathematically sufficient to cover the operational costs, cost of funds, capital charge, and the specific Expected Loss of that exact risk profile, thereby protecting profitability.
A borrower with a low credit score (subprime) poses a higher probability of default, leading to a higher Expected Loss (EL). To compensate, the bank must increase the risk premium, resulting in a higher overall interest rate for that borrower.
Statement 2 is incorrect: Applying a "flat interest rate" uniformly across all borrowers is completely contrary to risk management principles.
It penalizes low-risk borrowers (who would subsidize high-risk ones) and leads to adverse selection, where the bank only attracts the riskiest customers.
Statement 3 is correct: Risk-based pricing ensures that the revenue generated from a loan is mathematically sufficient to cover the operational costs, cost of funds, capital charge, and the specific Expected Loss of that exact risk profile, thereby protecting profitability.