IDEAS home Printed from https://ideas.repec.org/a/eme/jrfpps/jrf-09-2022-0240.html
   My bibliography  Save this article

A risk-neutral approach to the RAROC method of loan pricing using account-level data

Author

Listed:
  • Arun Kumar Misra
  • Molla Ramizur Rahman
  • Aviral Kumar Tiwari

Abstract

Purpose - This paper has used account-level data of corporate and retail borrowers, assessed their credit risk through the risk-neutral principle and examined its implication on loan pricing. Design/methodology/approach - It derives the capital charge and credit risk-premium for expected and unexpected losses through a risk-neutral approach. It estimates the risk-adjusted return on capital as the pricing principle for loans. Using GMM regression, the article has assessed the determinants of risk-based pricing. Findings - It has been found that risk-premium is not reflected in the current loan pricing policy as per Basel II norms. However, the GMM estimation on RAROC can price risk premium and probability of default, LGD, risk weight, bank beta and capital adequacy, which are the prime determinants of loan pricing. The average RAROC for retail loans is more than that of corporate loans despite the same level of risk capital requirement for both categories of loans. The robustness tests indicate that the RAROC method of loan pricing and its determinants are consistent against the time and type of borrowers. Research limitations/implications - The RAROC method of pricing effectively assesses the inherent risk associated with loans. Though the empirical findings are confined to the sample bank, the model can be used for any bank implementing the Basel principle of risk and capital assessments. Practical implications - The article has developed and validated the model for estimating RAROC, as per Basel II guidelines, for loan pricing that any bank can use. Social implications - It has developed the risk-based loan pricing model for retail and corporate borrowers. It has significant practical utility for banks to manage their risk, reduce their losses and productively utilise the public deposits for societal developments. Originality/value - The article empirically validated the risk-neutral pricing principle using a unique 1,520 retail and corporate borrowers dataset.

Suggested Citation

  • Arun Kumar Misra & Molla Ramizur Rahman & Aviral Kumar Tiwari, 2023. "A risk-neutral approach to the RAROC method of loan pricing using account-level data," Journal of Risk Finance, Emerald Group Publishing Limited, vol. 24(2), pages 212-225, January.
    • Handle: RePEc:eme:jrfpps:jrf-09-2022-0240
    DOI: 10.1108/JRF-09-2022-0240
    as

    Download full text from publisher

    File URL: https://www.emerald.com/insight/content/doi/10.1108/JRF-09-2022-0240/full/html?utm_source=repec&utm_medium=feed&utm_campaign=repec
    Download Restriction: Access to full text is restricted to subscribers
    File URL: https://www.emerald.com/insight/content/doi/10.1108/JRF-09-2022-0240/full/pdf?utm_source=repec&utm_medium=feed&utm_campaign=repec
    Download Restriction: Access to full text is restricted to subscribers
    File URL: https://libkey.io/10.1108/JRF-09-2022-0240?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Rahat, Birjees & Nguyen, Pascal, 2023. "Does ESG performance impact credit portfolios? Evidence from lending to mineral resource firms in emerging markets," Resources Policy, Elsevier, vol. 85(PB).
    2. Umar, Muhammad & Mirza, Nawazish & Ribeiro-Navarrete, Samuel, 2023. "The impact of financial restatements on sell-side recommendation accuracy," Finance Research Letters, Elsevier, vol. 55(PA).
    3. Rahman, Molla Ramizur & Misra, Arun Kumar & Kumar, Satish, 2024. "A financial supply chain on corporate working capital and interbank lines of credit," International Review of Financial Analysis, Elsevier, vol. 91(C).
    4. Xie, Xin & Mirza, Nawazish & Umar, Muhammad & Ji, Xiaoman, 2024. "Covid-19 and market discipline: Evidence from the banking sector in emerging markets," International Review of Economics & Finance, Elsevier, vol. 89(PB), pages 612-621.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eme:jrfpps:jrf-09-2022-0240. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Emerald Support (email available below). General contact details of provider: .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.