Bank loans pricing and Basel II: a multi period risk-adjusted methodology under the new regulatory constraints

Under the new Basel II regulatory framework, the need for an effective risk-adjusted pricing mechanism has become even more central in banking than in the past: banks are spurred to develop risk-adjusted measures, to avoid wasteful customers’ cross-subsidization and support the value creation process for their shareholders. The paper aims at detecting how the Internal Ratings-Based approach affects the bank loan pricing mechanism, by developing a multi- period risk-adjusted pricing methodology, which allows us to separate the contribution of the two components of credit losses (the expected loss and the unexpected loss), under the prevalent repayment schemes. Following Hasan and Zazzara (2006), risk-adjusted pricing can be split into two main parts: a “technical” one, which is based on Basel II- consistent risk factors (probability of default, loss in case of default, exposure at default and maturity); the second part, not analyzed in this paper, is defined as “commercial” and includes commissions, operational costs, and other subjectively allocated costs. In this research we focus on the remuneration for both the expected and unexpected losses. The main inputs we need in our pricing formula can simply be drawn from an internal rating model and from easy-to- find market data (risk-free interest rates and shareholders’ target return). The pricing formula we propose is consistent with the new Basel II regulatory approach to credit risk management and provides an immediate support for bank managers in making a loan price-related decision.