Tier Pricing By T.Y. Lee

Table of Contents Background Framework Process Power of Separation Adverse Selection Conclusion

Background (1/2) Dual Card Crisis in 2005 Financial Authority order banks to do Tier Pricing (or Risk Based Pricing) to manage risk

Background (2/2) Common response in Taiwan: –separate risk into tiers according to rough definition of revolvers vs. transactorsrevolverstransactors Pros: can be easily done and implemented Cons: loss of opportunities because of low power of separation – there are other factors determining risk

Framework (1/2) What I Did: –In addition to looking at risk, I also looked at potential revenue (or profit) –Set up a two-dimension framework and developed a scorecard for each dimension –Risk Scorecard on vertical axis –Revenue (or Profit) Scorecard on horizontal axis –There are 2 phases: 1.Existing Customers 2.New Applicants

Framework (2/2)

Process (1/2) For existing customers: –We have their information in-house –Both scorecards are updated monthly with latest customer information on consumption and payment –Set different strategies for customers in different cells –Movements between cells must be monitored

Process (2/2) For New Applicants: –We do not have their information in-house, need to check Joint Credit Information Center (JCIC) for information –Usually on first come first serve basis –There are 2 stages: 1.To decide whether to approve or decline 2.If approved, one should determine the interest rate and the credit limit

Power of Separation (1/7) Key to the success of this framework is the “Power of Separation” of scorecards, especially Risk scorecards – –assuming other things equal

Power of Separation (2/7)

Power of Separation (3/7) How to Measure Power of Separation: –KS ( Kolmogorov–Smirnov ) Advantage: easily understood and practical Disadvantage: not good with small BAD sample and not statistically intuitive –ROC (Receiver Operating Characteristics) Advantage: statistically intuitive and deals with small BAD sample well Disadvantage: difficult to determine rank order –Gini – similar to ROC

Power of Separation (4/7) KS Statistics (1)

Power of Separation (5/7) KS Statistics (2)

Power of Separation (6/7) ROC Statistics Area Under Curve=88.4% Gini = 2 * (Area Under Curve – 0.5)

Power of Separation (7/7) Citi Benchmarks

Adverse Selection (1/5) An Example: –Banks A & B are targeting potential customers 1 & 2 –Both banks use scorecards, but the one used in Bank A is more accurate than the one used in Bank B –Customer 1 is actually riskier than customer 2 –Customer 1 eventually defaults in the future but customer 2 remains in good standing

Adverse Selection (2/5) –Bank A correctly identifies that customer 1 is riskier because its model is more accurate –Unfortunately Bank B did not because its model is inferior

Adverse Selection (3/5) –Scenario 1: Bank B approves customer 1’s application but reject customer 2’s Bank A approves customer 2’s application but reject customer 1’s Bank A makes profits on customer 2 and avoids default loss on customer 1 While Bank B suffers default loss on customer 1 and misses opportunity of doing business with customer 2 Scenario 1 is called adverse selection

Adverse Selection (4/5) –Scenario 2: Both banks approve both customers’ application Due to Risk Based Pricing Bank A charges customer 2 a lower interest rate and higher rate for customer 1 Bank B charges customer 2 a higher rate than Bank A and customer 1 a lower rate than Bank A Customer 2 does business with Bank A only because of lower interest rate; while customer 1 does business with Bank B only because of lower interest rate as well

Adverse Selection (5/5) –Scenario 2 (cont’d): Customer 1 eventually defaults Bank B suffers loss from customer 1 while Bank A make profits from customer 2 Scenario 2 is also called adverse selection

Conclusion One should look at both risk and reward at the same time to have the whole picture Scorecards are powerful tools, if one knows how to use it

Q & A

Appendix Revolvers Transactors

Revolvers Different banks may have different definitions, such as: –Ever have balance greater than 0 after payment in the past 3 month –Ever have balance greater than 0 after payment in the past 6 month –Ever have balance greater than 1,000 after payment in the past 3 month –Etc.

Transactors Different banks may have different definitions, such as: –Never have balance greater than 0 after payment in the past 3 month –Never have balance greater than 0 after payment in the past 6 month –Never have balance greater than 1,000 after payment in the past 3 month –Etc.