Part 08 — Credit Risk Deep Dive

Pricing & ALM

Risk-based pricing is the bridge between credit risk and lender economics. A loan rate is not just “what the market will bear”; it must recover funding cost, operating cost, expected credit loss, capital cost, liquidity cost, taxes and target return while remaining fair, explainable and disclosed. For non-banking financial companies (NBFCs), pricing also has an asset-liability management (ALM) dimension: a profitable-looking loan can become dangerous if it is funded with unstable or mismatched liabilities.

For borrower-facing disclosure, RBI’s Key Facts Statement (KFS) circular requires all new retail and MSME term loans sanctioned from 1 October 2024 to include annual percentage rate (APR), charges and amortisation schedule, and it applies to banks and NBFCs (RBI KFS circular, 15 April 2024). Internally, the pricing engine should connect to scorecards and models, unit economics and the lender’s ALM limits.

Pricing Build-Up

A practical unsecured SME pricing stack:

Component	Example
Weighted average cost of funds	11.50%
Liquidity buffer and negative carry	0.60%
Operating cost allocation	5.20%
Expected credit loss	3.40%
Capital and target return	3.00%
Product and channel overhead	0.80%
Base required yield	24.50%

Now apply risk and structure:

Adjustment	Reason	Rate impact
Score band B instead of A	Higher PD	+1.75%
Banking surrogate with high cash deposits	Data quality risk	+1.00%
Short tenor, daily settlement collection	Faster exposure reduction	-0.75%
Repeat borrower with clean closure	Behavioural comfort	-1.00%
Final nominal reducing rate	Rounded grid	25.50%

This build-up should not be shown mechanically to borrowers, but the board-approved interest-rate policy should define how risk gradation works. RBI’s older fair-practice guidance for NBFCs states that boards should adopt an interest-rate model considering cost of funds, margin and risk premium, disclose risk gradation and communicate the annualised rate to borrowers (RBI Monetary and Credit Information Review, NBFC excessive interest guidance). The NBFC Scale Based Regulation Master Direction is the current consolidated regulatory home for NBFC prudential and conduct architecture (RBI NBFC SBR Master Direction, updated 17 July 2025).

Real-World Pricing Disclosure

Published lender policies show how explicit the stack can be. Kinara Capital’s interest-rate policy says its rate model considers weighted average cost of borrowing, operating cost, base return on assets and risk premium. It publishes an indicative benchmark with 14.5% borrowing cost, 7.5% opex and 4.0% base RoA, adding to a 26.0% base rate, and discloses loan rates from 14% to 36% on reducing balance (Kinara Capital interest-rate policy). That is a useful practitioner artefact: not because every lender has the same cost, but because it shows the components a credit system should store.

For a bank, the same borrower may receive a lower rate because deposit funding, branch economics and priority sector lending (PSL) strategy differ. For an NBFC, a co-lending structure may let the bank fund most of the exposure at bank cost while the NBFC earns spread, fee or servicing income on a smaller share. The borrower sees a blended rate; the system must still calculate partner economics and disclose terms correctly. See co-lending business.

Expected Loss in Pricing

Expected loss is not the observed gross NPA ratio. Use:

expected credit loss = PD x LGD x EAD

Example:

Input	Score Band A	Score Band C
12-month PD	3.0%	8.0%
LGD	55%	65%
EAD	₹10 lakh	₹10 lakh
Expected loss	₹16,500	₹52,000
Annualised expected loss rate	1.65%	5.20%

If both borrowers get 21%, the lender is cross-subsidising risk. Some cross-subsidy may be deliberate for inclusion, competition or relationship value, but it must be measured. Otherwise the best borrowers refinance away and the book becomes adverse-selected.

Fees, APR and Customer Fairness

Processing fee, documentation fee, insurance premium recovered by the lender, legal charges and other compulsory costs affect borrower economics. The RBI KFS circular says APR includes interest and all other charges associated with the facility, and charges recovered on behalf of third-party providers must be part of APR and separately disclosed where the regulated entity recovers them (RBI KFS circular). Therefore pricing systems need two views:

lender yield view: interest income, fee income, cost and expected loss;
borrower APR view: all compulsory borrower costs over the loan tenor.

For a ₹10 lakh, 24-month loan at 24% reducing rate with 2% processing fee plus GST and ₹8,000 insurance recovered upfront, borrower APR will exceed 24%. Sales teams should not quote “flat” rates or hide deductions. Mispricing creates conduct risk and complaints, not only bad economics.

ALM Basics for NBFCs

ALM is the discipline of matching asset cash inflows with liability cash outflows under normal and stressed conditions. NBFCs cannot rely on retail deposits like banks. They fund through bank term loans, non-convertible debentures (NCDs), commercial paper for stronger issuers, securitisation, direct assignment, co-lending, development-finance lines, external commercial borrowings where eligible, and equity.

RBI’s NBFC ALM directions describe board responsibility for risk policy, Asset-Liability Committee (ALCO) responsibility for limits and strategy, and ALM support groups for monitoring and reporting; ALCO also considers product pricing, maturity profile and funding mix (RBI NBFC ALM Master Direction). In practice, an SME NBFC should track:

structural liquidity statement by time bucket;
cumulative mismatch limits;
short-term dynamic liquidity;
interest-rate sensitivity;
lender concentration;
unencumbered cash and approved undrawn lines;
securitisation or assignment pipeline;
behavioural prepayment and delinquency impact on inflows.

ALM Worked Example

Assume an NBFC disburses ₹100 crore of 36-month unsecured SME loans at 24% with monthly EMIs. It funds ₹60 crore through a 12-month bank line at 11%, ₹25 crore through 24-month NCDs at 12.5%, and ₹15 crore equity.

The average asset tenor is longer than the largest liability. Month 12 risk is obvious: the bank line matures before most loan principal returns. If markets are normal, the line renews. If the NBFC’s early vintage deteriorates or market liquidity tightens, renewal may be costly or unavailable. The pricing build-up should include liquidity cost, and ALCO should limit how much 36-month lending can be funded with 12-month liabilities.

A safer structure could be:

Funding source	Amount	Tenor	Comment
Bank term loan	₹40 crore	30 months	Better asset match
NCD	₹30 crore	36 months	Higher cost but stable
Securitisation after seasoning	₹15 crore	Pool sale	Releases liquidity if pool performs
Equity/internal accrual	₹15 crore	Permanent	Absorbs first risk

The nominal cost may rise, but rollover risk falls. This is why treasury and credit should not work separately. If credit launches a 48-month machinery product, treasury must confirm funding tenor and prepayment assumptions before scale-up.

Pricing Governance

Good pricing governance includes:

board-approved interest-rate and risk-gradation policy;
score-band pricing grid with deviation authority;
minimum floor by product after expected loss;
APR and fee disclosure controls;
separate co-lending blended-rate logic;
ALCO review of funding cost changes;
monthly margin and vintage-loss back-testing;
caps on teaser pricing and high-risk exceptions.

Pricing is a living control. When cost of funds moves 100 basis points, scorecards drift, or a channel’s MOB 6 loss doubles, pricing must change or sourcing must stop. A lender that treats pricing as a static sales brochure will eventually learn through credit cost and liquidity stress.

The benchmark table in Cost Structures & What the Data Says gives current disclosed examples of yield, cost of borrowing, opex, credit cost and RoA across Indian SME-lending models.