When economic times are good and funds are relatively easy to lend without meaningful short-term risk, most financial institutions find themselves in strong positions from a credit risk and earnings perspective. Yet, the tough lessons of lending and risk over the past 30 years have taught us many times over that economic cycles repeat. It’s an all-too-often forgotten pattern that reminds us that good times, which always seem to feel like they are here to stay, only last so long.

Each of the major economic downturns over the past 30 years has had significant impacts. For one, each downturn was the catalyst for industry consolidation as institutions that failed to sufficiently prepare for the downturn found themselves in the regulatory crosshairs for closure. Secondly, for those institutions that weathered the storm, the regulatory lessons aimed at promoting change for the future were often significant enough that mergers and acquisition were the result.

Adapting to expanding requirements always challenges organizations that are in a position to stay in the game and choose to do so. Fortunately, for those organizations, technology often comes to the aid. Using that technology, however, creates its own risk factors.

“Risk-based pricing” was a term that emerged as part of the Fair and Accurate Credit Transaction Act of 2003. Yes, 2003. That’s a decade and a half ago. As such, it would seem that there has been plenty of time for organizations to make necessary adjustments to meet the technical requirements of the Act. And most financial institutions have much of it under control, such loan production systems that provide automated notices to applicants as part of the normal disclosure process. But that leaves the far larger question: what about the validity of actual pricing?

Most organizations rely on models to effectuate pricing. The growth of such models was inevitable from a competitive, compliance, and convenience perspective. But the use of such models comes with a clear expectation: you have tested the validity of your models, haven’t you?

The regulatory agencies promote specific guidelines for models, including model risk management. Key guidelines for the use of models include model development, implementation, and use. Evaluation of the effectiveness of the models starts with validation. Specifically, model validation seeks to verify that models are performing as expected and are in line with their design objectives and business uses. Guidance further notes that inputs, processing, outputs, and reports should be subject to validation. This includes models developed internally as well as those acquired from external resources.

Risk-based pricing systems used to automate decisions and pricing have been in place for years. As such, there have been years of data accumulated to evaluate the accuracy of those models as predictors of risk. Organizations would be well-served to conduct validation efforts on such outcomes. Such efforts would benefit from full regression modeling, where data input points are independently reviewed at loan inception, and then again with ultimate outcome of the credit product. While no model is likely to be perfect in its prediction, its longer-term accuracy should be tested to evaluate conceptual soundness of the model as well to assess whether modifications should be made.

Another benefit of risk-based pricing model validation is the potential to enhance fair lending compliance evaluation. With changes in HMDA heading our way, it makes sense to evaluate risk-based pricing relative to key fair lending and, as applicable, CRA aspects. Even with adjustments to HMDA thresholds to focus on larger reporting organizations, the adjustments will not alleviate fair lending factors. As such, organizations will be evaluated for soundness in their pricing relative to fair lending as well as to risk itself.

The next test of pricing to risk will come into play as time rolls on and the economy experiences the inevitable downturn. Evaluating and validating risk-based pricing models goes hand-in-hand with regulatory guidance and sound banking operations. Moreover, the process promotes sound ongoing monitoring of usage as well as evolution based on outcomes analysis, a central component to model usage.

We encourage all financial institutions to take time to complete an independent validation of risk-based pricing models that includes thorough outcomes analysis.