A quick piece in today’s Bobsguide reminded me of another reason why smaller institutions, even when going standardised, need to improve their risk management in response to the implementation of Basel II. The reason is adverse selection.

As the Advanced banks improve their ability to pick the good credits and price all their lending much better they will be able to demand higher prices from the customers their systems identify as poor and give lower prices to the customers identified as good. This means that a institution offering a single price to all customers that meet a minimum standard (the current norm) will end up with, increasingly, the customers identified as poor by the Advanced banks’ systems.

This is a real problem. Banks currently lend at one price for all on the basis that, on average, the good credits will cover the bad and because the systems required to price for risk are expensive.

This implicit assumption breaks down once one or more lenders are genuinely pricing for risk – they will tend to pick up the good credits while the bad credits will tend to move to the institutions that are still offering a single credit price. This will mean that the implicit assumption on which single pricing models are built breaks down – over time, the bad credits will dominate over the good.

This trend will take time. Customers are always slow to change banks. However, proper credit pricing is no longer a nice to have – it is simply a matte

r of survival.