Credit Risk Measurement

It is inevitable for all businesses to have a systemized way of keeping track of your financial records, or bookkeeping, so to speak. Bookkeeping is something that businesses should never be without because this is an organized method of keeping track of finances, to determine whether the business is indeed earning. For decades now, companies have used accounting sheets for efficient bookkeeping. However, the advent of technology has paved the way for accounting to become techie, so to speak, as well. Still, no matter how techie a company’s accounting system may be, it would still be important to keep track of this very system’s progress, to check if it is indeed aligned with corporate goals and objectives. One way to do this is to employ accounting KPI or accounting key performance indicators. This way, there would be smaller room for marginal errors here.

If you are not too sure about which KPIs to include here, well, do not fret altogether. Technology may have changed certain aspects about the method, especially when it comes to calculation of figures. However, the underlying concept remains the same. Thus, you might find the KPIs used here to be quite familiar. And one of these is revenue.

In fact, the revenue of the company itself is one of the first things that you should include as KPI. In its most basic form, revenue can be defined as the company’s net income once overhead expenses and costs are subtracted. Although overhead expenses and costs can differ from one company to another, these would typically include the capital used by companies for raw materials, the salaries of the workforce, the number of non-productive hours, and the many non-tangible items that any business has to pay for. By including this in your list of KPI for accounting, all managers have to do is look at these figures, and revenue is easily determined. Managers can also check for areas that need improvement.

Another KPI that you can include is yield. It is actually a common mistake amongst managers to look at merely sales figures. They do not really take the time to look at the measures that could have been undertaken to control waste and defects. For instance, let us say that it takes a web content editor two hours to edit ten articles. This is already the fastest that the editor can go at, to ensure quality assurance for the articles produced. However, because a computer virus was able to penetrate the computer network, the editor’s PC is also affected. The network has to be shut down, to eradicate the virus before it spreads to other PCs. Consequently, it took the editor five hours edit just ten articles. This could have been avoided with the simple installation of antivirus software. Making significant changes, therefore, will ensure more yield for the company.

Budget, as always, should be one of the accounting KPI as well. With this on your scorecard, you can easily determine if the company is spending within the budgetary constraints, or if it is already overspending. Thresholds have to be determined here as well. In the scenario mentioned above, it is ideal to get the best brand of antivirus software in the market today. However, it would be more practical to just go with a not too famous brand that still offers the same features that the best brand offers. This is just one of the ways that a company can avoid overspending.
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Metrics, scorecards, and key performance indicators are widely used by business organizations to help them see how far they have gone in terms of implementation of plans and achievement of goals. In the same manner, an accounting company scorecard is a beneficial tool that accounting firms can use to help them function more efficiently.

Accounting is a very important aspect in any business operation. It involves the measurement and provision of accurate financial information to managers, investors, tax authorities, and other stakeholders to help them make decisions about how they should allocate the resources of a company, organization, or public agency. Due to the nature of the accounting function, accounting firms provide critical support to their clientele. Among the most common financial services accounting firms offer are estate planning, accounting, taxation and investment, and retirement planning. Because what they offer are professional services, it is imperative for accounting firms to identify all factors and issues that would significantly impact their profitability and their reputation. Moreover, to increase their efficiency, management of accounting firms should always be ahead of everyone else when it comes to innovating and updating their knowledge and technology. In addition, there is a need for these companies to invest on their employees or workforce, as these people hold the key towards building lasting relationships with clients.

At present, accountants continue to do the traditional functions that are delegated to them. However, it is widely noted that there has been a tremendous change in the role that they play. Aside from recording and updating financial records and documents, they are now usually included when managers of business organizations formulate long-term plans. In short, they now become organizational strategic partners. Because of this new position that they play as members of a management team, there is an added pressure for them to foster improvement in all aspects of their operations. The Balanced Scorecard is a management system that would prove to be very useful for them. Developed by Robert Kaplan and David Norton, this scorecard approach will help accounting firms assess their performance using not only financial measures but also non-financial metrics. In fact, this performance measurement system advocates that there should be a balance between strategies implemented and four perspectives of business operation namely; financial, customer, business processes, and learning and growth.

Metrics that are commonly categorized under the financial perspective include return on capital, economic value of assets, and operating income. Common examples of customer perspective metrics, meanwhile, include customer satisfaction, market share, and customer retention. Business process perspective metrics also include cost and quality of procurement, production, and fulfillment of orders. Lastly, metrics for learning and growth perspective may include employee retention and employee satisfaction.

While the metrics previously mentioned may not exactly be the metrics that accounting firms find most relevant, they give the idea that the Balanced Scorecard approach is a more effective performance evaluation system. After carefully deliberating and identifying key indicators of success in their organizations, they can integrate all these metrics as they develop an accounting company scorecard.

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It is the risk that a counter party to a transaction will fail to perform according to the terms and the conditions of the contract, thus causing the holder of the claim to suffer a loss. This main reason for the risks is because of the poor understanding of the financial transactions that occur between the customer and the banker.

One of the tools to reduce the risks is through calculating the APY (Annual percentage yield). It is a tool for evaluating how much a deposit earns you, and it is a standardized way of comparing investments.  Your job as a consumer is to put your money where it will get the highest APY. APY , amount you earn on a deposit over an year. It refers to your earnings how much money you are making on the investment that you have made. Because we all want our money to work for us and grow, it is important to get a good Annual percentage yield through the bank. APY is notable because it takes compounding into account., Compounding means making earnings on your earnings.

This means that the quoted APY is telling how much you are really making on the money. In general, you will find that the Annual percentage yield is higher for more frequent compounding periods. Ask your financial institution how often they compound. If your money is compounded daily as opposed to quarterly, you’ll be able to earn a better APY. Don’t think of one compounded daily investment as separate from your checking account – they all go together and should be considered one. Think of yourself as the Chief Financial Officer of You. To make up your personal Annual percentage yield, find ways to make sure that your money is compounding as frequently as possible. If two compound daily investments pay the same interest rate, pick the one that pays out interest monthly instead of at maturity. Then, you can reinvest your interest payments and start earning interest on that payment. Even we can increase our investments by calculating the Annual planning yield and by making proper planning where we have to invest your money, which can yield us much more profit.

Calculating an investment’s APY can be tricky. If you want to just find out what an APY is with Excel, here’s the function:

=POWER((1+(A1/B1)),B1)-1 where A1 is the Rate and B1 is compounding frequency.

Try pasting this formula into any cell on a spreadsheet (except A1 or B1). In cell A1 you will put the stated annual interest rate – in decimal format. For example, if the stated annual rate is 6%, you’ll type “.06” in cell A1. Then, you put the number of times you’ll compound each year. For example, for daily compounding you would enter “365” (or 360 depending on the institution) in cell B1. In the example I’ve used, you’ll find that the Annual percentage yield is 6.183%. In other words, if you get 6% annually with daily compounding, your APY = 6.183. Try changing the compounding frequency and you’ll get an idea of how the APY changes.

For example, you might show quarterly compounding (4 times per year) or the unfortunate 1 payment per year (which just results in a 6% APY). Thus this is an efficient way of cutting short the problem of credit risk.

A credit is something that an organization or individual makes a sum available for you to borrow. There are two main types of credit. Home loans, or mortgages, and personal or shop loans are linked to a specific item or items – for example, a new kitchen, or a house.

Revolving credit on payment cards can give you access to a fixed amount of money that you can spend as you wish, in a wide range of retailers and other outlets. In finance, Credit risk management is the process of assessing risk in an investment. When the risk has been assessed, investment decisions can be made and the risk vs. return balance considered from a better position. The main way to reducing credit risk is by monitoring the behavior of clients who wish to apply for credit in the business. These clients may be businesses, individuals or sovereigns. Credit Risk is further divided into many areas in a somewhat hierarchical fashion.

Whereas the credit risk is the possibility that a bond issue will default by failing to repay principal and interest in a timely manner. Bonds issued by the federal government, for the most part, are immune from default (if the government needs money it can just print more). Bonds issued by corporations are more likely to be defaulted on, since companies often go bankrupt. Municipalities occasionally default as well, although it is much less common.

Credit risk management is a concept where Rocket scientists, financial engineers and mathematicians have revolutionized the management of credit risk. New analytical techniques to measure, manage and control credit risk are being developed and tested at a rapid pace. An enormous input of science has been injected into an area - risk assessment - that has often, in the past, been regarded as more of an art.

The collapse of Barings, Britain’s oldest merchant bank, and the billion-dollar losses suffered by Sumitomo Corporation catapulted the need for sound risk control into corporate consciousness which named as the credit risk control. But even before these spectacular losses, risk control had occupied the minds of those whose business it is to know - the regulators and the senior managers of the world’s leading financial institutions. They knew that sound internal risk control is essential to the prudent operation of a financial institution and to promoting stability of the financial system as a whole.

Some Aspects Regarding Banking Risk Management includes the financial and banking market is presently right in the middle of a developing and consolidating process. The banks are those institutions which can guarantee the financing for economic projects, generally speaking and particularly for the investment projects. The credit market got developed and secures financial sources for the entrepreneurs. But each and every credit is implying a less known aspect, as it is the subject of running a number of risks. The credit risk does exist; therefore, what really matters for both contracting parties is to properly evaluate it and learn about it in advance. The text below is emphasizing a number of aspects concerning the management of the credit risk (i.e. the non-payment risk, the exposure risk, the recovery risk).

There are various credit risk measurement methodologies today. It is a challenge for managers to see how these can be used to resolve the problem of credit risk measurement.

Executives of banks, financial institutions, and business organizations should be able to address the problem of credit risk measurement in order to protect their firms from credit loss.

Credit risk commonly refers to that risk that lenders face in case an obligor or creditor fails to settle or repay his debt. Credit risk measurement is, therefore, crucial as it helps determine and assign a quantitative value with regards to the capacity of a creditor to settle his account, as well as the default probability involved. Financial analysts consider credit risk more complex to measure compared to market risk for several reasons. It is also as difficult to model as market risk. One of the contributing factors for this is the absence of a liquid market that is capable of assigning a value of credit risk for a specific creditor and tenor. Another factor is that default probabilities can be distorted by inferring default rates that can be determined from historical public credit scores and subjective credit approval process. Lastly, default correlations are generally difficult to measure and observe, making it more complex to determine aggregate credit risk.

Company executives of banks and lending institutions now see the need to develop an accurate credit risk measurement process in order to balance rewards and risks. They should ensure that loan products do not have high interest rates, or else they stand the chance to lose a customer. At the same time, these loan products should not be too low to the point that they will translate to minimal profit margin or losses. In credit risk measurement, concepts like recovery rate, default exposure, unexpected losses, and default probability are just some of the concepts that are normally used. These measures are usually taken into account since small variations in credit risk measurement could have huge implications on credit risk estimates. Generally, consumer lenders use borrower credit scorecards as basis of improving portfolio management and decreasing underwriting costs. Nevertheless, the development of commercial credit risk measurement methodology is hampered by infrequency of defaults, as well as limited historical data that is available.

When measuring credit risk, two components are generally assessed. These components are unexpected and expected loss. According to the formula commonly used by banks, expected loss is a product of exposure, loss given default (LGD), probability of default (PD), and Exposure at Default (EAD). In essence, expected loss is a measure of average losses incurred over a given risk period. Unexpected loss (UL), on the other hand, is a measure of what might go wrong over a given period of time. To measure this, financial institutions usually employ a credit value-at-risk approach. The UL metric gives lenders an idea of potential volatility of a credit portfolio.

Most lending companies have departments that are specially organized to deal with the problem of credit risk measurement. The credit scorecard approach is widely used in the industry. Others also use specialized metrics and key performance indicators for measuring credit risk as part of their evaluation of clients seeking to benefit from their loan products.

Managers of financial institutions like banks need to familiarize themselves with metrics and performance indicators for banking industry since these will help them in making profitable investment decisions.

To efficiently manage banks and financial institutions, identifying relevant metrics and performance indicators for the banking industry is very crucial.

Banks exist to provide consumers and businesses financial services. They are financial institutions that receive, transfer, pay, collect, exchange, lend, safeguard, and invest money in behalf of its customers or depositors. Services provided by banks are extremely important in free market economies, like United States and Canada. Two of their primary functions are to supply customers with mediums of exchange like checking accounts, credit cards, and cash; and to accept money from depositors and lending this to borrowers. These two functions allow an economy to expand and grow.

In the face of tight competition and changing customer loyalties, the use of key performance indicators (KPIs) and relevant metrics will certainly help bank managers and executives make good corporate decisions that will help them achieve their organizational objectives. KPIs are quantifiable measures that can give managers a quick assessment of performance. A common dilemma for managers is to identify which among the many metrics that can be easily obtained can be used as basis of organizational performance. The metrics that will be used as KPIs should be relevant and should yield information that will be extremely useful for managers who are running banks. As is discussed in many textbooks, these indicators should pass the SMART acronym criteria. They should be specific, measurable, achievable, relevant or result-oriented, and time-bound.

Key performance indicators may be financial or nonfinancial, and are usually based on the organizational structure and operating strategies of a bank. Liquidity ratios are often used and considered as crucial KPIs by many financial institutions. According to the Uniform Bank Performance Report, there are twelve liquidity ratios that banks can use as KPIs. The amount of uninvested funds is another KPI that will help bank managers determine the amount or percentage of bank funds that are fully invested and income-generating. Another indicator that will come handy for bank managers is the amount of loan commitments the bank has from the beginning to the end of a certain period. A table indicating these figures will illustrate activity. Moreover, to obtain profitability information, it is a good idea to monitor outstanding loans, new loans, ending total loans, and principal reduction. Other factors that can be treated as KPIs are ratio of active depositors against dormant depositors, number of depositors per branch, number of closed accounts, and number of issued credit cards monthly.

Aside from the metrics previously mentioned, rate of credit risk and default risk rate should also be given close attention. This is for the reason that credit risk is one of the major challenges that banks and lending institutions worldwide face. In fact, this is very crucial and may lead to bankruptcy, if left unattended. Efficient credit risk measurement tools should be used in order to maintain credit risk level well within an acceptable range. Despite the differences in management styles and organizational structures of banks, the metrics and performance indicators for banking industry previously mentioned should help bank managers accurately assess their performance.

There is a need for bank managers to measure credit risk through a scorecard approach. This method helps determine which lending opportunities to take advantage and which to ignore.

Nowadays, it pays very well for business organizations to measure credit risk with scorecard. With this approach, company executives would be able to effectively manage any credit risk encountered.

There are various tools that can be used to measure credit risk. Aside from scorecards, other important tools are key performance indicators (KPIs) and metrics. To be able to thoroughly understand how these tools work, the concept of credit risk should be understood. The term “credit risk” is commonly defined as the risk of loss because of the inability of a debtor to pay for any line of credit or loan. Credit risk can be categorized into the following types, namely, the credit risk faced by lenders or consumer credit risk, credit risk faced by lenders to business clients, credit risk faced by businesses, and credit risk faced by individuals. In measuring consumer credit risk, credit scorecards are often used to rank existing and new customers according to the likelihood that they would be able to pay. Usually, higher interest rates are given to customers that are considered as high credit risks. Moreover, credit limits are also set especially for products like overdraft lines and credit cards. The second type of credit risk is typically applicable for lenders of business organizations. Generally, lenders determine the cost and benefits of a loan depending on the interest rate assessed and level of credit risk. Aside from controlling the interest rates, lenders are also afforded credit protection by protective clauses that are often integrated in loan agreements. Some lenders also opt to take advantage of credit derivatives like a credit default swap. Meanwhile, credit risk faced by business is that risk faced by businesses especially when they do not require cash payment for their products and services. Finally, credit risk for individuals is the risk that consumers face as bank depositors or parties of commercial transactions. To help minimize the repercussions of this credit risk type, governments usually adopt legal mechanisms to protect consumers like bank deposit insurance.

Compared to market risk, experts consider credit risk difficult to measure. There are several reasons behind this; but the most evident of which is the absence of a liquid market that makes it impossible to tag price to credit risk for the obligor and loan tenor. Nevertheless, there are simple credit risk measurement concepts that can be easy to determine, such as unexpected loss, default probability, exposure at default, and recovery rate.

An increasing number of companies, especially lenders, measure credit risk with scorecard. Credit scorecards are mathematical models that are designed to assign a quantitative value to a customer’s behavior with regards to his credit position. This tool computes and determines the financial value of a loan, given its risk level from the viewpoint of the debtor. Generally, credit scoring is done by deriving information from a certain database that contains observations and data on previous clients with loan defaults. Default probabilities are then placed on a scale with credit score. Modern credit scorecard techniques like logistic regression, hazard rate modeling, and reduced form credit models are now employed to make credit risk measurement more efficient.

Credit risk is a major problem faced by financial institutions. To generate revenue from lending opportunities, managers of these firms should be able to measure and control credit risk.

Due to the immense need of several business organizations, especially lending and financial institutions to measure and control credit risk, various credit risk management methodologies have been developed.

Since time immemorial, controlling credit risk had been a challenge for market regulators and risk managers. In fact, international regulation regarding the credit risks of banks had been instituted way back in 1998 to address this problem. It had also been revealed that financial institutions face serious problems due to their inattention and inability to control credit risk levels. This is usually evident through the lenient credit standards used, inattention to economic factors that may lead to credit standing deterioration of debtors, and poor portfolio management.

Understanding the concept of credit risk management is a must because this will help managers identify which lending opportunities to reject and which to pursue. Credit risk is basically the potential that debtors or borrowers are unable to repay loans and other lines of credit, or fail to perform their obligations as previously agreed. Through efficient credit risk measurement tools, managers should be able to monitor and keep credit risk levels within a desirable range. This is very similar to the goal of credit risk management, which is to maximize risk-adjusted return rate by limiting credit risk exposure within the desired parameters.

Credit risk exposure, to this day, is the biggest dilemma of banks worldwide. Based on historical data and past experiences, banks and other financial institutions are now more concerned with identifying, measuring, monitoring, and controlling credit risk. At the same time, these firms make sure that they have adequate assets and capital against these risks.

Perhaps the most common credit risk measurement tool used today is the credit scorecard. This statistics-based model is designed to attribute or assign a score or number to a customer or account indicating the predicted probability of certain customer behavior. In determining this score, various data sources can be used, including data indicated in the application form and data obtained from credit reference agencies. The application scorecard, in particular, is the most popular scorecard type. This is the type generally used when customers apply for a new loan or credit product. The score used in this tool is a three or four digit number that is consistent to the natural logit or probability of that customer turning “bad” or unable to perform its obligation. Other scorecard types, like behavioral scorecards and propensity scorecards, are also used to predict the chances of a current account turning “bad.”

Aside from credit scoring, other credit risk measurement and control methodologies, like reduced form credit models, logistic regression, and hazard rate modeling are now starting to gain popularity. Today, a number of managers are already using specialized software tools to accurately predict credit risk levels and potential losses. These also compute the capital reserves required against credit risks. The Internet is a wealthy resource for these products. You can easily find these products on the many online stores all over the web. Meanwhile, some financial institutions prefer to hire third-party firms to monitor and help them measure and control credit risk.

For banks to generate income from loan products and other lines of credit, managers should be able improve credit risk evaluation with KPI that quantitatively measure exposure to credit risk.

It is a challenge for many corporate executives and risk managers to improve credit risk evaluation with KPI or key performance indicators.

According to the Principles for the Management of Credit Risk released by the Basle Committee on Banking Supervision released in 1999, credit risk is the potential that a counterparty or bank borrower will fail to perform his obligations as previously agreed. In light of this, the goal of credit risk management is to maximize the risk-adjusted rate of return of a bank or financial institution by limiting credit risk exposure. This describes the urgency for banks to effectively manage credit risk in their loan portfolio and transactions. Moreover, this also establishes the need for bank managers to understand the relationship between other types of risks and credit risk. Since the early days of banks, lenient credit standards for counterparties and borrowers, inattention to economic factors that will affect consumer behavior, and poor portfolio and risk management had been identified as the major causes of banking dilemmas. Particularly for banks, loans and other lines of credit are the biggest sources of credit risk. For this reason, banks are expected to make use of efficient credit risk management tools in order to limit risk exposure. Perhaps the foremost manifestation of this is the increasing amount of effort that bank managers put into identifying, measuring, controlling, and monitoring credit risk.

Fortunately, it is now possible for financial institutions to perform credit risk evaluation conveniently due to the onset of modern technology. Some advanced software applications have now become essential tools to support decision-making when it comes to which lending opportunities to pursue and which to ignore. Aside from accurately predicting potential losses to be incurred with high credit risk, these software tools also calculate the amount of assets or capital reserves needed to satisfactorily minimize risk. Moreover, industry experts and risk managers now see the wisdom behind using key performance indicators when measuring and controlling credit risk.

According to credit professionals, credit risk management could be efficiently implemented with thorough understanding and proper use of indicators, like probability of default (PD), Loss Given Default (LGD), Exposure at Default (EAD), Expected Loss (EL), and Unexpected Loss (UE). Probability of Default (PD), or Expected Frequency Default (EFD) is a frequency measure that describes the risk that a borrower may not be able to give full and prompt payment. Loss Given Default (LGD), on the other hand, is a new measurement concept that describes the risk that loss is incurred if there is already a default event. This concept is also labeled as loss in the event of default (LIED). Exposure at Default (EAD), meanwhile, is that measure which quantitatively defines expected drawn risk exposure during the time of default. Expected Loss (EL), as per its name, is a measurement of losses that are anticipated over a given risk period. In contrast, Unexpected Loss (UL) measures what may go wrong in a loan transaction. Aside from these concepts, liquidity ratios can also be used as success indicators. Thorough understanding of these concepts should help bank managers improve credit risk evaluation with KPI.

Taking managerial decisions keeping growth, risk and returns in mind are tough and tricky for the best banking brains, but performance metrics can help…

Business decisions are getting tougher and tougher in a world of cut-throat competition and swaying customer loyalties. In a day and time when industry follows no fixed trend and age-old business practices are failing for no reason at all, making management decisions has become extremely tough. However the use of performance metrics and key performance indicators can actually help managers take better decisions and make calculated choices. As far as the banking sector is concerned, banking performance metrics may vary from performance metrics in other organizations. At the same time, different banks may choose to focus on different performance metrics based on their goals. Banking performance metrics about key focus areas in your company, based on the policies, vision and aims of your own organization can help you in analyzing current situations and determining future course of action in an extremely objective and calculated manner.

No matter what your goal is or what kind of banking policies you follow, the use of performance metrics in assessing the overall performance of your organization can definitely help you in improving the overall functioning of your bank and in pushing your profits. Since most banking sector decisions involve trade-offs between risk and returns, almost every bank is into calculating the newly evolved EVA (economic value added) and RAROC (risk-adjusted return on capital). On the other hand, due to the extreme importance that is being given to customer relations nowadays, formulae for performance metrics calculating customer satisfaction are being developed every other day.

In order to help the performance of their banks, most managers are nowadays using specialized software tools or calculators for determining their performance metrics. Other banks simply employ the services of consultancies and financial firms who assess performance in different areas and provide detailed metric values. In either case, banks today need to get data on key performance indicators in all sectors ranging from customer satisfaction, growth, employee turnover and performance, productivity, profitability and risk management. Some of the main performance metrics that almost all banks need to focus on are return on capital employed, overhead cost ratio, ,return on operating capital, return on average assets, operating margin, fee income level, non-interest income level and different types of capital ratios.

Many companies also use the balanced scorecard method for gathering and calculating their key performance metrics. The balanced scorecard is a tool that provides formulae for calculating different performance metrics for different organizations and different operational situations. Industry experts may use varying terms for denoting performance metrics like business activity monitoring, business intelligence, business performance management and enterprise metrics management but the plain and simple truth is that nobody is making any kind of decisions without first checking out their performance metrics.

Successful banking is impossible without continuously assessing performance variables and acting upon what these numbers tell you. Whether you run a small bank or a worldwide chain, you need to work with banking performance metrics before taking any decisions because performance metrics are the best decision making variables that you can get your hands on today.