Effective Methods to Measure Financial and Credit Risks
Lending money entails a considerable amount of risk, as evidenced by the number of banking and financial institutions going bankrupt. These institutions need ways to measure financial and credit risks.
Banks and other financial institutions are the most common sources of funds for personal use or for the capitalization of businesses. Funds mostly come in the form of credit extensions. Profits from lending activities comprise a good part of bank profits. But many times, lending losses also lead to financial difficulties and even bankruptcies. With advances in technology, lending institutions are finding it easier coming up with more effective tools to reduce and measure financial and credit risks.
Credit metric systems contained in credit risk scorecards are very useful to lending institutions in determining the ability of a loan applicant, a group, or a business organization to pay loans on time. The scorecard system is a set of quantitative measurement indicators where past and current credit standing of the loan applicant are analyzed. The scorecard process starts with the gathering of clients’ historical credit data, analyzing such data, and then presenting it in a coherent form – credit rating. Although the credit rating does not point to the likelihood of loan defaults, it provides lending institutions with sound basis in deciding whether the loan applicant is a justifiable risk or a possible risk.
Assessing a loan applicant’s credit risk sounds easy, but in reality, it is not that simple. The credit scorecard model is hard to handle because first, it is difficult to price the credit riskiness of a loan applicant, especially in the absence of liquid markets. Second, default rate estimates are not often that reliable, as they may have been influenced by biased or subjective approval of past credit applications. The third factor is the difficulty in accurately measuring the relationships between instances of defaults; thus, the difficulty also in relating them to credit risk measurements.
The difficulty in accurately pricing a customer’s credit risk is offset by other measurement indicators in the scorecards. These other indicators would include the lender’s capitalization levels, gross debt service, customer standpoint, and company standpoint. This means a holistic approach to credit risk management as it takes into consideration the overall financial condition of the lending institution. This is most helpful in banks where credit portfolios are just a part of profit earning services and activities.
The emergence of new credit metrics has enhanced the serviceability of credit risks scorecards. Some of the new credit risk metrics that have facilitated more effective measurement of credit risks are logistic regression, reduced form credit models, and hazard rate modeling. These measurement methodologies differ only in their database organization and their ability to determine the financial value of the loan.
Many lending institutions use credit risk scorecards not only because they are simple to use, but also because they are effective measurement tools. What poses some difficulty is in the identification of the appropriate credit risk metrics, but after the task is satisfactorily accomplished, it is just a matter of encoding the company account. The system will automatically calculate financial ratios based on selected credit risk metrics and other factors usually related to the company’s perspectives.
Financial management is a constant area of concern among banks and lending institutions. But by far, the biggest problem they face today are those related to credit risks. They are always on the lookout for new and more reliable methods to measure financial and credit risks from which they can facilitate new credit approaches and strategies that would earn for them respectable profits, and at the same time, be of help to the customers.
