Credit Risk Measurement

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 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.