Credit Risk Measurement

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.