Credit Risk Measurement

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.

There are different approaches to credit risk measurement, most of them focus on such performance management tools as KPIs, Metrics, Scorecards. On this web-site we are reviewing the most popular tools and methods to measure credit risk.

There are three popular Balanced Scorecard products that are useful if you want to get started with credit risk measurement, this metrics are:

If you will purchase these 3 metrics together, then you will have 30% discount for your order.

There are also some other metrics in financial niche that you might find useful:

• Financial Statement Analysis. Download trial version, purchase full version for 60 US$, add to shopping cart.
• Active Portfolio Management. Download trial version, purchase full version for 60 US$, add to shopping cart.
• Passive Investments. Download trial version, purchase full version for 60 US$, add to shopping cart.

If you will purchase these 3 metrics together, then you will have 30% discount for your order.