Credit Risk Measurement

The entire world is living on credit. Or it is more correct to say that the entire world lived on credit several years ago just before the financial meltdown. However, the banking sector seems to be gradually recovering, and some banks have already restored credit programs to millions of customers.

Issuing a loan or a credit is also associated with certain amount of risk. Indeed, a bank gives money to a person or organization hosing to get money back (plus interest). If the bank does not get its money on time, it faces certain problems. Besides, it is a very painful situation for borrower as well. Credit risks need to be always measured, even if this is very difficult to do.

Use BSC System for proper loan risk management

By assessing credit portfolio you are able to protect yourself against undesirable problems with the borrowers and potential partners who may turn insolvent. What is the best tool to evaluate credit risks? Finance managers and credit experts recommend using Scorecard System to measure loan and credit risks. Armed with this tool you will be able to feel more confident in the changeable business world.

Use reliable tools to measure credit risks

So, what are the most typical ways to use Balanced Scorecard system to measure credit risks? First of all this tool will be very helpful for bank managers. On the other hand Balanced Scorecard system is a great tool to be used by borrowers who might change their decision to ask for a credit if they see that there might be risks of possible insolvency. So, as you can see credit risk metric is helpful for both parties, as failure to pay credit is unpleasant for both bank and borrower.

As known, Balanced Scorecard system employs the principle of KPI evaluation. KPIs are key performance indicators, and they are different in different business spheres. So, what KPIs are measured in credit risk evaluation?

Capital adequacy. This is actual amount of capital divided by EC amount and multiplies by 100.

Gross Debt Service Ratio is property taxes plus annual loan payment divided by Gross Customer Income and multiplied by 100.

Customer credit quality. This figure is base don credit history and reports.

Sure, there are many more KPIs which directly or indirectly evaluate loan risks. But with Balanced Scorecard you will be able to measure the most important ones, thus getting the most accurate results.

Risk evaluation systems will be surely helpful for all market participants who deal with issuing and taking loans.

Just how do banks measure credit risks? This is important to know since these financial institutions deal with credit risk for a living.

When someone is in need of financial help, one usually goes to a lender or a bank for a loan. However, not everyone who applies for one is approved. Why is this so? Banks have a system to determine and compute how much they would be risking in losses, should the debtor fail to pay. This practice is called the credit risk measurement. But how do banks measure credit risks?

In actuality, it varies from bank to bank. Over the years, banks have been developing models and devoting resources to improve their calculation of such economic and financial threats. Because of this, bank regulators have begun to regulate and validate these models by imposing rules and standards for regulatory capital functions and computations. Such was the case in 1997 when the Market Risk Amendment was developed, as well as the IIF and ISDA both in 1998.

How an organization computes the credit risk the size of the loaning party is taken into consideration. However regardless of the size, they must take into account three factors.

1. Probability of default – this is the possibility of failure to pay over the period stipulated in the contract. The computation for that year may be termed as the projected default rate.
2. Exposure of Credit – how big of an amount will the debt be in case default should occur.
3. Estimated Rate of Recovery – what portion of the debt can be regained through freezing of assets and collateral and the like, should default transpire.

To understand this better, remember that each risk is composed of two essentials –  exposure (credit exposure) and the quality of credit (probability of default and estimated recovery rate).
Quality of credit is usually assessed through credit scoring. This process entails getting information, such as income statements, billing statements, and the like. This procedure is well standardized and has a formula. Such formula is applied to the gathered information and assigned a number known as a credit score. The bank will then decide whether or not to grant the loan, depending on the score obtained.

This procedure is also applied by banks when calculating the credit risk of larger organizations and businesses. However, it becomes more complex, as aside from looking at the credit rating and following the formulas, human judgment now comes into play. This is now what we call credit analysis. Credit analysts not only take into consideration the income statements, but also current economic status, the industry the business is in and the performance of that industry, and the reason for the loan and if it is worth “investing” in. There are many models used to compute credit analysis and ratings. As mentioned earlier on, many banks employ credit analysts to create such specific models, which are then subjected to regulation.

Calculating credit risks is pretty much similar to your school’s grading system. Some use the alphabet when rating. For example, those with higher ratings can be given and AAA, AA or A+, or those that are average a B, and those below a C, and so. Others may also use actual numerical values.

Aside from calculating the credit risks, banks may also instigate credit risk limits. This is the practice of stipulating a maximum amount that the individual or party can loan. Through this, the bank not only protects them, but also in a sense, protects the loaning party from loaning more than they are capable of paying. By answering the question “how do banks measure credit risks?”, a win-win situation can then be established for both parties.