Credit Risk Measurement

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.