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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.
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.
Credit Risk Measurement