Understanding the Need to Measure and Control Credit Risk
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.
Tags: control, credit risk, measure
