Credit Risk Assessment models INTRODUCTION Developing internal credit rating models by banks has been an increasingly important

agenda in the continued development and improvement of risk measurement methods on the backdrop of Basel II IRB. I have attempted to provide an overview of the basic classification of Credit Risk Rating models and briefly discussed the classification which is most prevalent in the Industry. TYPES OF CREDIT RATING MODELS The following illustrates the broad type of credit rating models. Heuristic models Questionnairre Qualitative systems Expert systems Fuzzy logic Statistical models Discriminant analysis Regression models Artificial neural networks Casual models Hybrid models

Option pricing models C/F simulation models

The type of model which is more prevalent in the banking industry on account of significant predictive power , availability of variables, calibration of PDs, etc. is statistical models. A brief overview of the most prevalent classification, statistical model is presented hereunder. STATISTICAL MODELS Discriminant analysis Multiple Discriminant Analysis (MDA) is a statistical technique used primarily to classify in problems where the dependent variable appears in qualitative form, ie, good or bad (default or nondefault) and the independent variables are usually in quantitative form ,ie, financial ratios. MDA takes the following form Z = a0 + a1 V1 + a2 V2 + .+ anVn Where, Z denotes the final score V1, V2,,Vn denotes the independent variables a1, a2,.,an denotes coefficients a0 denotes intercept. An important assumption in MDA is that each of the variables is normally distributed. An example of MDA based credit rating model is the famous Altman Z-Score.

Logistic Regression analysis Logistic Regression analysis is also used to model the dependence of default or non-default event (usually denoted by 1 or 0, ie binary variables) on independent variables. A linear regression analysis takes the form Y = b0 + b1V1 + b2V2+ + bnVn The value of Y can be anything. Inorder to obtain a probability value between 0 and 1, logistic regression is used which takes the form. Ln (odds of event) = b0 + b1V1+b2V2+.+bnVn. Odds of event = prob of event happening / prob of event not happening Ie, odds of event = p/(1-p) Hence Ln (p/1-p) = b0+b1V1+b2V2+..+bnVn 1 Hence, p = -----------------------------------------------1+ exp -(b0+b1V1+b2V2+.+bnVn) The above p is nothing but (prob of the event happening ie, p(Y=1) ) Ln (odds) is called logit function. An example of Regression analysis based credit scoring model is the BVR-II rating model used by the Federal Association of German Cooperative Banks. Neural Network Models (NNM) Neural networks attempt to model the biological process of simulating the way in which the human brain processes information. The conventional method of credit scoring used to be based on expert judgement which basically relied on 5 Cs , namely Character (reputation), Capital (leverage), Capactiy (earnings volatility), Collateral and Cycle (macroeconomic conditions), which results in subjective assessments and also exposed to inconsistencies on account of absence of weighting schemes / subjective weighting schemes. Neural networks evaluate expert systems more objectively. Neural networks are trained using default data and repayment history. Structural matches of variables are identified that coincide with default data. These variables are then weighted. Neural networks update its weighting scheme each time it evaluates the credit risk of a new loan, thereby learning from experience. An illustration of a simple neural network based model is as under:

Basically, the NNM consists of 3 layers namely, Input layer, Inner Layer and Output Layer. The input layer takes the information (variables - Vi) and pass it on to the input layer by means of links. Each piece of information is assigned a connection weight `g. In the input layer (upstream neurons) all incoming information is linked with a value `y such that y = gi X Vi The compressed value `y is then transformed into another variable `s, normally by a logistic function. 1 s = ------------------------1+ exp (-y) The transformed values are passed on to all downstream neurons which inturn carry out the same procedure with the output factors from the upstream neurons. Once the information has passed through the inner layers it is delivered to the neuron in the output layer. The output may be a linear or non-linear function. An example of neural network based credit model is BBR (Baetge Bilanz Rating BP-14) where 14 variables are used as input parameters and compresses them into an `N score on the basis of which companies are assigned rating scores. SELECTION OF VARIABLES The selection of variables is the key in all the three types of models. Variables are basically shortlisted from among the prominent financial ratio classification and is further filtered based on the predictive power of the individual shortlisted variables. A simple illustration of visualising predictive power of variables is as under: a) The variable (for eg., current ratio) is calculated for all the borrowers. b) The variable is grouped into 5 percentile levels from 0-20 percentile, 20-40 percentiletill 80-100 percentile. c) The number of borrowers falling under each percentile level of the variables is derived which yields 5 set of borrowers. d) Among each set, default rate is derived. Ie, among each set, the ratio of number of default borrowers to the total borrowers is derived. This yields 5 default rates namely D1, D2, D3, D4 and D5. e) For a variable like current ratio to distinguish default from non-default borrowers, the default rates should be in the following order, ie, D1 > D2 > D3 > D4 > D5, meaning low percentile levels of current ratios experience high default rate and as percentile levels increase default rate decrease. This kind of behaviour denotes high predictive power. The same can be quanitatively arrived at by deriving Accuracy Ratio (AR) by plotting Cumulative Accuracy Profile (CAP), which is not discussed here. Statistical softwares like SPSS, Stata, R, etc can be employed for running MDA and logistic regression.