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Credit Risk Analytics: A

Cornerstone for Effective Risk


Management
An Oracle White Paper
October 2008

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Credit Risk Analytics:
A Cornerstone for Effective Risk Management

In this information age, analysts can tap huge volumes of information quickly and
cost effectively. Analyzing this information for business benefits has opened up a
new branch of analytics called credit risk analytics. To develop credit risk analytics,
statistics are analyzed to pick out characteristics related to creditworthiness.
Credit risk analysis, mainly through credit scoring/rating models, is becoming
prevalent for acquiring new accounts, managing existing accounts, up‑selling,
cross‑selling and predictive analysis such as recovery and collection forecasting.
Computers and the availability of data in electronic formats, mainly from the
internet and credit bureaus, have automated the whole process. Businesses can now
take quick and objective decisions about the creditworthiness of borrowers.
Thus, analytics help banks to control credit risks. Today, credit analytics through
rating/scoring is set to become the cornerstone of the receivables management
process and is essential to effective credit risk management.

Drivers of Credit Risk Analytics


Analyzing information for business benefits The consistent use of credit risk analytics has many advantages. It improves an
has opened up a new branch of analytics
institution’s risk assessment time, speed, accuracy, consistency, bad debt reduction
called credit risk analytics. To develop
and prioritization of collections. Using credit‑scoring analytics, an institution can
credit risk analytics, statistics are analyzed
to pick out characteristics related to review its entire receivables portfolio in the time that it would take to review just
creditworthiness. one account by traditional methods. Credit risk analytics assures accuracy since the
review process is mostly free of human error. It offers consistency, by using the same
set of rules and weighted variables over the entire portfolio. Scoring permits regular
reviews of the entire account base, thereby, quickly and efficiently identifying
accounts that require immediate attention, and isolating customers who warrant
human intervention. The net effect is a substantial reduction in risk assessment time
and a more systematic approach to collection.
Credit scoring can also be a tool to identify accounts that have the potential for
fraud. It can provide an overall evaluation of the receivables portfolio by identifying
its quality as well as the potential for bad debt write‑offs and corresponding reserve
requirements. It facilitates an accurate assessment of the true value of receivables as
liquid assets to be reflected on balance sheets.
Growing compliance requirements are another big driver for the spread of credit
scoring. Since receivables represent a significant portion of the asset base, it is
important to state this portfolio’s true value, particularly for publicly traded

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companies. The Basel II Accord is one of the main drivers of credit risk analytics. Its
advanced approaches stipulate that to measure credit risk capital, each bank must
internally rate/score borrowers, individually or in a pool. Banks also need analytics
to measure risk parameters like probability of default (PDs), loss given default
(LGD), among others. Thus, if deployed properly, credit risk analytics can enhance
value beyond regulatory compliance, providing a competitive advantage.
The consistent use of credit risk analytics
Different Approaches to Credit Scoring/Rating Models
has many advantages. It improves an
institution’s risk assessment time, speed, There are several approaches to credit scoring/rating. These include (Figure 1) rules
accuracy, consistency, bad debt reduction and based scoring and statistical methods including neural network modeling and
prioritization of collections.
option pricing models.
Rules based scoring/rating is a judgmental scoring model based on the experience of
the model’s designers. It automates the traditional risk assessment process. It allows
the user to assign weighted values to key elements deemed essential to sound credit
decisions. Its major advantage is the consistency it provides to account reviews.
Statistical methods examine all variables relevant to default or business failure using
regression techniques. They identify a select set of key variables that point to the
differences between marginal and sound businesses. They then weight the variables
based on their importance to the outcome.
To develop credit‑scoring systems, different statistical methods such as linear
probability models, logit models, probit models, and discriminate analysis models
are used. The first three are statistical techniques for estimating the probability of
default (PD) based on factors like loan performance and borrower characteristics.
The linear probability model assumes that the PD varies linearly with the factors;
the logit model assumes that the PD is logistically distributed; and the probit
model assumes that the PD has a (cumulative) normal distribution. Discriminate
analysis differs: instead of estimating the PD, it divides borrowers into high and low
default‑risk classes.
Neural network modeling is a part of statistical based scoring. Its basis is a series of
algorithms that are automatically refined and updated as information is gathered

Figure 1: Approaches to Credit Scoring/Rating Models

Credit Assessment
Models

Rules Based Scorings Statistical Models Causal Models

- Expert System - Regression Models - Option Pricing


- Questionnaire - Discriminant Analysis - Simulation Models
- Fuzzy Logic - Cluster Analysis - Cash-Flows
- Neural Networks
Hybrid forms
(Combination of Heuristic Models and One of the Two other Model Types)

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and incorporated. Its advantage is that it is not static and constantly adjusts to
changes, such as business and economic cycles that may affect the outcome. It can
also be used to identify fraudulent accounts.
Commercial loans tend to be more heterogeneous than retail loans, making
traditional statistical methods harder to apply. Options‑pricing theory models start
with the observation that a borrower’s limited liability is comparable to a call option
written on the borrower’s assets, with the strike price equal to the value of the
outstanding debt. If the value of the borrower’s assets falls below the value of the
outstanding debt, the borrower may default. The models infer the probability that
a firm will default by estimating the firm’s asset‑price volatility, which is usually
based on the observed volatility of its equity price.
An ongoing debate persists about which of the three scoring methods is best suited
for credit risk analysis; however, none hold a distinct advantage. In determining
which model is best suited to an organization’s requirements, it is important to
clearly understand how each works and choose the one that seems best suited. In
a perfect world, the best approach is in combining the models, creating a hybrid
approach to the overall credit scoring process.
In general, statistical credit scoring methods are prudent for retail loans, given their
bigger sample size and larger data points. Hybrid models work better for corporate

Figure 2: Results of a Validation Excercise on Rating Models

Economic Capital (EC) models are used to


Validation Modeling
quantify the risk of loss over specific time AUC 0.640 0.647
horizons. Institutions are becoming aware
of the importance of using EC to make a
KS 22.5% 23%
variety of business decisions: pricing, capital Gini Coefficient 0.28 0.29
allocation (especially among business lines),
profitability analysis, capital budgeting, and
Information Statistic 0.30 0.316
risk and performance measurement.
ROC Curve

1.0
0.8
Sensitivity

0.6
0.4
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0

1. Specificity
Diagonal segments are produced by ties

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customers, where the observations are limited and Basel II requirements make it
advisable to use all the material information for credit scoring. Hybrid models
combine statistical and judgmental models. If the companies are listed, thus giving
an equity price history, and the country has an efficient stock exchange, options
pricing models are among the best ways to derive default probability.

Key Factors Determining the Credit Scoring & Ratings


Many banks adopt an enterprise-wide credit
risk management approach, for an integrated Credit scoring models compute scores primarily from information in the credit
risk view. Best practices in credit risk report, including the person’s occupation, disposable income, length of employment,
management should demonstrate objectivity, and home ownership. For behavioral models, the person’s payment history reflects
prioritization, speed and accuracy, timeliness
his/her various accounts including credit cards, mortgage loans and retail accounts.
and active portfolio management.
Collections, foreclosures, lawsuits, and other collection items are also factored in.
Each factor is weighted. The behavioral score based on particular account behavior
(say, of credit cards) can be used to cross‑sell other products (say, personal loans) or
up‑sell (say, move to a platinum card).
Credit ratings for corporate customers mainly rely on past financial performance
and projections, covering growth, profitability, liquidity, and leverage and coverage
indicators. Plenty of other information on the management, industry performance
and macro‑economic indicators is also considered to make ratings comprehensive.

Validation and Maintenance of Credit Scoring/Rating


Models
The models developed by using different analytics must be maintained and
validated due to company‑specific factors like new product features, or systemic
factors like the dynamic operating environment. In general, retail models should

Figure 3: Portfolio Loss Distribution

Expected Loss =
1%
Economic Capital
99% confidence
Relative Frequency

Catastrophe Loss

Value-at-Risk
Standard Deviation 99%
1% Tail Region

0% 1% 2% 3% 4% 5%
Portfolio Loss
Source: Warburg D Read

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be validated once a quarter when new default information comes in (since the
Basel definition of default is 90 days past‑due), which can be used as early warning
signals. The commercial/corporate models are much more stable, needing to be
validated only semi‑annually or annually, depending upon the stability of the
operating environment. Models are generally validated against bad debt, against
scores from credit reporting agencies, by comparing actual performance against the
model’s predictive metrics, against holdout samples, and by monitoring performance
measures over time for steadiness.
The rating/scoring models are validated through validation of PDs by using
statistical techniques including parametric methods like binomial test, normal test,
Kolmogorov‑Smirnof (KS) statistics, information statistics, Ginni coefficient ROC
curve and traffic lights approach; and non‑parametric methods like Mann‑Whitney
Test, Brier score test, among others. Figure 2 shows some validation exercise results
carried out on rating models.

Increasing Use of Economic Capital


Economic capital (EC) is defined as the amount of capital, taking account of
portfolio correlations, which a firm requires to run its business. This involves
building a risk distribution and measuring capital in line with the institution’s
target financial strength, say, credit rating.
EC models are used to quantify the risk of loss over specific time horizons.
Institutions are becoming aware of the importance of using EC to make a variety
of business decisions: pricing, capital allocation (especially among business lines),
profitability analysis, capital budgeting and risk and performance measurement.
There are different models constructed around estimates of loss distributions
that depend on such risk factors as PDs, asset correlations, loss given default, and
exposure at the time of default. Clearly, the accuracy of the EC model depends on
the reliability of the estimates of the risk factors.
Data limitations and fundamental differences in model design have resulted in an
array of modeling techniques that can help construct a useful EC model. Some of
the most popular models have become industry standards. One is KMV’s Portfolio
Manager, introduced in 1993, which uses an option‑based, Merton Model approach
to measure default probabilities. Empirical distributions of default probabilities are
created from KMV’s proprietary database.
JP Morgan’s CreditMetrics was introduced in 1997 to measure VAR in credit
portfolios. This framework uses the Monte Carlo simulation to create a portfolio
loss distribution at the horizon date. Each obligor is assigned a credit rating,
and a transition matrix determines the probabilities that the rating will be
changed, or of default. Credit Suisse Financial Products (CSFP) has a CreditRisk+
framework for analytically calculating the portfolio loss distribution. In 1998,
McKinsey introduced its CreditPortfolioView approach, which factors in the
current macro‑economic environment for credit portfolio risk measurement and
management.

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Although some of these models can incorporate retail credit transactions, they are
primarily designed for portfolios with large, publicly rated corporations. For retail
portfolios, most banks follow a segmentation/bucketing approach for different
product categories like mortgages or credit cards. Then the risk parameters viz.,
PD, LGD, EAD and asset value correlations (AVC) or loss default correlation (LDC),
are measured for the segments/pools. Typically, for retail assets, intra‑portfolio
correlations are much lower than for wholesale portfolios due to higher granularity.
Lower correlation means lower economic capital.
Despite their different methodologies, all credit risk models create a distribution
of possible credit portfolio values at some future point. Correlated changes in the
obligor’s credit quality change the exposure values. These exposures are aggregated
to produce the portfolio loss distribution, which indicates the probability
of achieving a certain portfolio value at the horizon date. The resulting loss
distribution in Figure 3 is similar to those produced by VAR models for market
risk. The confidence level indicates the probability of portfolio losses exceeding EC:
an AAA institution may require a very high confidence level such as 99.98 percent,
while a BBB institution may only require 99.85 percent.
Regulatory capital (RC), estimated with a set of rules provided by the Basel Accord,
aims to align with EC. RC is what a bank must actually provide. Therefore, if RC
exceeds EC, the excess can be treated as a cost (regulatory overhead), increasing the
bank’s hurdle rate. This cost can be allocated pro rata to all EC elements so that
every unit of the bank shares the burden of regulatory requirements.

Conclusion
Today, many banks adopt an enterprise-wide credit risk management approach
for an integrated risk view. Best practices in credit risk management should
demonstrate objectivity, prioritization, speed and accuracy, timeliness and active
portfolio management. The pressure from regulatory requirements such as Basel II
or International Swap Derivatives Association (ISDA) also encourages this. Credit
risk analytics makes all this possible.
An important prerequisite for effectively using credit risk analytics is to have
appropriate organizational skill sets capable of understanding, building and
maintaining risk models. Otherwise, banks should consider outsourcing. Also
important are consistent and accurate data and integrated technology. By putting
these prerequisites in place and constantly enhancing existing analytical tools and
methods, banks can quickly move to best practices in risk management.

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Credit Risk Analytics: A Cornerstone for Effective Risk Management
October 2008
Author: Kuntal Sur

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