Credit risk strategies:
The past won't work

Two-thirds of executives in the world’s largest banks say credit risk is the primary threat facing their business. That’s why they’re now developing more forward-looking analytics, reports Will Cain.

Credit risk management was an area of sharp banking industry focus in 2010 and looks likely to remain so in 2011. As the dust starts to settle after the financial crisis, a handful of important trends have emerged and highlight a fundamental reevaluation of credit risk management in finance.

Banks are moving back to basics, plugging the gaps in their existing credit risk management operations and developing more sophisticated analytics.

Ernst & Young’s 2010 survey on risk at the world’s largest banks, for example, shows 67 per cent of executives believe credit risk is the primary risk challenge facing their business.

And increasingly, it says, banks are conducting their own independent credit analysis for both borrowers and credit providers and guarantors. This has included the deployment of special teams to manage loan portfolios more rigorously and to monitor any deterioration in credit quality, chargeoffs and related delinquencies.

Banks had significant holes in their capabilities in the lead-up to the financial crisis, claims James Lam, the author of Enterprise Risk Management and head of James Lam & Associates, a consultancy which advises Asian and US banks on risk. “Banks took their eye off the ball regarding some fundamental risks within the organisation, like credit risk and market risk,” he says.

“There’s been a lot of focus on operational, strategic and enterprise risk in general. But credit risk will always be a core risk for banking organisations. Knowing the customer, having some of the essential data in terms of loan balances or loan equivalent balances for off balance sheet items and being able to estimate probability of default (PD) and loss-given default (LGD) – two very basic data points for credit risk – are important.”

As well as addressing these basic elements within their credit risk set-ups – effectively plugging the gaps – banks are now developing improved credit analytics to build more robust models.

One recent development has been the launch of forward-looking credit decisioning models. Credit decisions in the past have been based primarily on backward-looking data, on a borrower’s or set of borrowers’ credit history and credit score.

This was successful, according to UK-based credit information provider Experian, with relatively benign economic conditions through most of the last decade. The financial upheaval in the last three years, however, has placed pressure on this model and led vendors, including Experian and US-based FICO, to build forward-looking economic indicators into the credit decisioning process.

FICO launched its Economic Impact Service package in February last year and a number of banks, including central and eastern Europe’s largest, Raiffeisen International, are now using the service. It allows lenders to adjust the use of risk scores based on economic projections and lender-defined scenarios.

FICO says the service was developed as a response to the difficulty banks faced in assessing external economic risks and predicting the impact that would have on future default rates.

It says this can help lenders adapt their strategies quickly to changing market conditions and enables them to determine appropriate levels of loan loss reserves and capital requirements.

Experian launched a similar product this January called Future Delphi. It developed the product because “while credit scoring based on historical data was an integral part of most lending decisions, the past may not be a good guide to the future in times of rapid economic change”. It says building economic data into scoring models mitigates the problem by linking credit performance of the individual to the wider economy.

These are developments Lam believes will play an important role in the future development of credit risk management. “Very often, companies spend so much time focusing on the past,” he declares. “If you look at the risk reports which go to the board and senior management, very often you find 80-90 per cent of that focuses on the past. They focus on what has been happening with loan losses, what has been happening on delinquencies or the current portfolio and slicing and dicing that by industry, region and credit rating.

“But they don’t spend enough time looking forward at what new business is coming down the pipeline or what macroeconomic factors are affecting the business environment, like interest rates, unemployment, GDP growth or oil prices. These factors could have a dramatic impact on portfolio performance.”

Lam says these tools can also help banks manage capital more efficiently through their ability to provide stress testing and scenario analysis. The development of in-house stress testing is particularly important for banks that rely on Basel 2 as a capital framework, which he believes led to significantly undercapitalised banks.

“Very often, when companies measure economic capital or value at risk, they have some defined probability level, like a 99 per cent or 95 per cent confidence level. But, as we’ve seen, the most significant risks are outside the bell curve, so you have to think outside that in a way.

“That emphasises the need for stress testing, scenario analysis and being able to incorporate those analytics into loan loss reserve calculations and economic capital calculations.”

Another key trend, according to Lam, is increasing the transparency of risk operations and reporting between different layers within the organisation. Lam says this is important both internally and externally. “Once you have achieved risk transparency internally, it’s about working on how you disclose that to external parties like regulators, ratings agencies and investors so they have a good sense of your risk profile.”

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