A COMPLETE GUIDE TO CREDIT RISK MODELLING

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This article explains basic concepts and methodologies of credit risk modelling and how it is important for financial institutions. In credit risk world, statistics and machine learning play an important role in solving problems related to credit risk. Hence role of predictive modelers and data scientists have become so important. In banking under analytics division, it's one of the highest paid job.
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What is Credit Risk?

In simple words, it is the risk of borrower not repaying loan, credit card or any other type of loan. Sometimes customers pay some installments of loan but don't repay the full amount which includes principal amount plus interest. For example, you took a personal loan of USD 100,000 for 10 years at 9% interest rate. You paid a few initial installments of loan to the bank but stopped paying afterwards. Remaining unpaid installments are worth USD 30,000. It's a loss to the bank.

It's not restricted to retail customers but includes small, medium and big corporate houses. In news, you might have heard of Kingfisher Company became non-performing asset (NPA) which means the company had not been able to pay dues. High NPAs lead to huge financial losses to the bank which turns to reduction of interest rate on the deposit into banks. Serious honest borrowers with good credit history (credit score) would have to suffer. Hence it is essential that banks have sufficient capital to protect depositors from risks

Why Credit Risk is important?

Do you remember or aware of 2008 recession? In US, mortgage home loan were given to low creditworthy customers (individuals with poor credit score). Poor credit score indicates that one is highly likely to default on loan which means they are risky customers for bank. To compensate risk, banks used to charge higher interest rate than the normal standard rate. Banks funded these loans by selling them to investors on the secondary market. The process of selling them to investors is a legal financial method which is called Collateralized debt obligations (CDO). In 2004-2007, these CDOs were considered as low-risky financial instrument (highly rated).

As these home loan borrowers had high chance to default, many of the them started defaulting on their loans and banks started seizing (foreclose) their property. The real estate bubble burst and a sharp decline in home prices. Many financial institutions globally invested in these funds resulted to a recession. Banks, investors and re-insurers faced huge financial losses and bankruptcy of many financial and non-financial firms. Even non-financial firms were impacted badly because of either their investment in these funds or impacted because of a very low demand and purchasing activities in the economy. In simple words, people had a very little or no money to spend which leads to many organisations halted their production. It further leads to huge job losses. US Government bailed out many big corporate houses during recession. You may have understood now why credit risk is so important. The whole economy can be in danger if current and future credit losses are not identified or estimated properly.

Basel Regulations

A committee was set up in year 1974 by central bank governors of G10 countries. It is to ensure that banks have minimum enough capital to give back depositors’ funds. They meet regularly to discuss banking supervisory matters at the Bank for International Settlements (BIS) in Basel, Switzerland. The committee was expanded in 2009 to 27 jurisdictions, including Brazil, Canada, Germany, Australia, Argentina, China, France, India, Saudi Arabia, the Netherlands, Russia, Hong Kong, Japan, Italy, Korea, Mexico, Singapore, Spain, Luxembourg, Turkey, Switzerland, Sweden, South Africa, the United Kingdom, the United States, Indonesia and Belgium.

Basel I

Basel I accord is the first official pact introduced in year 1988. It focused on credit risk and introduced the idea of the capital adequacy ratio which is also known as Capital to Risk Assets Ratio. It is the ratio of a bank's capital to its risk. Banks needed to maintain ratio of at least 8%. It means capital should be more than 8 percent of the risk-weighted assets. Capital is an aggregation of Tier 1 and Tier 2 capital.

1. Tier 1 capital : Primary funding source of the bank. It includes shareholders' equity and retained earnings
2. Tier 2 capital : Subordinated loans, revaluation reserves, undisclosed reserves and general provisions

In Basel I, fixed risk weights were set based on the level of exposure. It was 50% for mortgages and 100% for non-mortgage exposures (like credit card, overdraft, auto loans, personal finance etc). See the example shown below -

Mortgage $5,000
Risk Weight 50%
Risk Weighted Assets $2500 (Mortage * Risk Wei

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