Book 2. Credit Risk

FRM Part 2

CR 7. Credit Scoring and Retail Credit Risk Management

Presented by: Sudhanshu

Module 1. Credit Risk

Module 2. Creditwothiness

Module 1. Credit Risk

Topic 1. Credit risks and other risks generated by retail banking.

Topic 2. Retail Credit Risk vs. Corporate Credit Risk

Topic 3. Downside of Retail Credit Risk

Topic 4. Credit Risk Scoring Models

Topic 1. Credit Risks and Other Risks Generated by Retail Banking

• Credit Risk in Retail Banking

  • Definition: The primary risk in retail banking is credit risk. This is the potential for financial loss when a customer fails to repay a loan.

  • Examples of Products with Credit Risk: This risk is associated with products like home mortgages, home equity lines of credit (HELOCs), installment loans (auto loans), credit cards, and small business loans.

  • Management: Banks manage credit risk by assessing a borrower's creditworthiness, setting appropriate credit limits, and using strategies like diversification and collateralization.

• Other Risks in Retail Banking

  • Interest Rate Risk: The potential for a bank's earnings to be affected by changes in interest rates. This arises from mismatches in the timing of rate changes and cash flows.

  • Liquidity Risk: The risk that a bank cannot meet its financial obligations when they are due without incurring significant losses. It can be caused by unexpected decreases in funding sources.

• Operational Risk: The risk of losses due to failed internal processes, systems, people, or external events. This includes risks like fraud, system failures, and human error.

• Compliance Risk: The risk of financial or reputational damage from violating laws, regulations, or ethical standards.

• Reputation Risk: This is the potential for damage to the bank's reputation, which can be present throughout the organization.

Topic 1. Credit Risks and Other Risks Generated by Retail Banking

Practice Questions: Q1

Q1. Which of the following statements is most accurate regarding risks incurred by retail lenders?

A. Reputation risk is more of a concern for the borrower rather than the lender.

B. Business risk relates to the day-to-day operational risks of the business.

C. Credit risk relates to the potential for a lender to default on their obligation.

D. Refinancing a mortgage when rates decrease is an example of asset valuation risk.

Practice Questions: Q1 Answer

Explanation: D is correct.

Refinancing a mortgage is considered a prepayment risk to the lender, which is a component of asset valuation risk. When rates decrease, borrowers are more
likely to refinance their existing (higher rate) mortgage into a lower rate
obligation. The lender then earns less in interest on the debt obligation than they would have previously. Reputation risk is primarily a concern for the lender.
Business risk relates to strategic risks tied to new products and volume, while
credit risk is the risk that the borrower (rather than the lender) will default.

Topic 2. Retail Credit Risk vs. Corporate Credit Risk

• Retail Credit Risk

  • Customer Base: Individuals, families, and small businesses.

  • Characteristics: Typically involves a large number of customers with smaller transaction and loan sizes. The financial fortunes of one customer are generally independent of others, and a single default is unlikely to cause significant financial turmoil for the bank.

  • Predictability: Retail credit risk is considered relatively predictable.

• Corporate Credit Risk

  • Customer Base: Medium-sized enterprises, large corporations, and multinational companies.

  • Characteristics: Involves a smaller customer base with larger transaction and loan amounts. A single corporate default can lead to significant financial turmoil for a bank.

  • Risk: Generally considered to be riskier than retail banking due to the size of the exposures.

Topic 3. Downside of Retail Credit Risk

• Systematic Risk: While individual defaults are small, a major, unforeseen systematic event can influence the behavior of a large number of retail credits at once.

• Widespread Losses: An economic downturn, such as a deep recession combined with high interest rates, can trigger a simultaneous increase in defaults across a retail portfolio.

• Operational Flaws: Retail banking relies on automated processes for credit decisions, which may not capture all customer-specific characteristics, potentially leading to loans being offered to higher-risk individuals.

• Challenges of New Products: The continuous development of new credit products can lead to modeling and pricing challenges due to a lack of historical data for reliable risk assessment.

Practice Questions: Q2

Q2. The dark side of retail credit risk is perpetuated by all of the following factors except:

A. capital set aside to protect a bank in the event of default.

B. process flaws resulting in high risk applicants receiving credit.

C. new products which do not have suffcient historical loss data.

D. a social acceptance of bankruptcy and borrowers “walking away” from their obligations.

Practice Questions: Q2 Answer

Explanation: A is correct.

Capital must be set aside to protect banks in the event of default, but this is a response to the dark side of retail credit risk rather than a perpetuating factor. A process flaw which grants credit to high risk individuals, a new product which doesn’t have historical loss data, and the social “acceptance” of failing to meet debt payments are all considered perpetuating factors of retail credit risk.

Topic 4. Credit Risk Scoring Models

• Purpose: A credit risk scoring model assigns a score to each credit applicant to measure their risk. The higher the score, the lower the risk that the borrower will default.

• Types of Models:

  • Credit Bureau Scores: Standardized scores like FICO and VantageScore, which are widely used by lenders.

  • Pooled Models: Models that use data from multiple lenders.

  • Custom Models: Proprietary models developed by a bank to meet its specific needs.

• Key Variables:

  • FICO Scores: A widely used model based on factors like payment history (35%), credit utilization (30%), length of credit history, new accounts, and credit mix.

  • Loan-to-Value (LTV) Ratios: The ratio of a loan to the value of the asset securing it.

  • Debt-to-Income (DTI) Ratios: The percentage of a person's monthly gross income that goes toward paying debts.

  • Documentation Types: Refers to the level of verification of a borrower's income and assets.

• Model Performance Evaluation:

  • The Cumulative Accuracy Profile (CAP) and Accuracy Ratio (AR) are used to assess the performance of a credit scorecard.

  • An AR closer to 1 indicates a more accurate model in predicting the distribution of defaults relative to risk levels.

• Risk-Based Pricing: This approach involves charging different interest rates to different customers based on their assessed credit risk. This can help a bank venture into underserved segments and reward low-risk customers with more favorable terms.

Topic 4. Credit Risk Scoring Models

Practice Questions: Q3

Q3. Which of the following statements is correct regarding credit risk scoring models?

A. A pooled model will result in scores ranging from 300 to 850.

B. A custom model is cheaper to implement than credit bureau scores.

C. Multiple requests for new credit will reduce an applicant’s credit score.

D. An example of a characterisc in a scoring model is the applicant’s current gross salary of $50,000.

Practice Questions: Q3 Answer

Explanation: C is correct.

An individual’s credit file will show a history of credit requests, with multiple requests causing an applicant’s credit score to decline. A credit bureau score model (rather than pooled model) will result in scores ranging from 300 to 850. A custom model is more expensive to implement than credit bureau scores. “Gross salary with current employer” is an example of a characteristic, with the actual
salary number itself representing an attribute.

Module 2. Creditworthiness

Topic 1. Mortgage Credit Assessment

Topic 2. Cutoff Scores

Topic 3. Scorecard Perfomance

Topic 4. Tradeoff Between Creditworthiness and Profitability

Topic 5. Risk-Based Pricing

Topic 1. Mortgage Credit Assessment

• Definition: The process by which lenders evaluate a customer's ability to pay and determine if a mortgage is a "qualified" loan. This involves a comprehensive analysis of the borrower's financial profile.

• Key Variables:

  • FICO Scores: A numerical representation of a borrower's creditworthiness. It is a critical factor in the approval process and in determining the interest rate.

  • Loan-to-Value (LTV) Ratios: The ratio of the loan amount to the appraised value of the property. A higher LTV ratio indicates greater risk for the lender.

  • Debt-to-Income (DTI) Ratios: The percentage of a borrower's gross monthly income that goes toward paying debts. A lower DTI ratio indicates a higher capacity to repay the mortgage.

  • Payment Types and Documentation: The type of payments and the level of documentation provided by the borrower (e.g., verified income and assets) are key to assessing risk.

Topic 2. Cutoff Scores

• Concept: Lenders set threshold scores, known as cutoff scores, that dictate whether a loan will be extended.

• Application:

  • Applicants with scores above the cutoff are approved.

  • Applicants with scores below the cutoff are typically denied.

• Dynamic Nature: Cutoff scores are not static. Lenders may adjust them based on their risk tolerance, economic conditions, and the specific loan product. A higher cutoff score indicates a more conservative lending policy.

Practice Questions: Q1

Q1. In assessing the key variables associated with a potential mortgage loan, a bank will charge a higher interest rate if the borrower has a relavely:

A. high FICO score.

B. high loan-to-value ratio.

C. low debt-to-assets ratio.

D. low debt-to-income ratio.

Practice Questions: Q1 Answer

Explanation: B is correct.

The loan-to-value ratio represents the amount of the mortgage versus the appraised value of the property. The higher this ratio is for a property and an associated borrower, the more risk there is to the lender. In order to protect their position, a lender will charge a higher interest rate. Each of the other scenarios will result in a lower interest rate.

Topic 3. Scorecard Perfomance

• Evaluation: The performance of a credit scorecard is assessed using specific metrics.

• Key Metrics:

  • Cumulative Accuracy Profile (CAP): A visual representation of how well the model separates good and bad borrowers.

  • Accuracy Ratio (AR): A numerical measure derived from the CAP. It quantifies the model's predictive power.

  • Interpretation: An AR closer to 1 signifies a highly accurate model that is effective at predicting the distribution of defaults relative to the risk levels of the population.

Topic 4. Tradeoff Between Creditworthiness and Profitability

• The Balancing Act: Lenders must balance the risk of default (creditworthiness) with the potential for profit.

• Profit Drivers: A lender's profit comes not only from interest income but also from fees and cross-selling other financial products to the customer.

• Strategic Approach: Lenders may choose to accept a slightly higher credit risk in a particular segment if the potential for long-term profitability from that customer relationship (e.g., through other banking services) is high.

• Concept: A modern lending approach where the interest rate and loan terms are tailored to the individual borrower's credit risk.

• How it Works: Borrowers with higher credit scores (lower risk) are offered lower interest rates and more favorable terms, while those with lower scores (higher risk) are charged higher interest rates to compensate the lender for the increased risk of default.

• Benefits:

  • Allows lenders to extend credit to a wider range of customers.

  • Helps to avoid adverse selection, where only high-risk borrowers seek a loan.

  • Rewards customers with low-risk behaviors.

Topic 5. Risk-Based Pricing

Practice Questions: Q2

Q2. By implementing risk-based pricing on its mortgage products, a bank will likely charge a:

A. higher interest rate to a customer with a higher FICO score.

B. lower interest rate to a customer with a lower credit bureau score.

C. higher interest rate to a customer with a higher probability of default.

D. lower interest rate to a customer posioned on a lower relative score band.

Practice Questions: Q2 Answer

Explanation: C is correct.

The more likely it is that a customer will default, the higher the interest rate the bank will charge. A customer with a higher (lower) FICO/credit bureau score will be offered a lower (higher) interest rate. A customer positioned on a lower relative score band will be offered a higher interest rate.