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How Machine Learning Technology is Enhancing Credit Risk Modeling

How Machine Learning Technology is Enhancing Credit Risk Modeling

Risk is an intrinsic part of the money lending system. There’s always the chance that customers borrowing money from financial institutions fail to repay their loans. And to determine the exact probability of a customer paying off a loan or defaulting on it, banks and other lenders rely on credit risk modeling.

Next-Gen Credit Assessment Techniques

The credit situation has changed a lot from how it used to be ten years ago. And to keep up, lenders must also evolve by identifying and responding to issues in real-time.  Credit risk strategy has become more complex and multiple factors need to be weighed to arrive at the correct decision that’s both profitable for the enterprise and customer. Sophisticated models that contain more than one dimension, such as additional information about a customer’s finance and behavior patterns, are in demand. These models help get a 360 degree view of the customer’s financial condition.

Moreover, banks want to provide broader financial inclusion with the intention that more customers get credit scores and avail their financial services. But they need to keep a check on their risk levels too. Traditional credit assessment techniques having linear nature, for example logistic regression, are useful, but only till a point.

Neural Networks

Recent developments in neural networks have greatly improved credit risk modeling and seem to provide a solution to the above mentioned problem. One such breakthrough is the NeuroDecision Technology from Equifax that facilitates more inclusive models, so scores and consent can be given to a bigger and varied group of customers.

Machine Learning (ML) is a fast-moving field and neural networks are used within deep learning, which is an advanced form of ML. It has the potential to make more accurate predictions and go beyond the linear analysis methods of logistic regression.  This is a positive development for both the business and its customers.

Linear Vs. Inclusive

What happens in a logistic regression model is that all customers above a straight line (prime) get approved, whereas everyone falling below that line (subprime) gets rejected. Hence, customers who are working hard towards creating a good credit profile but fall just below prime get declined repeatedly. Despite this problem, traditional linear models are widely used because outcomes can be easily conveyed to customers, which helps to be in sync with consumer credit regulations that demand higher transparency.

On the other hand, neural networks lead to non-linear or curved arcs that include those customers who aren’t yet prime, but are evidently moving in the right direction. This increases the ‘approved customer’ base, which is beneficial for the business because customers are being served better and the enterprise is growing. This model is advantageous from the perspective of customers also as it allows more people to access mainstream financial services.  The only problem is explaining the outcome to customers as neural networks tend to be rather complex.

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Concluding Note

Many companies are producing robust credit modeling tools employing deep learning techniques. And these game-changing developments highlight the fact that they are just the starting point of a series of interesting developments ahead.

You can be a part of this exciting and booming field too! Just enroll for credit risk modeling certification at DexLab Analytics. Detailed courses chalked out and taught by industry professionals ensure that you get the best credit risk training in Delhi.


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Role of Chief Risk Officers: From Managing Only Credit Risks to Playing Key Roles in Big Banks

Role of Chief Risk Officers: From Managing Only Credit Risks to Playing Key Roles in Big Banks

The job responsibilities of chief risk officers (CROs) have evolved drastically over the last two decades. CROs are playing key profitable roles is some of the world’s biggest banks. In the face of the global financial crisis, risk departments, particularly CROs, are handling many more tasks apart from what they were managing twenty years back, like modeling credit and market risks and avoiding fines and criminal investigations. The list of responsibilities entrusted to the CROs has grown exponentially since the last two decades. Operational risk that are quantifiable through capital necessities and penalties for nonconformity was actually developed from a set of unquantifiable ‘’other’’ risks.

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Cyber risk:

In the present times, cyber risk has become one of the most pressing global problems that the risk departments need to cope with. The number of cyber hacks is on the rise, wreaking havoc on daily lives as well as social settings. For example, Bank of America and Wells Fargo were among the major institutes hit by the DDoS attack of 2012. It is one of the biggest cyber attacks till date, which affected nearly 80 million customers. In 2016, Swift hack was only a typo away from disrupting the global banking network.

‘’What is called ‘operational resilience’ has spun out of business continuity and operational risk, financial crime, technology and outsourcing risk- anything with risk in the title, somehow there is an expectation that it will gravitate to risk management as their responsibility,’’ says Paul Ingram, CRO of Credit Suisse International. The array of responsibilities for a CRO is so immense, including regulatory compliance, liquidity risk, counterparty risk, stress-test strategy, etc, that it is imperative for the CRO to be a part of the board of directors.

Previously, CROs reported to finance director; now they are present on the board itself. They are playing crucial roles in forming strategies and executing them, whereas around two decades ago they were only involved in risk control. The strategies should be such that the capital allocated by the board is utilized optimally, neither should the limits be exceeded nor should it be under-utilized. CROs add value to the business and are responsible for 360 degree risk assessment across the entire bank.

Banks are tackling problems like digital disruption, rising operational costs and increased competition from the non-banking sector. CROs play a crucial role in helping banks deal with these issues by making the best use of scarce resources and optimizing risk-return profiles.

Regulatory attack:

‘’Since the crisis, CROs have had their hands full implementing a vast amount of regulation,’’ says BCG’s Gerold Grasshoff. However, regulation has almost reached its apex, so CROs must now use their expertise to bring in more business for their institutions and help them gain a competitive advantage. CROs need to play active roles in finding links between the profits and losses of their businesses and balance sheets and regulatory ratios.

Risk departments were once the leaders in innovations pertaining to credit and market risk modeling. They must utilize the tactics that kept them at the forefront of innovation to help their institutions generate improved liquidity, asset and fund expenditure metrics. Their skill in spotting, checking and gauging risk is essential to provide risk-related counsel to clients. Risk departments can team up with Fintechs and regtechs to improve efficiencies in compliance and reporting sections and also enable digitizing specific risk operations.

Thus risk departments, especially CROs can add a lot of value to the banking infrastructure and help steer the institutes forward.

Credit risk modeling is an essential part of financial risk management. To develop the necessary knowledge required to model risks, enroll for credit risk analytics training at DexLab Analytics. We are the best credit risk modeling training institute in Delhi.

 

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To Be Ahead of the Curve: Banks Must Beef Up Technology

To Be Ahead of the Curve: Banks Must Beef Up Technology

Technology is critical. To improve efficiency, reduce costs, stay on the cutting edge over tailing rivals, fulfill customer requirements and initiate a proper risk management process, technology is an incredible tool to possess.

The abovementioned facts received momentum at the SAS Risk & Finance Analytics Roadshow in Lagos, during which it was inferred that the banks nowadays are adapting themselves to regulatory changes, thus reducing costs in no time.

In this context, Charles Nyamuzinga, Senior Business Solutions Manager, Pre-Sales Risk Practice, stated that banks in Africa need to confront with additional challenges, including risk analytics skills gaps, challenges associated with data management and integrating finance and risk management nuances across an organization.

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“But, on the positive side, they have started considering technology as a way of eliminating these challenges, and have access to new streams of data that are also helping to advance the financial inclusion mandate,” he noted.

In compliance with global financial norms, African banks should by now be compliant with the new IFRS9 Accounting Standard, which comes with some changes in the way expected credit losses used to be calculated.

“There is also need to start thinking about the new ‘Basel IV’ framework, which impacts on how banks calculate their risk weighted assets, and the amount of capital they need to offset those risks,” he added.

According to Charles, banks are feeling intense regulatory pressure nowadays, while tussling with daily requirements, challenges and questions associated with taking stress tests. The regulators have become severe on stress testing processes, and that may be for good! Besides, banks need to worry about the effect on reputation, capital shortfalls and negative influence on earnings, along with non-compliance penalties.

His concern was thoroughly evident in these statements, “There’s a good chance that banks in Africa could get this wrong if they use disparate and fragmented systems for data management, model building and implementation and reporting – which is often the case – or if they try to do the computations manually.

 

“The biggest causes of incorrect modeling are data management and quality issues and skills shortages. Banks have to obtain and analyze enormous amounts of detailed data, for example. And, to comply with IFRS 9, banks must look at millions of customers with hundreds of data points.”

In support of the above observations, SAS Sales Manager, West Africa, Babalola Oladokun raised concerns if a bank ends up miscalculating a customer’s credit score, it would result in giving a loan to someone, who for sure won’t be able to repay it. This can have serious implications for IFRS 9expected credit loss calculations. Furthermore, if a bank lacks in capital on hand to offset the loan deficiency, the case will go straightaway to Basel Capital requirements compliance issues.

“Data gathering and manipulation from disparate data sources wastes time and resources that banks could have used to develop new products and find more convenient ways to serve their customers – something their competitors in the FinTech space are very good at,” he noted.

As last thoughts, FinTechs use virgin data streams to draw instant conclusions and fuel decision-making processes for customers. For an example, they base their inferences about granting a loan to someone who doesn’t even have a bank account – surely, this is an innovative way to give non-banking population access into the world of finance.

If finance and big data interests you, we suggest you go through our credit risk management courses in Delhi. DexLab Analytics is not only a trailblazer in credit risk modelling courses, but also a robust platform for training young minds.

 

This article first appeared in – https://guardian.ng/business-services/technology-crucial-to-tackling-risks-skill-gaps-in-banks

 

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Developing a Big Data Culture is Crucial for Banks to be Customer Centric

Developing a Big Data Culture is Crucial for Banks to be Customer Centric

It is important for banks to be customer centric because a customer who is better engaged is easier to retain and do business with. In order to provide services that are valued by customers, banks need to exploit big data. When big data is combined with analytics it can result in big opportunities for banks. The volume of banking customers is on the rise, and so is their data. It is time for the banking sector to look beyond traditional approaches and adopt new technologies powered by big data, like natural language processing and text mining, which help convert large amount of unstructured information into meaningful data that can lead to valuable insights.

Switching to big data enable banks to get a 360-degree view of their customers and keep providing excellent services. Many banks, like the Bank of America and U.S. Bank, have implemented big data analytics and are reaping its benefits. Rabobank, which has adopted big data analytics to detect criminal activity in ATMs, is ranked among the top 10 safest banks in the world.

Big Data’s Advantages for the Banking Industry:

  • Streamline Work Process and Service Delivery:

Banks need to filter through gazillions of data sets in order to provide relevant information to a customer, when he/she enters account details into the system. Big data can speed up this process. It enables financial institutes of spot and correct problems, before they affect clients. Big data also helps in cost-cuttings, which in turn lead to higher revenues for banks.

In case of erroneous clients, who tend to go back on their decisions, big data can help alter the process of  service delivery in such a manner that these clients are bound to stick to their commitments. It allows banks to track credit and loan limits, so that customers don’t exceed them.

Cloud based analytics packages sync in with big data systems to provide real-time evaluation. Banks can sift through tons of client information to track transactional behaviors in real time and provide relevant resources to clients. Real-time client contact is very useful in verifying suspicious transactions.

  • Customer Segmentation:

Big data help banks understand customer spending habits and determine their needs. For example, when we use our credit cards to purchase something, banks acquire information about what we purchase, how much we spend and use these information to provide relevant offers to us. Through big data, banks are able to trace all customer transactions and answer questions about a customer, like which services are commonly accessed, what are the preferred credit card expenditures and what his/her net worth is. The advantage of customer segmentation is that it enables banks to design marketing campaigns that cater to specific needs of a customer.  It can be used to deliver personalized schemes and plans. Analyzing the past and present expenses of a client helps bank create meaningful client relationships and improve response rates.

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  • Fraud detection:

According to Avivah Litan, a financial fraud expert at Gartner, big data supports behavioral authentication, which can help prevent fraud. Litan says, ‘’using big data to track such factors as how often a user typically accesses an account from a mobile device or PC, how quickly the user types in a username and password, and the geographic location from which the user most often accesses an account can substantially improve fraud detection.’’

Utah-based Zions Bank is largely dependent on big data to detect fraud. Big data can detect a complex problem like cross-channel fraud by aggregating fraud alerts from multiple disparate data sources and deriving meaningful insights from them. 

  • Risk Management:

Financial markets are becoming more and more interconnected, which increases their risk. Big data plays a pivotal role in risk management of financial sector as it provides more extensive risk coverage and faster responses. It helps create robust risk prediction models that evaluate credit repayment risks or determine the probability of default on loans for customers. It also aids in identifying risk associated with emergent financial technologies.

Hence, banks need to adopt a big data culture to improve customer satisfaction, keep up with global trends and generate higher revenues.

For credit risk management courses online, visit DexLab Analytics. It is a leading institute offering credit risk analytics training in Delhi.

 

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Predictive Analytics: What It is and Why It’s Important for Businesses

Predictive Analytics: What It is and Why It’s Important for Businesses

Did you know that 2.5 quintillion bytes of data are generated on a daily basis? Big data is a valuable asset for companies provided that this data can be utilized to improve their performance. Companies employ predictive analytics to uncover hidden patterns in data and develop quick and efficient strategies that will steer their businesses forward.

IMB Watson is a popular predictive analytics processor that employs natural language processing technology to analyze human speech. IBM Watson can analyze a vast amount of data, often in a fraction of a second, to answer human-framed questions.

What is predictive analytics?

Predictive analytics use a combination of statistical modeling and machine learning techniques to determine the likelihood of future events based on historical data, which can come from structured, unstructured and semi-structured sources. A good example of the use of predictive analytics is the preparation of a credit report of a customer by a financial institution.

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Credit Score:

Financial lenders use predictive analytics to scrutinize relevant data of an individual who has applied for a loan, including data pertaining to the individual’s current assets and debts, his/her employment and history of paying off loans. All this data is analyzed and boiled down to a single value known as credit score. This value represents the lending risk and helps the lender determine a customer’s creditworthiness. The higher the credit score, the more confident is the lender that the customer will fulfill his/her credit obligation.

predictive_analytics_and_cross-selling-01_1

Predictive analytics help lenders make quick and efficient decisions, such as accepting or rejecting a customer and increasing or decreasing their loan value. Credit risk modeling training has become extremely important across many sectors, including banking, insurance and retail.

Importance of predictive analytics:

Thanks to the plethora or new age analytics tools and software, predictive analytics make it easier for organizations to plan the future and gain competitive advantage.

Below are some ways in which predictive analytics are used:

  • To predict the probability of certain diseases affecting a specific group of people so that the necessary preventive healthcare measures can be taken.
  • To predict the probability of certain machine parts failing so that preventive maintenance can be administered.
  • To predict the probability of an interruption in a business’s supply chain.
  • To predict customer behavior.
  • To predict safety risks on railroads.
  • To predict traffic flows and the infrastructure requirements of a city.

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How businesses use predictive analytics:

It is imperative for every company to include predictive analytics in their technology portfolio. The major vendors of predictive analytics include SAP, IBM, Oracle, SAS, Information Builders, etc. Their on-premise and cloud-based versions give companies a lot of options to choose their predictive analytics tools from.

On-premise predictive analytics systems are used by companies requiring high level of analytical power and predictive intelligence. These include companies in the drug and pharmaceutical sector; companies working on life science fields like genomics; and research institutes and universities.

Cloud-based versions provide predictive analytics solutions to companies on a per usage or subscription basis. These are highly beneficial for small and medium sized companies where predictive analytics aren’t the core component, but they are still critical for their success and need to be fitted in a stipulated IT budget. Companies can use the ‘’try and buy’’ facility provided by cloud-vendors to test if a particular software is working for them before finalizing a contract.

Companies that lack prior experience in predictive analytics can opt for SaaS (Software as a Service), which are cloud-based solutions with expertise in a specific sector, for example healthcare.

Role of Business Leaders:

Business leaders must be skilled in using the insights provided by predictive analytics to develop strategies that drive their businesses forward. This includes two things; firstly coming up with well-construed questions and secondly identifying the right kind of data to analyze. These will determine whether predictive analytics is working for a company or not.

Companies in all industry verticals are employing predictive analytics to formulate future strategies. As mentioned in a report- ‘’the global market for predictive analytics is projected to grow to $3.6 billion USD by 2020.”

To more about predictive analytics follow Dexlab Analytics– a premier analytics training institute in Gurgaon. Do take a look at their credit risk modeling courses.

 

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How Fintechs Help Optimize the Operation of Banking Sector

How Fintechs Help Optimize the Operation of the Banking Sector

Financial technology- Fintech plays a key role in the rapidly evolving payment scenario. Fintech companies provide improved solutions that affect consumer behavior and facilitate widespread change in the banking sector. Changes in data management pertaining to the payment industry is occurring at a fast pace. Cloud-based solution and API technology (Application Programming Interfaces) has played a major role in boosting the start-up sector of online payment providers like PayPal and Stripe. As cited in a recent PwC report over 95% of traditional bankers are exploring different kinds of partnerships with Fintechs.

 Interpreting consumers’ spending behavior has enhanced payment and data security. Credit risk modeling help card providers identify fraudulent activities. The validity of a transaction can be checked using the GPS system in mobile phones. McKinsey, the consulting firm has identified that the banking sector can benefit the most from the better use of consumer and market data.  Technological advancements have led to the ease of analyzing vast data sets to uncover hidden patterns and trends. This smart data management system helps banks create more efficient and client-centric solutions. This will help banks to optimize their internal system and add value to their business relationship with customers.

Role of Big Data

 Over the past two years, the digital revolution has created more data than in the previous history of humankind. This data has wide-ranging applications such as the banks opening their credit lines to individuals and institutions with lesser-known credit-score and financial history. It provides insurance and healthcare services to the poor. It also forms the backbone of the budding P2P lending industry which is expected to grow at a compound annual growth rate (CAGR) of 48% year-on-year between 2016 and 2024.

The government has channelized the power of digital technologies like big data, cloud computing and advanced analytics to counter frauds and the nuisance of black money. Digital technologies also improve tax administration. Government’s analysis of GST data states that as on December 2017, there were 9.8 million unique GST registrations which are more than the total Indirect Tax registrations under the old system. In future big data will help in promoting financial inclusion which forms the rationale of the digital-first economy drive.

Small is becoming Conventional

Fintechs apart from simplifying daily banking also aids in the financial empowerment of new strata and players. Domains like cyber security, work flow management and smart contracts are gaining momentum across multiple sectors owing to the Fintech revolution. For example workflow management solution for MSMEs (small and medium enterprises) is empowering the industry which contributes to 30% of the country’s GDP. It also helps in the management of business-critical variables such as working capital, payrolls and vendor payments. Fintechs through their foreign exchange and trade solutions minimizes the time taken for banks to processing letter of credit (LC) for exporters. Similarly digitizing trade documents and regulatory agreements is crucial to find a permanent solution for the straggling export sector.

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Regulators become Innovators

According to the ‘laissez-faire’ theory in economics, the markets which are the least regulated are in fact the best-regulated. This is owing to the fact that regulations are considered as factors hindering innovations. This in turn leads to inefficient allocation of resources and chokes market-driven growth. But considering India’s evolving financial landscape this adage is fast losing its relevance. This is because regulators are themselves becoming innovators.

The Government of India has taken multiple steps to keep up with the global trend of innovation-driven business ecosystem. Some state-sponsored initiatives to fuel the innovative mindset of today’s generation are Startup India with an initial corpus of Rs 10,000 crore, Smart India Hackathon for crowd-sourcing ideas of specific problem statements, DRDO Cyber Challenge and India Innovation growth Program. This is what enabled the Indian government to declare that ‘young Indians will not be job seekers but job creators’ at the prestigious World Economic Forum (WEF).

From monitoring policies and promoting the ease of business, the role of the government in disruptive innovations has undergone a sea change. The new ecosystem which is fostering innovations is bound to see a plethora of innovations seizing the marketplace in the future. Following are two such steps:

  • IndiaStack is a set of application programming interface (APIs) developed around India’s unique identity project, Aadhaar. It allows governments, businesses, start-ups and developers to utilize a unique digital infrastructure to solve the nation’s problems pertaining to services that are paperless, presence-less and cashless.
  • NITI Ayog, the government’s think tank is developing Indiachain, the country’s largest block chain. Its vision is to reduce frauds, speed up enforcement of contracts, increase transparency of transactions and boost the agricultural economy of the country. There are plans to link Indiachain to IndiaStack and other digital identification databases.

As these initiatives start to unfold, India’s digital-first economy dream will soon be realized.

Advances in technologies like Retail Analytics and Credit Risk Modeling will take the guesswork and habit out of financial decisions. ‘’Learning’’ apps will not only learn the habit of users but will also engage users to improve their spending and saving decisions.

To know more about risk modeling follow Dexlab Analytics and take a look at their credit risk analytics and modeling training course.

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Breaking the Misconceptions: 4 Myths Regarding Data-Driven Financial Marketing

A majority of low-mid financial services companies toil under the wrong notion that owing to their capacity, size and scope, the complex data-driven marketing tactics are simply out of their reach – this is not true and frankly speaking quite a shame to consider even.

BREAKING THE MISCONCEPTIONS: 4 MYTHS REGARDING DATA-DRIVEN FINANCIAL MARKETING

Over the past decade, the whole concept of data analytics has undergone a massive transformation – the reason being an extensive democratization of marketing tactics. Today’s mid-size financial service providers can easily implement marketing initiatives used by dominant players without any glitch.

Besides, there are several other misconceptions regarding data and its effect on financial marketing that we hear so often and few of them are as follows:

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Myth1 – Legally, banks are only allowed to run broad-based advertising

While it’s partially true that there are certain restrictions on banking institutions when it comes to target consumers, based on income, age, ethnicity and other factors, marketers can still practice an array of tactics, both online and offline.

Marketers can leverage a pool of data for online and offline marketing to formulate data models, keeping in mind the existing customers need and preferences. Once you have an understanding of their online behavior, how they use the data power to carry out transactions, these insights can be applied to attract new customers, who exhibit similar behaviors.

Myth 2 – Data-driven marketing doesn’t bolster customer relationship

It’s a fact, Millennials, especially wants to be aware about financial services and its associated products, and are keen to understand how can banks lend an additional support to their living and social life. Companies can start building relationship based out of it, while implementing data-driven marketing perspective into them.

Myth 3 – You need a huge budget and an encompassing database to drive marketing campaigns

Corporate honchos and digital natives certainly maintain sprawling in-house database to boost marketing activities, but don’t be under the impression that mid-size institutions cannot leverage much from virtual datamart. The impressive SaaS-based solutions houses first-party data, safely and securely and offer you mechanisms that let you integrate with other third-party data, both online and offline.

Datamarts let mid-size marketers achieve a lot of crucial task success. Firstly, you will be able to link online user IDs with offline data – this lets you derive insights about your current customers, including their intents, interests and other details. The most important thing is that it will usher you to build customer models that could target newer customers for your bank.

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Myth 4 – Data-driven marketing is too much time-consuming

A lot of conventional marketers are of the opinion data-driven marketing is a huge concept – time-consuming and labor-intensive. But, that’s nothing but a myth. Hundreds and thousands of mid-size companies develop models, formulate offers and execute campaigns within a 30-day window using a cool datamart.

However, the design and execution part of campaigns need no time, whereas the learning part needs some time. You need to learn how to develop such intricate models, and that’s where time is involved.

To ace on financial models, get hands-on training from credit risk analysis course onlineDexLab Analytics offers superior credit risk management courses, along with data analytics, data science, python and R-Programming courses.

In the end, all that matters is prudent marketing campaigns powered by data yields better results than holding onto these misconceptions. So, break the shackles and embrace the power of data analytics.

The article has been sourced from – http://dataconomy.com/2017/08/5-misconceptions-data-driven-marketing

 

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How Credit Risk Modeling Is Used to Assess Credit Quality

Given the uproar on cyber crimes today, the issue of credit risk modeling is inevitable. Over the last few years, a wide number of globally recognized banks have initiated sophisticated systems to fabricate credit risk arising out of significant corporate details and disclosures. These adroit models are created with a sole intention to aid banks in determining, gauging, amassing and managing risk across encompassing business and product lines.

 

How Credit Risk Modeling Is Used to Assess Credit Quality

 

The more an institute’s portfolio expands better evaluation of individual credits is to be expected. Effective risk identification becomes the key factor to determine company growth. As a result, credit risk modeling backed by statistically-driven models and databases to support large volumes of data needs tends to be the need of the hour. It is defined as the analytical prudence that banks exhibit in order to assess the risk aspect of borrowers. The risk in question is dynamic, due to which the models need to assess the ability of a potential borrower if he can repay the loan along with taking a look at non-financial considerations, like environmental conditions, personality traits, management capabilities and more.

Continue reading “How Credit Risk Modeling Is Used to Assess Credit Quality”

The Basics Of The Banking Business And Lending Risks:

The Basics Of The Banking Business And Lending Risks:

Banks, as financial institutions, play an important role in the economic development of a nation. The primary function of banks had been to channelize the funds appropriately and efficiently in the economy. Households deposit cash in the banks, which the latter lends out to those businesses and households who has a requirement for credit. The credit lent out to businesses is known as commercial credit(Asset Backed Loans, Cash flow Loans, Factoring Loans, Franchisee Finance, Equipment Finance) and those lent out to the households is known as retail credit(Credit Cards, Personal Loans, Vehicle Loans, Mortgages etc.). Figure1 below shows the important interlinkages between the banking sector and the different segments of the economy:

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Figure 1: Inter Linkages of the Banking Sector with other sectors of the economy

Banks borrow from the low-risk segment (Deposits from household sector) and lend to the high-risk segment (Commercial and retail credit) and the profit from lending is earned through the interest differential between the high risk and the low risk segment. For example: There are 200 customers on the books of Bank XYZ who deposit $1000 each on 1st January, 2016. These borrowers keep their deposits with the bank for 1 year and do not withdraw their money before that. The bank pays 5% interest on the deposits plus the principal to the depositors after 1 year. On the very same day, an entrepreneur comes asking for a loan of $ 200,000 for financing his business idea. The bank gives away the amount as loan to the entrepreneur at an interest rate of 15% per annum, under the agreement that he would pay back the principal plus the interest on 31st December, 2016. Therefore, as on 1st January, 2016 the balance sheet on Bank XYZ is:

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Consider two scenarios:

Scenario 1: The Entrepreneur pays off the Principal plus the interest to the bank on 31st December, 2016

This is a win – win situation for all. The pay-offs were as follows:

 

Entrepreneur: Met the capital requirements of his business through the funding he obtained from the bank.

Depositors: The depositors got back their principal, with the interest (Total amount = 1000 + 0.05 * 1000 = 1050).

Bank: The bank earned a net profit of 10%. The profit earned by the bank is the Net Interest Income = Interest received – Interest Paid (= $30,000 – $10000 = $20,000).

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Scenario2: The Entrepreneur defaults on the loan commitment on 31st December, 2016

This is a drastic situation for the bank!!!! The disaster would spread through the following channel:

 

Entrepreneur: Defaults on the whole amount lent.

Bank: Does not have funds to pay back to the depositors. Hence, the bank has run into liquidity crisis and hence on the way to collapse!!!!!!

Depositors: Does not get their money back. They lose confidence on the bank.

 

Only way to save the scene is BAILOUT!!!!!

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The Second Scenario highlighted some critical underlying assumptions in the lending process which resulted in the drastic outcomes:

Assumption1: The Entrepreneur (Obligor) was assumed to be a ‘Good’ borrower. No specific screening procedure was used to identify the affordability of the obligor for the loan.

Observation: The sources of borrower and transaction risks associated with an obligor must be duly assessed before lending out credit. A basic tenet of risk management is to ensure that appropriate controls are in place at the acquisition phase so that the affordability and the reliability of the borrower can be assessed appropriately. Accurate appraisal of the sources of an obligor’s origination risk helps in streamlining credit to the better class of applicants.

Assumption2: The entire amount of the deposit was lent out. The bank was over optimistic of the growth opportunities. Under estimation of the risk and over emphasis on growth objectives led to the liquidation of the bank.

Observation: The bank failed to keep back sufficient reserves to fall back up on, in case of defaults. Two extreme lending possibilities for a bank are: a. Bank keeps 100% reserves and lends out 0%, b. Bank keeps 0% and lends out 100%. Under the first extreme, the bank does not grow at all. Under the second extreme (which is the case here!!!) the bank runs a risk of running into liquidation in case of a default. Every bank must solve an optimisation problem between risk and growth opportunities.

The discussion above highlights some important questions on lending and its associated risks:

 

  1. What are the different types of risks associated with the lending process of a bank?
  2. How can the risk from lending to different types of customers be identified?
  3. How can the adequate amount of capital to be reserved by banks be identified?

 

The answers to these questions to be discussed in the subsequent blogs.

Stay glued to our site for further details about banking structure and risk modelling. DexLab Analytics offers a unique module on Credit Risk Modelling Using SAS. Contact us today for more details!

 

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