Credit Risk Management in Commercia
Credit Risk Management in Commercia
Credit Risk Management in Commercia
Introduction
The problem of credit risk management, as well as carrying out a quantitative
assessment and analysis of the credit risk and rating of borrowers, is relevant to all
banks involved in lending to individuals and legal entities. In general, when
commercial banks grant loans to individuals and legal entities, the credit risk
involved is characterized by the following quantitative parameters: risk as the
probability of the borrower’s failure to repay the loan; acceptable risk; average
risk; possible losses given loan default; the average value of losses; the maximum
allowable losses; the number of loans given by the bank; the possible number of
different loans the bank can give; the number of problem loans.
*
Natalia Konovalova Asoc. Prof., RISEBA University; Ineta Kristovska Dr. oec.,
RISEBA University; Marina Kudinska Asoc. Prof., University of Latvia
Corresponding author: [email protected]
[email protected]; [email protected]
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each individual credit service that one can begin to manage the loan portfolio as
a whole. The credit risk assessment of the borrower consists in the study and
evaluation of the qualitative and quantitative indicators of the economic situation
of the borrower (Korobova, 2010). The assessment of the risk factors attending the
granting of a particular loan and their comprehensive and systematic analysis
enable the bank to take these factors into account in credit risk management and to
prevent their recurrent and adverse impact on the results of the bank’s future
activities (Rodina et al., 2013). The methods used to quantify credit risk are
accompanied by a special transparency requirement, including a quantitative
assessment of the methods’ accuracy and a statistical method property known as
robustness. The transparency of the credit risk methodology presents an
opportunity to view a given phenomenon not only as a whole but also in detail
(Dmitriadi, 2010). Transparency has become the most important characteristic of
credit risk assessment methods thanks to the need for the most thorough
identification of both credit risk and the credit risk model itself. Methodological
transparency refers to the precision of the employed mathematical methods,
the reduction of the element of subjectivity in expert assessments, the clarity of the
results of risk assessment and analysis, the bank employees’ thorough
understanding of these results, and the accessibility of the given methods to
regulatory authorities and borrowers. In order to analyze, forecast, and manage
credit risk, each bank must be able to quantify relevant credit risk factors, to
analyze the risk involved, and to permanently monitor credit risk factors
(Andrianova and Barannikov, 2013). The bank’s decisions about granting, or
refusing to grant, a loan, about the interest rate, and about the level of loan default
provisioning will depend on the accuracy of risk recognition and assessment.
The accuracy of risk factor assessments is evaluated relative to the number of
errors in the recognition of "bad" and "good" loans (i.e. borrowers) and their
average number. The accuracy of risk factor assessments is determined in a similar
manner when loans are classified into more than two classes. Furthermore, the
stability of risk assessment methodologies is characterized by the property of
statistical methods known as robustness. Different methodologies of risk
assessment, or one and the same methodology used with different algorithms, yield
dissimilar classifications of loans into "good" and "bad". The application of
different methodologies may result in the categorization of one and the same loan
as either “good” or “bad”. Such instability in loan classification may affect the
assessment of 20% of total number of loans (Solojentsev, 2004). Banks need to
adapt their crediting-related activities to the changing conditions of the nation's
developing economy and to the changes in the standard of living. The methods
used to quantify and analyze credit risk are of great importance for the smooth
functioning of a bank (Seitz and Stickel, 2002). Each bank develops its own risk
probability assessment model in order to quantify and analyze credit risk, taking
into account the general recommendations of the Basel Committee on Banking
Supervision. The high accuracy of credit risk assessment helps to minimize the
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bank’s losses, to reduce the interest rate, and to enhance the competitiveness of the
bank (BCBS, 2004). Creating an effective risk assessment model and managing
credit risk successfully is possible only thanks to continuous quantitative analysis
of statistical information on credit success. There are such different approaches to
the determination of the credit risk posed by a particular borrower as the bank
experts’ subjective evaluation and automated risk assessment systems
(Konovalova, 2009). Global experience shows, however, that credit risk
assessment systems based on mathematical models are more efficient and reliable
than any others. In order to build a credit risk assessment model, first those clients
of the credit institution are selected who have already proved themselves to be
either good or bad borrowers (Ralf, 2009).
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We will use a factor analysis module comprising the principal components of the
dispersion and correlation analysis. This procedure should be carried out in stages.
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Stage One: setting initial parameters of the problem. We will determine the number
of factors equal to the number of input variables that is six, as the risk and
problems variables are not taken into consideration when performing factor
analysis. In the course of the sequential factor selection, the factors comprise less
and less variability. Therefore, the next stage is limited to three factors.
Stage Two: calculating the eigenvalues of the factors involved. The eigenvalues
reflect the dispersion of the newly selected factor. Table 2 shows that the first
factor explains 34% of the total dispersion, the second factor explains 21.5 % of the
total dispersion, and the third, 17%. On the basis of the information received about
the dispersion explained by each factor, we can proceed to the question about the
number of factors that should be kept. For this purpose, we will use factor loadings,
which can be interpreted as the correlations between the selected factors and the
baseline variables.
Stage Three: a study of factor loadings. First, we estimate the factor loadings
without rotation for all six original variables (Table 3).
Table 3. The values of the factor loadings for the operation "without rotation"
Variable Factor 1 Factor 2 Factor 3
month 0.525012 0.127251 0.627152
value 0.831036 -0.357891 -0.167013
age -0.485724 -0.281432 0.680030
children -0.219991 -0.738915 -0.325576
sex 0.293715 0.716111 -0.381722
income 0.871327 -0.395768 0.122874
The selection of the relevant factors is done so that subsequent factors include less
and less dispersion. Factor 1, as can be seen from Table 2, has the highest loadings
values for the variables pertaining to the clients’ economic characteristics. Factor 2
reflects the maximum loadings for the variables related to the social status of the
client.
Stage Four: specification of the number of relevant factors. We will use the method
Varimax row, which is the most common rotation method. The use of this method
allows factors to remain independent of each other, so that the values of the
variables of one factor are not correlated with the values of other factors (Table 4).
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Table 4. The values of the factor loadings for the operation Varimax row
Variable Factor 1 Factor 2 Factor 3
month 0.405878 0.602158 0.277682
value 0.891231 -0.123397 -0.169583
age -0.235723 0.171479 0.750813
children 0.177915 -0.812786 0.221899
sex -0.020836 0.317501 -0.771215
income 0.921728 0.197343 0.027119
Stage Five: assessing the adequacy of the achieved solutions. In order to verify the
validity of the selection of the relevant factors, it is necessary to build a correlation
matrix. If the coefficients of this reproduced correlation matrix turn out to be close
to those of the original matrix, then this will validate the selection of the relevant
factors. In order to determine the extent of the possible deviations of the elements
of this matrix from those of the original one, we need to build a matrix of residual
correlations, the elements of which are equal to the differences between the
elements of the original and reproduced matrices. The initial and residual
correlation matrices are shown in Tables 5 and 6.
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The members of the most numerous class, the fourth (43 borrowers), have taken
the lowest loan amounts (from 800 EUR to 5,000 EUR). The level of credit risk in
this class of borrowers is the highest: 38%. However, the share of loans in this
class is insignificant: 9.5%. The third cluster is quite stable: the coefficient of
variation is 23%; the loan amounts are small: from 6 to 10 thousand EUR and they
constitute 8.4% of the total loan amount. However, the loan terms of the customers
in this class are the longest: an average of 49.5 months. The second class is not
numerous (only 13 customers); its members have taken a relatively large average
loan amount; and it can be characterized by the average level of stability.
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The highest income class is the first (almost ¼ of all clients), and its members have
taken large loans for the average term of 3 years. In general, this class is stable.
This analysis would further facilitate credit risk management. We have established
the regression dependence of the level of risk on the following factors: the loan
amount (value), the average earnings (income), and the loan term (month) for the
fourth class of customers:
Risk = – 3112 + 37.96 x month – 0.12 x value + 0.29 x income, = 0.98; dw = 2.9
Statistical error 653 41 0.01 0.02
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Summary
When lending to individuals (retail clients) the most significant factors affecting
the value of the credit risk of a bank are the average income of the borrower, the
loan amount, and the loan term.
In determining the values of factor loadings, it has been revealed that the primary
factor that has the highest values of loadings for the variables is related to the
customers’ economic characteristics, such as the loan amount (value) and earnings.
The main source of information in determining the level of credit risk for the
creditor banks is the credit history of the client.
Based on these findings, we have developed the following suggestions for the
improvement of credit risk management in commercial banks, lending to retail
customers.
To form a predictive assessment of credit risk in commercial banks, it is necessary
to use the methodology of factor analysis utilized in the current article. This
methodology is based on the study of borrowers’ credit histories and it takes into
account the amounts and terms of loans.
The proposed methodology should be based on the use of clustering methods,
the method of dispersion analysis and the analysis of principal factors.
Credit risk management on the basis of the proposed methodology should aim at
achieving the following objectives:
to identify common patterns of bank customers’ economic behavior,
to formulate a set of differentiated requirements for borrowers in particular
groups in accordance with their specificity,
to determine the risk appetite of the person making decisions about the amount
and the term of a loan to be granted and about the interest on this particular
loan.
The differentiation of the methods used in credit risk management in different
groups of borrowers is due to the international standards and requirements of the
Basel Committee and it will contribute to banks’ transition to the use of an internal
ratings approach in assessing and managing credit risk.
It should be noted that the current study is limited in its scope as it has researched
only those loans that are given to retail clients. This limitation determines the
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future direction of the research, which will involve the study of credit risk
management in those cases when loans are given to other categories of borrowers,
such as small and medium enterprises (SME) and large industrial businesses.
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