March 23

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March 23

• Current events
• Early semester feedback
• Risks of intermediation
• Credit risk
• Chapters 9-10
• Where from here?
• Measurement of individual risks
• Management of individual risks

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Credit Scoring and Credit Evaluation
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Numerical Credit Scoring

• Mathematical rules/formulas/model that can be
  used to assess default risk on loans
• Typically based on historical ratios
• Credit bureau ratings

4
Motivations

• improve operating efficiency
• improve credit risk management
• price loans
• used by lenders unfamiliar w/industry

5
Uses

• make loan acceptance decisions
• more equitable loan pricing
• monitoring of existing loans
• quality appraisals of loan portfolios

6
History

• 1950s, Bill Fair and Earl Isaac
• Housing last 10 years
• MBS analysts
• Small business and agricultural lenders

7
OCC Statement

• Shorten processing time
• Help lenders control risk
• Manage credit losses
• Evaluate new programs
• Improve lender profitability
• Cautions
• consistent implementation
• use on appropriate products

8
Basic framework

• Identify key variables that represent a
  borrowers credit risk
• Select the appropriate measures for each variable
• Weigh the measurements according to relative
  importance
• Assign the credit score to the appropriate credit
  class for loan acceptance, pricing, monitoring
  and so on.

9
Use of credit repositories

• Equifax Beacon Score
• Experian (TRW) FICO
• Trans Union Emperica Score

10

• range 365 to 850
• typically need score gt 660
• assured if greater gt 700
• number of credit lines
• level of credit line usage
• length of history
• derogatory items
• past bankruptcy
• number of credit inquiries

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Limitations

• Implementation of model
• Quality of information
• Accounting issues
• Variation of businesss types/characteristics
• Standardization issues
• Collateral??

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Sample Models
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Sample Small Business Credit Scoring Model
Characteristic Value and Weights
Variable
Measure
Profitability
Return on equity
lt 0
0-4
5-9
10-14
15-19
gt20
score
0
1
2
3
4
5
Liquidity
Current ratio
lt 0.50
0.50-0.99
1.00-1.49
1.50-1.99
2.00-2.49
gt 2.50
score
0
2
4
6
8
10
Solvency
Debt-to-equity ratio
gt 2.50
2.00-2.49
1.50-1.99
1.00-1.49
0.50-0.99
lt 0.50
score
0
2.5
5
7.5
10
12.5
Repayment capacity
Term debt coverage ratio
lt 0.50
0.50-0.99
1.00-1.49
1.50-1.99
2.00-2.49
gt 2.50
score
0
2.5
5
7.5
10
12.5
Collateral
Secured assets/max loan
lt 1.00
1.00 -1.19
1.20-1.39
1.40-1.59
1.60-1.79
gt 1.80
score
0
2
4
6
8
10
Score
Credit Class
0 - 9.99
Non-acceptable loan
10-19.99
Very High Risk Loan
20-29.99
High-Risk Loan
30-39.99
Intermediate-Risk Loan
40-50
Low-Risk Loan
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Suppose a small business has the following data
Measure
Value
Score
Return on equity
6
2
Current ratio
1.50
6
Debt to equity ratio
0.75
10
Term debt coverage ratio
1.75
7.5
Secured asset to max loan
1.50
6
Total score
31.5
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Example Credit Classification Model for an Small
Business Revolving Operating Loan.
Class 1 Criteria, Very Low Risk
Debt to equity must not be greater than 0.33
Current ratio must be 2.0 or greater
Operating funds to borrow must be less than 40
of projected gross revenue
Term debt repayment margin must be 1.5 or greater
Three year average equity change must be greater
than 15
Class 2 Criteria, Low Risk
Debt to equity must not be greater than 0.66
Current ratio must be 1.5 or greater
Operating funds to borrow must be less than 50
of projected gross revenue
Term debt repayment margin must be 1.25 or greater
Three year average equity change must be greater
than 9
Class 3 Criteria, Moderate Risk
Debt to equity must not be greater than 1.00
Current ratio must be 1.25 or greater
Operating funds to borrow must be less than 60
of projected gross revenue
Term debt repayment margin must be 1.1 or greater
Three year average equity change must be greater
than 6
Class 4 Criteria, High Risk
Debt to equity must not be greater than 1.50
Current ratio must be 1.1 or greater
Operating funds to borrow must be less than 70
of projected gross revenue
Term debt repayment margin must be 0.9 or greater
Three year average equity change must be greater
than 0
Class 5 Criteria, Very High Risk
Debt to equity must not be greater than 2.33
Current ratio must be 0.85 or greater
Operating funds to borrow must be less than 75
of projected gross revenue
Term debt repayment margin must be 0.8 or greater
Three year average equity change must be greater
than -6
Evaluation
All Class 1 borrowers receive base interest rate
All Class 2 borrowers receive base interest rate
0.50
All Class 3 borrowers receive base interest rate
1.00
All Class 4 borrowers receive base interest rate
1.50
All Class 5 borrowers or below are not normally
considered a new credit.