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Agenda for Day 3




                   Credit Rating Models



                   Lunch Break




                   Case Studies



                   Open Session/ Q&A




                                                               IM aCS 2010
                                                         Printed 11-M ay-11
                         For Classroom discussion only               Page 1
Introduction to credit risk modeling – What is a model




  Risk Score = Co-eff1*Leverage + Co-eff2 *Current Ratio +…….
        Co-eff6 *Integrity +….. Co-eff8 *Industry Phase….




                                                                      IM aCS 2010
                                                                Printed 11-M ay-11
                        For Classroom discussion only                       Page 2
Credit Risk Models - Some Examples

    Altman’s Z - score model (Multiple Discriminant)


    Merton model


    Judgmental

    Hybrid




                                                                 IM aCS 2010
                                                           Printed 11-M ay-11
                           For Classroom discussion only               Page 3
Altmans’s Z Score Model


           Z = 0.012 X 1 + 0.014 X 2 + 0.033 X 3 + 0.006 X 4 + 0.999 X 5




 Where,

 •   X 1 = Net Working Capital / Total Assets

 •X 2 =   Retained earnings / Total Assets

 •X 3 =   PBIT/ Total Assets

 •X 4 =   Market value of equity/ Book Value of Total Liabilities

 •X 5 =   Sales/ Total Assets




                                                                                 IM aCS 2010
                                                                           Printed 11-M ay-11
                                         For Classroom discussion only                 Page 4
Altmans’s Z Score Model


           Z = 0.012 X 1 + 0.014 X 2 + 0.033 X 3 + 0.006 X 4 + 0.999 X 5




                    < 1.81 - Failing Zone




   Z                                             1.81 to 2.99 - Ignorance Zone




                         > 2.99 - Non-failing Zone




                                                                                       IM aCS 2010
                                                                                 Printed 11-M ay-11
                             For Classroom discussion only                                   Page 5
Merton Model

       Expected Default Frequency - is calculated using 3 steps




Step 1: Estimate asset value and asset volatility from equity value and
volatility of equity return


Step 2: Calculate distance                     =Asset Value - Default point
        to default (DfD)                        Asset Value * Asset Volatility

Step 3: Calculate expected default frequency


                                                                                       IM aCS 2010
                                                                                 Printed 11-M ay-11
                                       For Classroom discussion only                         Page 6
Calculating distance to default: Merton
   The market value of a firm’s assets and its historical volatility imply a distribution of future firm value

   Given today’s obligations (debt), we can calculate the probability that the market value of assets will be
   lower than the firm’s obligations one year from now (i.e., default)

   Distance to default is mean value minus debt, normalized by S.D.
       in
       •Amount




                                                                                                                IM aCS 2010
                                                                                                          Printed 11-M ay-11
                                       For Classroom discussion only                                                  Page 7
The quantitative model would derive its strength from the
    Bank’s data and the human expertise and experience of CO

                          Industry Firm Standing Management….




                                 Convert into proxies
Professional Judgement                                                Check for
for weights                                                           consistency

                                 Construct indices




                         Statistically explanatory set of variables

                                                                                    IM aCS 2010
                                                                              Printed 11-M ay-11
                                 For Classroom discussion only                            Page 8
The benefit of the model




   Reduces the dimensionality of space of the credit officer




                                                                     IM aCS 2010
                                                               Printed 11-M ay-11
                          For Classroom discussion only                    Page 9
Banks need different risk scoring models for different
credit segments

               Corporate               Small                                 Bank
                                                              Retail Loan
               Credit                  Business                              Exposures


Quality of
financial       Reasonably                Less                Partial         More
statements      Reliable                  Reliable            Information     Reliable

                Global,                                                      Global,
Market                                    Regional               Local
                National or                                                  National or
Situation                                 or Local
                Regional                                                     regional



Type           High value &          Lower value &            Low value &    High Value &
               Low Numbers           Higher Numbers           High Numbers   Low numbers



                                                                                                 IM aCS 2010
                                                                                           Printed 11-M ay-11
                              For Classroom discussion only                                           Page 10
No. of rating models/ borrower categories in new systems

    The number of rating models should be determined:
        Based on the current portfolio of the bank
        Based on business strategy and focus areas of the bank


    A good thumb rule, is that 80-85% of the bank’s credit portfolio should be risk rated.
    For the remaining portfolio, the bank could use pool-based approach

    Banks use the following models:
        Corporate Segment: Large, SME and Small Business models;
        Retail Segments: Home Loan, Personal Loan & Credit Card models;
        Commercial Segment: Bank and NBFC models;
        Project Models: Infrastructure, Green-field and Brown-field models




                                                                                                   IM aCS 2010
                                                                                             Printed 11-M ay-11
                                  For Classroom discussion only                                         Page 11
Data Collection - What Type of Data is required to be collected



          Accounts (On which data is being collected)




    Performing Accounts                            Non - Performing Accounts




      This sample of accounts has to be representative of the Bank’s portfolio
                                                                                       IM aCS 2010
                                                                                 Printed 11-M ay-11
                                 For Classroom discussion only                              Page 12
Data Collection - What Type of Data is required to be collected

                 Financial Information – Balance Sheet, Profit and Loss, Cash Flow


Data
(Historical)                                       Management
                   Qualitative Data

                                                   Industry



                                                   Firm Standing




                                                   Conduct of Account



                                                                                           IM aCS 2010
                                                                                     Printed 11-M ay-11
                               For Classroom discussion only                                    Page 13
Why do we need to collect this data ?

• Historical Data is the basis of estimating the model equation (along with
  expert opinion)

• What is the model ?
  Risk Score = A*Leverage + B* Current Ratio +C*Sales/Total Assets……


• The Data would be the basis for both deducing the predictor variables and the
  coefficients of the model equation (along with expert opinion)

• In other words, the fact that Leverage is to be chosen in the model and the A
  (coefficient of Leverage) is both coming from the Bank’s historical data



                                                                                    IM aCS 2010
                                                                              Printed 11-M ay-11
                              For Classroom discussion only                              Page 14
Data Collection – The criticality of this exercise



 The model is only as good as the data used to construct it




• The Data sample used to estimate the model should be representative of the
  Bank’s portfolio
• The Data sample has to be accurate




                                                                                     IM aCS 2010
                                                                               Printed 11-M ay-11
                                 For Classroom discussion only                            Page 15
The Broad Model Construction Philosophy


Phase I                   Phase II                               Phase III
Parameter Selection       Modeling Technique                     Risk Grading


                                                               Implied probabilities
Choose Universal set of                                        (Output of the Statistical
                          Limit/Filter parameters              Technique)
Risk Drivers




Qualitative variables                                          Risk Grading
                          Transform Parameters                 (by probability)
Index construction




Shortlist Predictive                                           Adjustment for account
Parameters                 Statistical Technique -
                                                               Operations
                           (DA, LR, Probit etc)
                                                               (Modified Borrower
                                                               risk score)

                                                                                                  IM aCS 2010
                                                                                            Printed 11-M ay-11
                               For Classroom discussion only                                           Page 16
Choosing of predictor parameters – The art and science of it

 How are financial ratios related to default ?
• There exists a correlation between select ratios and default
• The relation is non-linear (at no point is default certain)
• Default would depend upon other predictor variables of the account




                                                                             IM aCS 2010
                                                                       Printed 11-M ay-11
                            For Classroom discussion only                         Page 17
Choosing of predictor parameters – The art and science of it


 Analysis Univariate relation of predictor parameters to default (Financial Ratios)



                                     Aid the modeler
                                     in answering




• The curve – Shape of the relationship between the predictor variable and
  default (In essence, what default probability corresponds to what parameter values)
• What are the most potent ratios (What profitability ratio is the most potent predictor
• How do correlations affect the coefficients in a multivariate model framework

                                                                                                 IM aCS 2010
                                                                                           Printed 11-M ay-11
                                    For Classroom discussion only                                     Page 18
Forward selection process

• Start with variables with the highest univariate correlation with default
  and add more until additional variables have no additional importance
• Ensure that variables selected do not suffer from “multicollinearity” (The
   wrong sign problem, inflated variances of coefficients, poor out of sample
   performance)


                               The essence
                               of the activity



 •Selection done based on suggestion of univariate power
 •Validation done in a multivariate framework
                                                                                      IM aCS 2010
                                                                                Printed 11-M ay-11
                               For Classroom discussion only                               Page 19
The Broad Model Construction Philosophy

                        Most critical processes in model construction
Phase I                               Phase II                               Phase III
Parameter Selection                   Modeling Technique                     Risk Grading


                                                                           Implied probabilities
Universal set of                                                           (Output of the Statistical
Predictor Parameters                   Limit/Filter parameters             Technique)




Qualitative variables                                                      Risk Grading
                                       Transform Parameters                (by probability)
Index construction




Choose Predictive                                                          Adjustment for account
                                       Statistical Technique -
Parameters                                                                 Operations
                                       (DA, LR, Probit etc)
                                                                           (Modified Borrower
                                                                           risk score)
                                                                                                              IM aCS 2010
                                                                                                        Printed 11-M ay-11
                                           For Classroom discussion only                                           Page 20
Transformations applied to Predictor Parameters

      Why is there a need to
      apply transformations??




 Movement of Leverage from 1-2                           The idea behind applying
 is not at as risky as a movement                        transformations is to mimic this analysis
 from 2-3                                                happening in the credit officers mind



Movements of values in predictor variables result in non-linear Credit Risk profile
is highly non-linear. We need to transform predictor variables to factor this

                                                                                                       IM aCS 2010
                                                                                                 Printed 11-M ay-11
                                    For Classroom discussion only                                           Page 21
The Borrower Risk Score will be adjusted for risk impact of
account operations


    Financial Risk                                       Account Operations*



    Industry Risk
                        Borrower                              Adjusted
                        Score
                                                              Borrower Score
    Management
                                                             * For existing accounts
    Risk


    Firm Standing




                                                                                             IM aCS 2010
                                                                                       Printed 11-M ay-11
                         For Classroom discussion only                                            Page 22
The monitoring parameters will be set in consultation with the
management and will be an input for deriving modified risk grade

  Factors on which monitoring levels are to be set are as follows:

 1.   No. of days delay in receipt of principal/interest instalments
 2.   Submission of progress reports
 3.   Compliance with sanctioned/disbursement conditions
 4.   Key employees turnover
 5.   Comments on operations/assets during site visits
 6.   Change in accounting period during the last five years
 7.   No. of times rescheduling/relief obtained from lending institutions




                                                                                  IM aCS 2010
                                                                            Printed 11-M ay-11
                                     For Classroom discussion only                     Page 23
The weightages of the various components – Concept of
Dynamic Weights

        A Linear Rating Model

                    40 %          Financial Risk


                    15%           Industry Risk
                                                          Borrower
                                                          Score
                                  Management
                    15 %          Risk


                    10%           Firm Standing

                                  Account
                    20 %          Operations

                                                                           IM aCS 2010
                                                                     Printed 11-M ay-11
                          For Classroom discussion only                         Page 24
The weightages of the various components – Dynamic Weights


     Credit Risk is highly non-linear.

 •     Borrower scoring low on integrity will not be
       accepted irrespective of scores on other parameters
 •     Borrower with a leverage of 10 would not be accepted
       irrespective of scores on other parameters


 It is critical that the risk-scoring model mimics this non – linear
  thinking of a experienced credit risk officer



                                                                             IM aCS 2010
                                                                       Printed 11-M ay-11
                              For Classroom discussion only                       Page 25
The weightages of the various components – Dynamic Weights

Case Study – Consider a account which got the following scores in Management Risk


Parameter                                                                        Risk Score

   Integrity----------------------------------------------------------------------------- 4

   Diversion of Funds-----------------------------------------------------------------4

   Business Commitment-------------------------------------------------------------3

   Payment Record of Group companies-------------------------------------------4

   Internal Control---------------------------------------------------------------------4

   Succession Planning----------------------------------------------------------------4


                                The scale is defined such that 1 is the best and 4 is the worst

                                                                                                        IM aCS 2010
                                                                                                  Printed 11-M ay-11
                                         For Classroom discussion only                                       Page 26
The weightages of the various components – Dynamic Weights

• The Borrower has a very high management risk. The Credit officer automatically
  recognizes this and would not lend no matter how impressive the financials or business


• The credit risk model has to adjust accordingly to mimic this non-linear analysis
  happening in the credit officer’s mind. It cannot be churning out a safe risk-grade for
  such an obviously high risk account


• The solution is the dynamic weights concept where the importance of every parameter
  would depend on the value allotted to it by the Credit officer




                                                                                                  IM aCS 2010
                                                                                            Printed 11-M ay-11
                                        For Classroom discussion only                                  Page 27
Model Calibration – The Process

  LR Output                                              Model Output
  Account 1 – 0.001
  Account 2 – 0.002
  Account 3 – 0.004
                                                         RG1 0.00 – 0.05
  Account 4 – 0.007
  …………………..                                              RG2 0.05 – 0.08
  ……………………
  ……………………                                               RG3 0.08 - 0.12
  …………………..                                              ……………….
  ……………………             Model Calibration
  …………………….            Process                           ……………….
  …………………….
                                                         ……………….
  ……………………..
  …………………….                                              ……………….
  Account 347 – 0.97
  Account 348 – 0.98
                                                         ……………….
  Account 349 – 0.99                                     RG10 0.85 – 1.00



                                                                                  IM aCS 2010
                                                                            Printed 11-M ay-11
                         For Classroom discussion only                                 Page 28
Model Calibration Process – What are the guidelines of
the process
  For Basel II IRB compliance, each risk grade is to be mapped to a unique PD - No overlap of
  risk
  There should be no undue concentrations of borrowers in any one risk grade

  Number of Risk grades and interpretation desired is decided apriori and the spreading is done
  based on this

  Ensure that the statistical PD estimates for every risk grade follow a desired trend




                                                                                                  IM aCS 2010
                                                                                            Printed 11-M ay-11
                                    For Classroom discussion only                                      Page 29
Model Calibration Process – What are the guidelines of the
                  process
                                 90.00%                                                                                                           4.0%

                                 80.00%                                                                                                           3.5%       There should be no
                                 70.00%
                                                                                                                                                  3.0%       overlap of PDs by
        Probability of Default




                                                                                                                         Probability of Default
                                 60.00%
                                                                                                                                                  2.5%       grade
                                 50.00%
                                                                                                                                                  2.0%
                                 40.00%

                                 30.00%                                                                                                           1.5%


                                 20.00%                                                                                                           1.0%

                                 10.00%
                                                                                                                                                  0.5%

                                  0.00%
                                           1   2        3   4         5       6         7        8   9         10   11                            0.0%
                                                                                                                                                         0    1      2     3                  4   5   6                  7
                                                                          Risk Grade
                                                                                                                                                                               R isk Rating




                                 45%      Reduce
                                 40%      concentrations in                  39%


                                 35%      any one rating
                                          grade
Percent of Borrowers




                                 30%

                                 25%                                                        23%
                                                                20%
                                 20%

                                 15%                                                                     13%

                                 10%

                                 5%
                                                   2%                                                               2%
                                          1%
                                 0%
                                          1        2             3             4             5            6          7
                                                                          Risk Rating                                                                                                                           IM aCS 2010
                                                                                                                                                                                                          Printed 11-M ay-11
                                                                                                     For Classroom discussion only                                                                                   Page 30
Entry and exit criterion
        100%                                                                                                                   100%   1.   At an operating level, an
        90%                                                                                                         89%                    entry grade of RG 6 or
        80%                                                                                         82%                                    better would roughly
        70%                                                                              73%                                               correspond to the credit
                                                                             63%                        Exit
        60%                                                                                                                                acceptance levels based on
        50%                                                     52%          Entry                                                         risk appetite.
        40%                                       40%                                                               41%
        30%
                                                                                                       32%                            2.   The exit criteria (in case
        20%                             20%                                              27%
                                                                             23%                                                           this means exiting from the
        10%            11%
                       0%               0%       0%                 9%                                                                     portfolio to other banks)
            0%                                                                                                                             may be set slightly lower at
                     RG1       RG2             RG3            RG4        RG5         RG6         RG7            RG8        RG9
                                                                                                                                           RG 7
                                                              % defaults         % portfolio

                                              Relative Risk of Default
                                                                                                                                      3.   The monitoring intensity
        1                           3                           5                            7                        10                   may be set depending on the
             •Gr 1     •Gr 2             •Gr 3        •Gr 4              •Gr 5       •Gr 6             •Gr 7   to      •Gr 9
                                                                                                                                           grades , which need to be
Strong Credit Quality
                                                                                                                                           annually re-evaluated
Low Risk                   Green                     Risk scores between 1 & 3                    Good quality credit
                           Zone
                           Yellow                    Risk scores > 3 & up to 5                    No immediate concern
                            Zone
                           Amber                     Risk scores > 5 & up to 7           Requires intensive
                            Zone                                                         monitoring                                                                     IM aCS 2010
•High                       Red                                                           NPA/ Could turn NPA
                                                      Risk scores greater than 7Classroom discussion only
                                                                          For                                                                                     Printed 11-M ay-11
                                                                                                                                                                             Page 31
                            Zone                                                          over the medium term
•Risk
Risk Scoring Model - the end product



                                                              NPA/ Could turn NPA
   Risk                                                       over the medium term

                                             Requires
                                             intensive
                             No              monitoring

          Good quality       immediate
          credit             concern

                                                                         Risk Scale


          1      2       3      4        5      6       7       8    9




                                                                                            IM aCS 2010
                                                                                      Printed 11-M ay-11
                                    For Classroom discussion only                                Page 32
The criticality of model calibration



A Model may be powerful (able to distinguish between good and bad)



                                BUT


     It maybe be incorrectly calibrated




                                                                           IM aCS 2010
                                                                     Printed 11-M ay-11
                             For Classroom discussion only                      Page 33
Model Validation Results- Cumulative Accuracy Profile (CAP)
Plots

                                                                  CAP Plot                 Perfect Model
                                       120%
         Percentage reduction in NPA




                                       100%


                                       80%
                                                          Rating Model
                                       60%


                                       40%
                                                   Random Model
                                       20%


                                        0%
                                              0%    20%         40%         60%           80%     100%
                                                      Percentage of Proposals accepted




                                                                                                                 IM aCS 2010
                                                                                                           Printed 11-M ay-11
                                                          For Classroom discussion only                               Page 34
CAP curve metric to assess Model Power – The GINI
coefficient

 •   The Gini Coefficient of the CAP plot is defined as the ratio of the
     area between the model curve and the random plot and area
     between the perfect model and random plot. Consequently the
     closer the AR of the model is to one the better the discriminatory
     power of the model is.
 •   Gini Coefficient (AR) = Area between model curve and
     random plot / Area between Perfect model and Random plot




                                                                            IM aCS 2010
                                                                      Printed 11-M ay-11
                           For Classroom discussion only                         Page 35
Classification Matrix

                            Classification Matrix

                                  Classification Results
                                       Predicted Group Membership    Total
                                       Default Non Default
             Count       Default           43               13           56
                         Non Default       78              323          401
             Percentage Default          76.79            23.21         100
                         Non Default     19.45            80.55         100
             80.1% of original grouped cases correctly classified.



                              Error Type Matrix


                                       Number of
                                       Accounts Percentage
             Type 1 Error                  13        2.84
             Type 2 Error                  78       17.06


                                                                                    IM aCS 2010
                                                                              Printed 11-M ay-11
                               For Classroom discussion only                             Page 36
Firm defaulted
   Graphical Back Testing                                                                 at this point


                                         Movement of R isk Grade (N PA Account)
Model signalled     9
default well in     8
advance of the event7
                              6
                 Risk Grade




                              5
                              4

                              3
                              2

                              1
                              0
                                  1999        2000             2001          2002       2003
                                                               Ye ar



             • Ability of the model to signal default before the actual occurrence
             • Critical attribute of a robust credit risk model as a signal in advance gives
               the Bank time to take precautions (sell of the asset)


                                                                                                          IM aCS 2010
                                                                                                    Printed 11-M ay-11
                                             For Classroom discussion only                                     Page 37
Definition of Probability of Default (PD)


     PD is the greater of
        One-year PD associated with the internal borrower grade to which
        that exposure is assigned, OR
        0.03% per annum




     PD of borrowers assigned to a default grade(s) is 100%




                                                                                 IM aCS 2010
                                                                           Printed 11-M ay-11
                             For Classroom discussion only                            Page 38
Methods to generate Probability of Default – Basel II
  recommended techniques

   Every Risk Grade of the model has a unique Probability of Default



                       Probability of Default




Based on Internal         Mapping to                    Statistical Model
Default experience        external data                 Estimates (LR)


                                                                                  IM aCS 2010
                                                                            Printed 11-M ay-11
                            For Classroom discussion only                              Page 39
Method 1 – Internal Default Experience

               Static Pool of
               Borrowers

            Transition of Borrower
            Risk Grades over Time
            Horizon – Transition Matrix
RG1   RG2       RG3   RG4   RG5    RG6    RG7


                                                                            RG1    0.04
RG2

                                                                            RG2    0.1
RG3

                                                                            RG3    0.2
                                                   Probability of
RG4                                                                         RG4    0.3
                                                   Default estimates
RG5




RG6                                                                         RG10   0.98

RG7
                                                                                                IM aCS 2010
                                                                                          Printed 11-M ay-11
                                            For Classroom discussion only                            Page 40
Method 2 – Mapping to external ratings

                2               2
               R = 0.4991   R = 0.631        Mappings R2 = 0.631           2
                                                                         R = 0.5048

               10
                                                                           2
                                                                         R = 0.5533       Mapping the Internal
                9                                                          2
                                                                         R = 0.6309
                8
                7
                                                                           2
                                                                         R = 0.5994       Ratings to Risk Grades
 Risk Scores




                                                                      Series1
                6
                                                                      Expon. (Series1)
                5
                4
                                                                      Linear (Series1)    of select External Credit
                                                                      Log. (Series1)
                3                                                     Power (Series1)
                2                                                     Poly. (Series1)
                                                                                          Rating agencies
                1                                                     Poly. (Series1)
                    1   2   3       4   5    6    7   8   9   10      Poly. (Series1)
                                        Ratings




                                                                                                                            IM aCS 2010
                                                                                                                      Printed 11-M ay-11
                                                              For Classroom discussion only                                      Page 41
Method 2 – Mapping to external ratings




                                                           IM aCS 2010
                                                     Printed 11-M ay-11
                     For Classroom discussion only              Page 42
Method 2 – Mapping to external ratings




                                                           IM aCS 2010
                                                     Printed 11-M ay-11
                     For Classroom discussion only              Page 43
Method 2 – Mapping to external ratings




                                                           IM aCS 2010
                                                     Printed 11-M ay-11
                     For Classroom discussion only              Page 44
Method 3 – Statistical Probability of Default estimates



                                                               Probability of Default based
     Account       LR Model                                    on the estimating equation

                                                                                Calibration
                                                                                Scale
                 PD Table
                                                                          Calibration Scale

                 RG1 - 0.025
                                                                          RG1 0.00 – 0.05
                 RG2 - 0.075
RG -> 3                                        Average PD estimates
                                                                          RG2 0.05 – 0.08
                 RG3 - 0.10
PD -> 0.1        ……………….                       for every RG
                                                                          RG3 0.08 - 0.12
                                                                          ……………….
                 ……………….
                                                                          ……………….
                 ……………….
                                                                          ……………….
                 ……………….
                                                                          ……………….
                 ……………….
                                                                          ……………….
                 RG10 - 1.00
                                                                          RG10 0.85 – 1.00



                                                                                                    IM aCS 2010
                                                                                              Printed 11-M ay-11
                               For Classroom discussion only                                             Page 45
Where does this model fit in to the IRB(F) approach



                                       Regulator

                                      LGD
                                      EAD estimator
                                      M

                                                            •   RAROC
Corporate Business                                          •   Provisioning
                     PD estimates                           •   Expected Loss
Segment Model                                               •   Unexpected Loss
                                                            •   Pricing
                                                            •   Economic Capital for Credit Risk
                                                            •   Investor Transparency
                                                            •   Regulatory Transparence
                                                            •   Securitisation

                                                                                                  IM aCS 2010
                                                                                            Printed 11-M ay-11
                            For Classroom discussion only                                              Page 46
IMaCS LGD Calc – An overview

                            Categories of CRM

        Collateral
                                     Guarantee               Structure
         (asset)

                         Haircuts and other deductions


                     Estimated Net Realisable Value of CRM


       Claims by senior lenders & adjustments with pari passu claims



                        Value of CRM available to YBL

                                                                               IM aCS 2010
                                                                         Printed 11-M ay-11
                            For Classroom discussion only
                              Loss Given Default                                    Page 47
Characteristic of a good risk scoring model


    Ability of the model to distinguish “good” borrower from a “weak” borrower




    Ability of the model to “measure change” in the credit quality of a borrower
    on a time series



    Ability of the model to “predict defaults”




                                                                                         IM aCS 2010
                                                                                   Printed 11-M ay-11
                               For Classroom discussion only                                  Page 48
DISCUSSIONS




                                      IM aCS 2010
                                Printed 11-M ay-11
For Classroom discussion only              Page 49
All the contents of the presentation are confidential and
should not be published, reproduced or circulated without the
   written consent of IFC, Bangladesh Bank and IMaCS.



                                                                      IM aCS 2010
                                                                Printed 11-M ay-11
                        For Classroom discussion only                      Page 50

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RMPG Learning Series CRM Workshop Day 3

  • 1. Agenda for Day 3 Credit Rating Models Lunch Break Case Studies Open Session/ Q&A IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 1
  • 2. Introduction to credit risk modeling – What is a model Risk Score = Co-eff1*Leverage + Co-eff2 *Current Ratio +……. Co-eff6 *Integrity +….. Co-eff8 *Industry Phase…. IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 2
  • 3. Credit Risk Models - Some Examples Altman’s Z - score model (Multiple Discriminant) Merton model Judgmental Hybrid IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 3
  • 4. Altmans’s Z Score Model Z = 0.012 X 1 + 0.014 X 2 + 0.033 X 3 + 0.006 X 4 + 0.999 X 5 Where, • X 1 = Net Working Capital / Total Assets •X 2 = Retained earnings / Total Assets •X 3 = PBIT/ Total Assets •X 4 = Market value of equity/ Book Value of Total Liabilities •X 5 = Sales/ Total Assets IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 4
  • 5. Altmans’s Z Score Model Z = 0.012 X 1 + 0.014 X 2 + 0.033 X 3 + 0.006 X 4 + 0.999 X 5 < 1.81 - Failing Zone Z 1.81 to 2.99 - Ignorance Zone > 2.99 - Non-failing Zone IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 5
  • 6. Merton Model Expected Default Frequency - is calculated using 3 steps Step 1: Estimate asset value and asset volatility from equity value and volatility of equity return Step 2: Calculate distance =Asset Value - Default point to default (DfD) Asset Value * Asset Volatility Step 3: Calculate expected default frequency IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 6
  • 7. Calculating distance to default: Merton The market value of a firm’s assets and its historical volatility imply a distribution of future firm value Given today’s obligations (debt), we can calculate the probability that the market value of assets will be lower than the firm’s obligations one year from now (i.e., default) Distance to default is mean value minus debt, normalized by S.D. in •Amount IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 7
  • 8. The quantitative model would derive its strength from the Bank’s data and the human expertise and experience of CO Industry Firm Standing Management…. Convert into proxies Professional Judgement Check for for weights consistency Construct indices Statistically explanatory set of variables IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 8
  • 9. The benefit of the model Reduces the dimensionality of space of the credit officer IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 9
  • 10. Banks need different risk scoring models for different credit segments Corporate Small Bank Retail Loan Credit Business Exposures Quality of financial Reasonably Less Partial More statements Reliable Reliable Information Reliable Global, Global, Market Regional Local National or National or Situation or Local Regional regional Type High value & Lower value & Low value & High Value & Low Numbers Higher Numbers High Numbers Low numbers IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 10
  • 11. No. of rating models/ borrower categories in new systems The number of rating models should be determined: Based on the current portfolio of the bank Based on business strategy and focus areas of the bank A good thumb rule, is that 80-85% of the bank’s credit portfolio should be risk rated. For the remaining portfolio, the bank could use pool-based approach Banks use the following models: Corporate Segment: Large, SME and Small Business models; Retail Segments: Home Loan, Personal Loan & Credit Card models; Commercial Segment: Bank and NBFC models; Project Models: Infrastructure, Green-field and Brown-field models IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 11
  • 12. Data Collection - What Type of Data is required to be collected Accounts (On which data is being collected) Performing Accounts Non - Performing Accounts This sample of accounts has to be representative of the Bank’s portfolio IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 12
  • 13. Data Collection - What Type of Data is required to be collected Financial Information – Balance Sheet, Profit and Loss, Cash Flow Data (Historical) Management Qualitative Data Industry Firm Standing Conduct of Account IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 13
  • 14. Why do we need to collect this data ? • Historical Data is the basis of estimating the model equation (along with expert opinion) • What is the model ? Risk Score = A*Leverage + B* Current Ratio +C*Sales/Total Assets…… • The Data would be the basis for both deducing the predictor variables and the coefficients of the model equation (along with expert opinion) • In other words, the fact that Leverage is to be chosen in the model and the A (coefficient of Leverage) is both coming from the Bank’s historical data IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 14
  • 15. Data Collection – The criticality of this exercise The model is only as good as the data used to construct it • The Data sample used to estimate the model should be representative of the Bank’s portfolio • The Data sample has to be accurate IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 15
  • 16. The Broad Model Construction Philosophy Phase I Phase II Phase III Parameter Selection Modeling Technique Risk Grading Implied probabilities Choose Universal set of (Output of the Statistical Limit/Filter parameters Technique) Risk Drivers Qualitative variables Risk Grading Transform Parameters (by probability) Index construction Shortlist Predictive Adjustment for account Parameters Statistical Technique - Operations (DA, LR, Probit etc) (Modified Borrower risk score) IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 16
  • 17. Choosing of predictor parameters – The art and science of it How are financial ratios related to default ? • There exists a correlation between select ratios and default • The relation is non-linear (at no point is default certain) • Default would depend upon other predictor variables of the account IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 17
  • 18. Choosing of predictor parameters – The art and science of it Analysis Univariate relation of predictor parameters to default (Financial Ratios) Aid the modeler in answering • The curve – Shape of the relationship between the predictor variable and default (In essence, what default probability corresponds to what parameter values) • What are the most potent ratios (What profitability ratio is the most potent predictor • How do correlations affect the coefficients in a multivariate model framework IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 18
  • 19. Forward selection process • Start with variables with the highest univariate correlation with default and add more until additional variables have no additional importance • Ensure that variables selected do not suffer from “multicollinearity” (The wrong sign problem, inflated variances of coefficients, poor out of sample performance) The essence of the activity •Selection done based on suggestion of univariate power •Validation done in a multivariate framework IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 19
  • 20. The Broad Model Construction Philosophy Most critical processes in model construction Phase I Phase II Phase III Parameter Selection Modeling Technique Risk Grading Implied probabilities Universal set of (Output of the Statistical Predictor Parameters Limit/Filter parameters Technique) Qualitative variables Risk Grading Transform Parameters (by probability) Index construction Choose Predictive Adjustment for account Statistical Technique - Parameters Operations (DA, LR, Probit etc) (Modified Borrower risk score) IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 20
  • 21. Transformations applied to Predictor Parameters Why is there a need to apply transformations?? Movement of Leverage from 1-2 The idea behind applying is not at as risky as a movement transformations is to mimic this analysis from 2-3 happening in the credit officers mind Movements of values in predictor variables result in non-linear Credit Risk profile is highly non-linear. We need to transform predictor variables to factor this IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 21
  • 22. The Borrower Risk Score will be adjusted for risk impact of account operations Financial Risk Account Operations* Industry Risk Borrower Adjusted Score Borrower Score Management * For existing accounts Risk Firm Standing IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 22
  • 23. The monitoring parameters will be set in consultation with the management and will be an input for deriving modified risk grade Factors on which monitoring levels are to be set are as follows: 1. No. of days delay in receipt of principal/interest instalments 2. Submission of progress reports 3. Compliance with sanctioned/disbursement conditions 4. Key employees turnover 5. Comments on operations/assets during site visits 6. Change in accounting period during the last five years 7. No. of times rescheduling/relief obtained from lending institutions IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 23
  • 24. The weightages of the various components – Concept of Dynamic Weights A Linear Rating Model 40 % Financial Risk 15% Industry Risk Borrower Score Management 15 % Risk 10% Firm Standing Account 20 % Operations IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 24
  • 25. The weightages of the various components – Dynamic Weights Credit Risk is highly non-linear. • Borrower scoring low on integrity will not be accepted irrespective of scores on other parameters • Borrower with a leverage of 10 would not be accepted irrespective of scores on other parameters It is critical that the risk-scoring model mimics this non – linear thinking of a experienced credit risk officer IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 25
  • 26. The weightages of the various components – Dynamic Weights Case Study – Consider a account which got the following scores in Management Risk Parameter Risk Score Integrity----------------------------------------------------------------------------- 4 Diversion of Funds-----------------------------------------------------------------4 Business Commitment-------------------------------------------------------------3 Payment Record of Group companies-------------------------------------------4 Internal Control---------------------------------------------------------------------4 Succession Planning----------------------------------------------------------------4 The scale is defined such that 1 is the best and 4 is the worst IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 26
  • 27. The weightages of the various components – Dynamic Weights • The Borrower has a very high management risk. The Credit officer automatically recognizes this and would not lend no matter how impressive the financials or business • The credit risk model has to adjust accordingly to mimic this non-linear analysis happening in the credit officer’s mind. It cannot be churning out a safe risk-grade for such an obviously high risk account • The solution is the dynamic weights concept where the importance of every parameter would depend on the value allotted to it by the Credit officer IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 27
  • 28. Model Calibration – The Process LR Output Model Output Account 1 – 0.001 Account 2 – 0.002 Account 3 – 0.004 RG1 0.00 – 0.05 Account 4 – 0.007 ………………….. RG2 0.05 – 0.08 …………………… …………………… RG3 0.08 - 0.12 ………………….. ………………. …………………… Model Calibration ……………………. Process ………………. ……………………. ………………. …………………….. ……………………. ………………. Account 347 – 0.97 Account 348 – 0.98 ………………. Account 349 – 0.99 RG10 0.85 – 1.00 IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 28
  • 29. Model Calibration Process – What are the guidelines of the process For Basel II IRB compliance, each risk grade is to be mapped to a unique PD - No overlap of risk There should be no undue concentrations of borrowers in any one risk grade Number of Risk grades and interpretation desired is decided apriori and the spreading is done based on this Ensure that the statistical PD estimates for every risk grade follow a desired trend IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 29
  • 30. Model Calibration Process – What are the guidelines of the process 90.00% 4.0% 80.00% 3.5% There should be no 70.00% 3.0% overlap of PDs by Probability of Default Probability of Default 60.00% 2.5% grade 50.00% 2.0% 40.00% 30.00% 1.5% 20.00% 1.0% 10.00% 0.5% 0.00% 1 2 3 4 5 6 7 8 9 10 11 0.0% 0 1 2 3 4 5 6 7 Risk Grade R isk Rating 45% Reduce 40% concentrations in 39% 35% any one rating grade Percent of Borrowers 30% 25% 23% 20% 20% 15% 13% 10% 5% 2% 2% 1% 0% 1 2 3 4 5 6 7 Risk Rating IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 30
  • 31. Entry and exit criterion 100% 100% 1. At an operating level, an 90% 89% entry grade of RG 6 or 80% 82% better would roughly 70% 73% correspond to the credit 63% Exit 60% acceptance levels based on 50% 52% Entry risk appetite. 40% 40% 41% 30% 32% 2. The exit criteria (in case 20% 20% 27% 23% this means exiting from the 10% 11% 0% 0% 0% 9% portfolio to other banks) 0% may be set slightly lower at RG1 RG2 RG3 RG4 RG5 RG6 RG7 RG8 RG9 RG 7 % defaults % portfolio Relative Risk of Default 3. The monitoring intensity 1 3 5 7 10 may be set depending on the •Gr 1 •Gr 2 •Gr 3 •Gr 4 •Gr 5 •Gr 6 •Gr 7 to •Gr 9 grades , which need to be Strong Credit Quality annually re-evaluated Low Risk Green Risk scores between 1 & 3 Good quality credit Zone Yellow Risk scores > 3 & up to 5 No immediate concern Zone Amber Risk scores > 5 & up to 7 Requires intensive Zone monitoring IM aCS 2010 •High Red NPA/ Could turn NPA Risk scores greater than 7Classroom discussion only For Printed 11-M ay-11 Page 31 Zone over the medium term •Risk
  • 32. Risk Scoring Model - the end product NPA/ Could turn NPA Risk over the medium term Requires intensive No monitoring Good quality immediate credit concern Risk Scale 1 2 3 4 5 6 7 8 9 IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 32
  • 33. The criticality of model calibration A Model may be powerful (able to distinguish between good and bad) BUT It maybe be incorrectly calibrated IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 33
  • 34. Model Validation Results- Cumulative Accuracy Profile (CAP) Plots CAP Plot Perfect Model 120% Percentage reduction in NPA 100% 80% Rating Model 60% 40% Random Model 20% 0% 0% 20% 40% 60% 80% 100% Percentage of Proposals accepted IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 34
  • 35. CAP curve metric to assess Model Power – The GINI coefficient • The Gini Coefficient of the CAP plot is defined as the ratio of the area between the model curve and the random plot and area between the perfect model and random plot. Consequently the closer the AR of the model is to one the better the discriminatory power of the model is. • Gini Coefficient (AR) = Area between model curve and random plot / Area between Perfect model and Random plot IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 35
  • 36. Classification Matrix Classification Matrix Classification Results Predicted Group Membership Total Default Non Default Count Default 43 13 56 Non Default 78 323 401 Percentage Default 76.79 23.21 100 Non Default 19.45 80.55 100 80.1% of original grouped cases correctly classified. Error Type Matrix Number of Accounts Percentage Type 1 Error 13 2.84 Type 2 Error 78 17.06 IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 36
  • 37. Firm defaulted Graphical Back Testing at this point Movement of R isk Grade (N PA Account) Model signalled 9 default well in 8 advance of the event7 6 Risk Grade 5 4 3 2 1 0 1999 2000 2001 2002 2003 Ye ar • Ability of the model to signal default before the actual occurrence • Critical attribute of a robust credit risk model as a signal in advance gives the Bank time to take precautions (sell of the asset) IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 37
  • 38. Definition of Probability of Default (PD) PD is the greater of One-year PD associated with the internal borrower grade to which that exposure is assigned, OR 0.03% per annum PD of borrowers assigned to a default grade(s) is 100% IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 38
  • 39. Methods to generate Probability of Default – Basel II recommended techniques Every Risk Grade of the model has a unique Probability of Default Probability of Default Based on Internal Mapping to Statistical Model Default experience external data Estimates (LR) IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 39
  • 40. Method 1 – Internal Default Experience Static Pool of Borrowers Transition of Borrower Risk Grades over Time Horizon – Transition Matrix RG1 RG2 RG3 RG4 RG5 RG6 RG7 RG1 0.04 RG2 RG2 0.1 RG3 RG3 0.2 Probability of RG4 RG4 0.3 Default estimates RG5 RG6 RG10 0.98 RG7 IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 40
  • 41. Method 2 – Mapping to external ratings 2 2 R = 0.4991 R = 0.631 Mappings R2 = 0.631 2 R = 0.5048 10 2 R = 0.5533 Mapping the Internal 9 2 R = 0.6309 8 7 2 R = 0.5994 Ratings to Risk Grades Risk Scores Series1 6 Expon. (Series1) 5 4 Linear (Series1) of select External Credit Log. (Series1) 3 Power (Series1) 2 Poly. (Series1) Rating agencies 1 Poly. (Series1) 1 2 3 4 5 6 7 8 9 10 Poly. (Series1) Ratings IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 41
  • 42. Method 2 – Mapping to external ratings IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 42
  • 43. Method 2 – Mapping to external ratings IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 43
  • 44. Method 2 – Mapping to external ratings IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 44
  • 45. Method 3 – Statistical Probability of Default estimates Probability of Default based Account LR Model on the estimating equation Calibration Scale PD Table Calibration Scale RG1 - 0.025 RG1 0.00 – 0.05 RG2 - 0.075 RG -> 3 Average PD estimates RG2 0.05 – 0.08 RG3 - 0.10 PD -> 0.1 ………………. for every RG RG3 0.08 - 0.12 ………………. ………………. ………………. ………………. ………………. ………………. ………………. ………………. ………………. RG10 - 1.00 RG10 0.85 – 1.00 IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 45
  • 46. Where does this model fit in to the IRB(F) approach Regulator LGD EAD estimator M • RAROC Corporate Business • Provisioning PD estimates • Expected Loss Segment Model • Unexpected Loss • Pricing • Economic Capital for Credit Risk • Investor Transparency • Regulatory Transparence • Securitisation IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 46
  • 47. IMaCS LGD Calc – An overview Categories of CRM Collateral Guarantee Structure (asset) Haircuts and other deductions Estimated Net Realisable Value of CRM Claims by senior lenders & adjustments with pari passu claims Value of CRM available to YBL IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Loss Given Default Page 47
  • 48. Characteristic of a good risk scoring model Ability of the model to distinguish “good” borrower from a “weak” borrower Ability of the model to “measure change” in the credit quality of a borrower on a time series Ability of the model to “predict defaults” IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 48
  • 49. DISCUSSIONS IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 49
  • 50. All the contents of the presentation are confidential and should not be published, reproduced or circulated without the written consent of IFC, Bangladesh Bank and IMaCS. IM aCS 2010 Printed 11-M ay-11 For Classroom discussion only Page 50