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Combining Quantitative and Qualitative Approaches in Credit Risk Scoring
April 2012 Andreas Kalenteridis Credit Risk Specialist
Combining Quantitative and Qualitative Approaches
2
Agenda
1. Quantitative Approach as the basis of a Rating Model
2. Capturing and Overlaying Qualitative Information
3. Weighting the two Approaches to Maximize Accuracy
Combining Quantitative and Qualitative Approaches
Sources of information to assess company’s credit standing
Other subjective factors
Future / past situation
of a company
Financial statement credit rating
Company’s credit standing
Management
Bank account data
3
Combining Quantitative and Qualitative Approaches
4
Models, Scorecards and Other Approaches to Rating
Pure Judgment
Potentially inconsistent within and across portfolios
No reliable link to expected loss.
Possibly accurate for rank ordering credits within a single portfolio.
Structuring of process for underwriter
Primary gain is consistency of approach within portfolio, less so across portfolios
Moderate link to probability of default and expected loss
Flexibility for nonstandard credits.
Ultimate decision still with credit-qualified officer.
Consistent process and evaluation of risk within and across portfolios.
Can be calibrated to probability of default and expected losses.
Intervention for exceptions only.
Can be calibrated to probability of default and expected losses
Can be used to prescreen databases
Template Scorecard Pure Model
Combining Quantitative and Qualitative Approaches
5
1. Quantitative Approach as the basis of a Rating Model
Combining Quantitative and Qualitative Approaches
6
1. Quantitative Data as the basis of a Rating Model
A quantitative approach to credit risk provides a sound foundation for assessing credit risk
Efficient Consistent Objective Testable
Combining Quantitative and Qualitative Approaches
A Large and Good Quality Data Sample is Paramount 7
Combining Quantitative and Qualitative Approaches
Select relevant financial inputs
Ratio
Density Insolvent Solvent
Ratio
Density Insolvent Solvent
“Irrelevant” ratios “relevant” ratios
8
Combining Quantitative and Qualitative Approaches
Financial inputs, ratios and weights in a PD model
Russian Model Input List
Cash & Marketable Securities
Accounts Payable
Total Assets
Total Liabilities
Current Liabilities
Retained Earnings
Net Worth
Sales
Operating Profit
Net Income
Industry
Russian Model Ratio List Weight
LEVERAGE RE to Current Liabilities Net Worth to Total Assets 33.70%
GROWTH Sales Growth 2.00%
PROFITABILITY ROA 21.23%
ACTIVITY Accounts Payables to Sales 18.16%
DEBT COVERAGE
Operating Profit to Total Liabilities 10.83%
LIQUIDITY Cash to Total Assets 14.10%
9
Combining Quantitative and Qualitative Approaches
Frequent Testing and Constant Monitoring Power Curve 1-Year Model
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
Percent of Sample
Perc
ent o
f Def
aults
Exc
lude
d
RC Russia ModelZ-scoreRandom Model
RiskCalc Russia v3.1 64%
Z-score 48%
P-Value of Difference <.0001
Power Curve 5-Year Model
0%
20%
40%
60%
80%
100%
0% 20% 40% 60% 80% 100%
Percent of SamplePe
rcen
t of D
efau
lts E
xclu
ded
RC Russia ModelZ-scoreRandom Model
RiskCalc Russia v3.1 54%
Z-score 34%
P-Value of Difference <.0001
Combining Quantitative and Qualitative Approaches
Combining Usage Data with RiskCalc EDF
Data is from eight US financial institutions
We collect usage information quarterly
We compute monthly EDF credit measures based on the latest available financial statement and credit cycle of that particular month
Usage level is higher for defaulted firms
Usage ratio is defined as total draw-down amount scaled by the total commitment amount
# Quarters # Firms # Defaults Time Period
355033 40277 2684 2000-2010
Usage Ratio Overall 47.3% Non-Defaulter 47.1% Defaulter 71.7%
Sample Description
Combining Quantitative and Qualitative Approaches
Usage Information Helps Improve the Accuracy of Default Prediction
Variable AR
EDF only 53%
Usage only 39%
70% weight on EDF, 30% on Usage 57%
Combining Quantitative and Qualitative Approaches
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2. Capturing and Overlaying Qualitative Information
Combining Quantitative and Qualitative Approaches
Qualitative Factors Compliment a Quantitative Model The qualitative factors in a Scorecard are generally designed to be broad and general.
14
Industry/Market Balance Sheet Factors Industry Audit Method Market Conditions Inventory Valuation Customer Power Debtor Risk/Accounts Receivable Risk Diversification of Products Owner's Support
Competitive Position Intrinsic Full Value of Intangibles
Company Management
Years in Relationship Experience in Industry
Business Stage Financial Reporting and Formal Planning
Supplier Power Risk Management
Credit History Openness
Conduct of Account Risk Appetite
Quality Management Management Style & Structure
Combining Quantitative and Qualitative Approaches
Normalizing Qualitative Information Gives a More Universal Interpretation to the Qualitative Score
Qualitative information is typically captured as answers to a series of questions.
Answers are assigned numbers and a weighted combination of answers forms the qualitative score.
The relative importance of the different questions are based on expert judgment.
It is convenient to convert the qualitative information to a “standardized score”:
15
mean( )stdev( )Q
Q QzQ
−=
Combining Quantitative and Qualitative Approaches
After financial statements are spread the analyst completes the judgmental sections:
• Balance Sheet Factors
• Industry / Market conditions
• Company profile
• Quality of Management
Combining Quantitative and Qualitative Approaches
Combining Quantitative and Qualitative Approaches
Final score for the Balance Sheet Factors 33% 16% 18% 22% 11%
Combining Quantitative and Qualitative Approaches
Final score for the Industry / Market assessment 0% 36% 36% 17% 11%
… Industry risk is reflected in the RiskCalc EDF values
Combining Quantitative and Qualitative Approaches
Final score for the Company assessment 10% 14% 10% 20% 23% 23%
Combining Quantitative and Qualitative Approaches
18% weight 19% weight 36% weight 27% weight
Combining Quantitative and Qualitative Approaches
22
3. Weighting the two Approaches to Maximize Accuracy
Combining Quantitative and Qualitative Approaches
The model produces a PD estimate based exclusively on historical and projected financial statements …
Combining Quantitative and Qualitative Approaches
18% weight 19% weight 36% weight 27% weight
Combining Quantitative and Qualitative Approaches
65% weight 35% weight Borrower rating and PD + =
Combining Quantitative and Qualitative Approaches
How to set appropriate weights for the 2 Approaches
Firms Statements Defaults
Low 3 7907 22916 536
Mid 5 18822 49402 407
Top 3 53338 160211 2835
Total 80067 232529 3778
26
In God We Trust….
All Others Will Have To Bring Data!
Data from 11 US banks from 2002 to 2009 grouped according to number of statements.
Combining Quantitative and Qualitative Approaches
A weight of 65% on the EDF yields a higher accuracy ratio than either the internal rating or the RiskCalc EDF
27
The combined score is computed as:
Presents the quartiles of ARs across the 11 banks.
Dashed lines represent the AR of the internal ratings of the 11 banks
( )( ) 1/ 22 2(1 ) (1 )EDF QScore wz w z w w−
= + − + −
Combining Quantitative and Qualitative Approaches
Conclusion A quantitative approach to credit risk provides a sound foundation for
assessing credit risk
– Efficient – Consistent – Objective – Testable
The qualitative factors that credit analysts look at can potentially add value The combination of the two approaches appears to be stronger than either
approach on its own RiskCalc can be used in combination with subjective factors through the
RiskCalc Scorecard
28
Combining Quantitative and Qualitative Approaches
29
© 2012 Moody’s Analytics, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding, or selling.