If you own or operate a small- to medium-sized business, then your financial partners will speak with you about advanced credit models soon if they have not done so already.
These models are a set of credit risk measurement techniques that use an advanced internal ratings-based approach to scoring. It allows your lender to develop a proprietary empirical model to quantify the risks associated with extending capital.
This approach is subject to approval from the lender’s local regulators.
What Do Advanced Credit Models Determine?
Banks and other financial institutions use advanced credit models to estimate several unique risk points that exist in the lending process.
Three primary parameters get addressed when using internal proprietary quantitative models.
1. Probability of Default
This measurement describes the likelihood of default over a specific time after the extension of a lending product. It is an estimation of a particular borrower being unable to meet their debt obligation.
2. Exposure at Default
EAD is a parameter used when calculating regulatory or economic capital. It is the entirety of the vulnerability that a financial institution would receive if a borrower were to default for any reason. It typically divides into drawn or undrawn commitments.
3. Loss Given Default
This parameter is a direct representation of the share of an asset that a financial institution loses if a default occurs. It reflects the amount that a bank could lose with their investment. If an outstanding debt of $100,000 goes into default and the institution can sell the security for $75,000, then the LGD is 25%.
Banks can set other parameters as needed to calculate their risk-weighted assets (RWAs). Then the total amount of required capital gets calculated as a fixed percentage of that figure.
Why Are Advanced Credit Models Necessary?
The financial industry’s credit scoring models are not aging well in an era of validated algorithms and artificial intelligence. Businesses today are still relying on expert scorecards with manually-assigned variables.
Static points cannot determine the correct amount of risk that a lending decision encounters with these technology advancements.
As competition continues rising and markets remain volatile, there is an unprecedented increase in the levels of business risk. Without advanced analytics, it becomes almost impossible to compute the likelihood of an event occurring.
According to Deltec Bank, “An entire ecosystem of databased systems operates today using options like Sybase, Oracle, and SQL. Improved management of this data combines with the advanced credit models to create more certainty in the evaluation process.”
Advanced Credit Models Can Apply to Other Problems
Advanced credit models might be popular in the banking and finance sector, but they can apply to a massive variety of analytics concerns.
This approach can determine what factors contribute to the choices that consumers make. It can identify the specific data points that impact the decision-making process. The risk evaluation can even look at the odds of a customer purchasing from a competitor.
These models create a statistical framework where the collected data becomes usable. That is why your financial partners are going to use this information to re-evaluate their relationship with your company.
Disclaimer: The author of this text, Robin Trehan, has an Undergraduate degree in economics, Masters in international business and finance and MBA in electronic business. Trehan is Senior VP at Deltec International www.deltecbank.com. The views, thoughts, and opinions expressed in this text are solely the views of the author, and not necessarily reflecting the views of Deltec International Group, its subsidiaries and/or employees.
About Deltec Bank
Headquartered in The Bahamas, Deltec is an independent financial services group that delivers bespoke solutions to meet clients’ unique needs. The Deltec group of companies includes Deltec Bank & Trust Limited, Deltec Fund Services Limited, and Deltec Investment Advisers Limited, Deltec Securities Ltd. and Long Cay Captive Management