Post-crisis risk management
I am very interested in the topic of credit risk, and when the offer was made for Dr Jennings to contribute, I readily accepted. The statistics graph is of particular interest.
Dr. Andrew Jennings, chief analytics officer, FICO
Guest post for TheBankWatch.com blog
The global economic crisis has tested some core beliefs in traditional risk management. We’ve had a real-world stress test, not just of bank portfolios but also of the tools used to manage those portfolios.
As our risk-management models came under stress, regulators in the U.S. and numerous other countries changed the rules that govern business practices for many personal financial products and services. Regulators and bank risk professionals in turn started to ask more questions about the creation and governance of the modeling process.
We are all familiar with the conventional wisdom that has emerged over the past few years — models tended to under-predict risk as the economic crisis unfolded. Risk ranking of consumers held up well, but the rating side of the models didn’t do so well. The shortcomings in the risk models rekindled interest in the relationship between the macro economy and credit risk.
While many factors influence risk outcomes, a major contributor is the state of the economy and predictions for its future state. Of course this isn’t new, but the crisis has forced risk managers to think about the problem more explicitly than in the past. Research by FICO Labs has discovered specific, measurable relationships between macro-economic variables (e.g., unemployment rate, home-price depreciation, per-capita income, GDP growth) and credit risk.
In fact, this is an area FICO Labs has been investigating for a while, as I recently discussed in American Banker, and we are engaged with banks in the U.S., Europe and Asia to help them understand their risk exposure given the economic dynamics in their geographic regions.
Each 12-month period is a different color. In each 12-month period, there is a clear drop in delinquency rates as the scores get higher. This means the FICO score did its job. It correctly ranked people with higher scores as less likely to default.
The blue bars represent the early recession (right up to the chaos of September 2008). The red bars represent the depth of the recession when there were no jobs, no credit, and home prices were in a free fall. The green bars represent the bottoming out of the recession and the beginning of the recovery. In all three 12-month periods, the FICO score performed extremely well.
The key for banks everywhere is to create a framework in which they can apply various assumptions about the future values of key economic variables, and then transform those inputs into an understanding of future default risk for borrowers at any given score. Only then can a bank develop a meaningful strategy and plan to manage risk appropriately.
When the economic crisis started, the challenge was to contain risk. By and large, banks did this by simply shutting down originations, closing accounts, and stopping credit-line increases. As the global economy continues to improve, lenders need to adopt a smarter approach when it comes to relaxing credit policy. This will require thinking through the impact of the macro economy on credit risk, and not returning to pre-crisis business as usual, which would be the riskiest decision of all!