Corporate Risk Management

CHAPTER 12Bank Credit Risk: Scoring of Individual Risks

Default risk generally refers to the default probability of the counterparty in a contractual relationship.¹ In bank credit, it refers to the borrower's probability of default or loan nonpayment. The recovery rate and the loan value at the time of default are also important to consider for computing the recovery value.

Bankers or lenders must evaluate individual default probabilities, a difficult risk management task. Most often, the borrower is more informed about its own default probability than the lender is. This situation of information asymmetry may generate adverse selection.

Several mechanisms are available to let banks protect themselves from this information problem:

1. Self-selection of risks²
2. Collateral or loan guarantees
3. Bank scoring

In this chapter, we will emphasize bank scoring, also known as risk classification by banks, which is a form of risk management.

This method consists of classifying risks using information that is inexpensive and that is correlated with the real unobservable risk that potential customers represent. The same method is used by insurers that, for example, price automobile insurance via different classification variables such as age, territory, type of car, and so on. This process has been shown to reduce asymmetric information within risk classes (Dionne, Gouriéroux, and Vanasse, 2001; Chiappori and Salanié, 2000; Dionne and Rothschild, 2014). It can even eliminate asymmetric information ...