Machine Learning for Financial Risk Management with Python

Chapter 6. Credit Risk Estimation

Although market risk is much better researched, the larger part of banks’ economic capital is generally used for credit risk. The sophistication of traditional standard methods of measurement, analysis, and management of credit risk might, therefore, not be in line with its significance.

Uwe Wehrspohn (2002)

The primary role of financial institutions is to create a channel by which funds move from entities with surplus into ones with deficit. Thereby, financial institutions ensure the capital allocation in the financial system as well as gain profit in exchange for these transactions.

However, there is an important risk for financial institutions to handle, which is credit risk. This is such a big risk that without it capital allocation might be less costly and more efficient. Credit risk is the risk that arises when a borrower is not able to honor their debt. In other words, when a borrower defaults, they fail to pay back their debt, which causes losses for financial institutions.

Credit risk and its goal can be defined in a more formal way (BCBS and BIS 2000):

Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximise a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters.

Estimating credit risk is so formidable a task that a regulatory body, ...