Shock-Proofing Your Credit Risk Models

Credit Rating forms the foundation of trust in the capital markets. However the US sub-prime crisis has brought forth the perils when risk and especially Credit risk is not accurately factored in the ratings. This is an area of glaring failure for erstwhile renowned rating agencies and has immense implications for management of risk both at the level of monetary authorities and of the individual risk manager.In the least, we now know that it is suicidal to rely on credit ratings especially in the context of a derivative that derives its value from repayments on a loan, which in turn is not rated accurately by the rating agencies. The way to resolve this is by going back to the basics and looking at the problem with a detailed, microscopic view.Pursuing this approach, our paper provides actionable, concrete solutions for integrating customer level information with changes in macroeconomic parameters. The result is a credit risk scorecard that not only stands the test of systemic economic events but in addition may signal their onset, thus enabling far more efficient risk management. This may then be used as a powerful input by financial institutions in designing and valuing credit derivatives.The whitepaper aims at retail and investment banks, treasuries in emerging markets and financial consultants who aim to discover the limitations of standard credit ratings in the context of the sub prime meltdown and henceforth assume a more detailed, mathematically rigorous yet fact-based testable approach to measuring and managing Credit Risk.