Building an Expert Judgement Credit Rating Tool for SME and Corporate Banking Customers

Building an Expert Judgement Credit Rating Tool for SME and Corporate Banking Customers

One of the key elements in improving the quality, consistency and efficiency of SME, and wider commercial and corporate banking, is the application of credit analysis and assessment tools. Sometimes called 'credit decisioning systems', these include a wide range of statistical and qualitative approaches. Increasingly these tools are also often demanded by regulators looking to implement improved capital management practices in their jurisdiction. In this case, we are going to take a deep dive into the expert judgement scorecard approach, in its many variations the most popular and practical approach for most commercial banks operating in most markets.

Risk Segmentation: The Foundation of SME Credit Rating

In this post we are exploring the idea of using risk segmentation to form the foundation of our SME credit risk model. Feel free to view the screencast below independently of the body text, as it might add some colour, or compress or substitute some valuable reading and comprehension time. Don’t forget to expand to full screen and watch in HD for best results!

You may recall from previous posts that Industry Sector can be considered the foot of the pyramid in terms of factors when rating a customer. Critically, industry sector analysis should also be at the root of our marketing and risk strategy for the SME market. However Industry Sector analysis, in itself, is not really nuanced enough to develop a truly sophisticated and differentiated approach to risk (and market segmentation).

For example, consider the case where you have an Industry Sector definition for, say something simple and easy to imagine like the ‘Food Service’ industry. Depending on the other parameters defining your SME banking business model, this could include tiny customers like street food or cart vendors (nano- or micro-enterprises), up to and including quite large restaurant or takeaway franchises or chains (perhaps classified as mid-cap or medium-sized enterprises). The risk characteristics of these customers will be very different, despite falling within the same industry sector.

We could just simply use size as an additional segmentation criteria (but what criteria? – turnover, capital, profit, staff or distribution channels), however what about other factors like longevity of the firm, or ownership structure, or some of the many other factors that may contribute to business risk. Rather than ignore them, or build a hugely complex multi-dimensional segmentation model, we have borrowed from Retail Banking marketing strategy somewhat to introduce the concept of ‘Commercial Profile’. The Commercial Profile can be used as an additional vector to be considered in risk segmentation, and will be covered in detail in future posts. It’s worth noting, however, that using Commercial Profiles is also a neat way to dovetail your risk strategy with your marketing strategy for the SME market.

So now we have two axes, Industry Sector and Commercial Profile, which we can assess discretely and combine to form a risk segmentation model, represented by the heat map below:

Remember from previous posts that Industry Sector and Commercial Profile are largely exogenous factors for a firm in the credit assessment process. They are not readily subject to manipulation by the firm itself, as opposed to business risk and financial criteria. For most practical purposes, firms can be allocated to segments based on these risk segmentation criteria, and not expected to shift markedly, at least for a short-medium term credit.

This is important, because it means we can prepare a risk segmentation model independently from the credit assessment process. Indeed, we may want to do this before even embarking on developing or changing our SME banking business model. And this process can be completed centrally, a collaboration between risk management and the SME Banking business, to ensure harmony between the risk and marketing strategies.

Note that the risk segmentation model is also ‘Through-the-Cycle’, and is only reviewed periodically or in the event of some significant problem or change in circumstances. This means we don’t have to complete a separate industry sector risk assessment (or commercial profile for that matter) for each and every customer or credit application. Believe it or not – we have seen some banks that do this! Not only is risk segmentation more efficient and reliable, but also imperative if you want to adopt any sort of portfolio approach to SME credit.

However, so long until next time. Please feel free to comment or email; feedback is gratefully received.