Credit risk measurement: Developments over the last 20 years

Credit risk measurement: Developments over the last 20 years Edward I. Altman, Anthony Saunders * Salomon Brothers Center, Leonard Stern School of Business, New York University, 44 West 4th street, New York, NY 10012, USA Abstractz This paper traces developments in the credit risk measurement literature over the last 20 years. The paper is essentially divided into two parts. In the first part the evolution of the literature on the credit-risk measurement of individual loans and portfolios of loans is traced by way of reference to articles appearing in relevant issues of the Journal of Banking and Finance and other publications. In the second part, a new approach built around a mortality risk framework to measuring the risk and returns

on loans and bonds is presented. This model is shown to oC128er some promise in analyzing the risk-re- turn structures of portfolios of credit-risk exposed debt instruments. 1998 Elsevier Science B.V. All rights reserved. JEL classification: G21; G28 Keywords: Banking; Credit risk; Default 1. Introduction Credit risk measurement has evolved dramatically over the last 20 years in response to a number of secular forces that have made its measurement more Journal of Banking & Finance 21 (1998) 1721–1742 * Corresponding author. Tel.: +1 212 998 0711; fax: +1 212 995 4220; e-mail: asaun- der@stern.nyu.edu. 0378-4266/97/$17.00 1997 Elsevier Science B.V. All rights reserved. PII S 0 3 7 8 - 4 2 6 6 ( 9 7 ) 0 0 0 3 6 - 8 important than ever before. Among these forces have been: (i) a worldwide structural increase in the number of bankruptcies, (ii) a trend towards disinter- mediation by the highest quality and largest borrowers, (iii) more competitive margins on loans, (iv) a declining value of real assets (and thus collateral) in many markets and (v) a dramatic growth of oC128-balance sheet instruments with inherent default risk exposure (see, e.g. McKinsey, 1993), including credit risk derivatives. In response to these forces academics and practitioners alike have responded by: (i) developing new and more sophisticated credit-scoring/early-warning sys- tems, (ii) moved away from only analyzing the credit risk of individual loans and securities towards developing measures of credit concentration risk (such as the measurement of portfolio risk of fixed income securities), where the as- sessment of credit risk plays a central role (iii) developing new models to price credit risk (such as the – risk adjusted return on capital models (RAROC)) and (iv) developing models to measure better the credit risk of oC128-balance sheet in- struments. In this paper we trace key developments in credit risk measurement over the past two decades and show how many of these developments have been reflect- ed in papers that have been published in the Journal of Banking and Finance over this period. In addition, we explore a new approach, and provide some empirical examples to measure the credit risk of risky debt portfolios (or credit concentration risk). 2. Credit risk measurement 2.1. Expert systems and subjective analysis It is probably fair to say that 20 years ago most financial institutions (FIs) relied virtually exclusively on subjective analysis or so-called banker ‘‘expert’’ systems to assess...

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