Customers and Markets: Both are Essential to Credit-Risk Measurement

Abstract

This paper compares credit models that incorporate a market component to those that are solely customerbased. We found that customer-only models understated credit risk during the Global Financial Crisis (GFC)and do not adequately differentiate between industries. Models that focus too heavily on the market canoverstate credit risk in times of high volatility. We recommend a two-factor modelling approach thatincorporates both customer and market risk to improve the accuracy of credit-risk measurement as well asassist lenders with early risk detection.

Keywords

• Banks
• Customers
• Conditional probability of default
• Conditional value at risk
• Credit risk
• Markets