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Measuring Risk on Consumer Instalment Credit

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  • Paul F. Smith

    (Wharton School, University of Pennsylvania)

Abstract

The advantages of statistical measures for grading credit risks in lending to consumers have been widely recognized but relatively little use has been made of such systems. The paper develops a relatively simple statistical method for measuring risk on individual accounts that can also be used for measuring and controlling portfolio quality and for estimating loss rates. The procedure entails four steps: -- Comparison of good and bad accounts in the search for characteristics that are associated with bad accounts; -- Calculation of bad account probabilities for discriminating characteristics; -- Development of a risk index from bad account probabilities to be used in grading accounts; -- Evaluation of the risk index. -- A test of the Method the accounts of a commercial bank is described and the judgements implied by the risk index are compared to the criteria used by interviewers in rejecting applicants. A great many similarities are found between the results of the two methods but a number of striking dissimilarities are observed. The last section of the paper illustrates the ways in which the risk index can be used to adjust credit quality to the desired volume and loss experience. It also demonstrates its use in measuring portfolio quality and in estimating loss rates.

Suggested Citation

  • Paul F. Smith, 1964. "Measuring Risk on Consumer Instalment Credit," Management Science, INFORMS, vol. 11(2), pages 327-340, November.
    • Handle: RePEc:inm:ormnsc:v:11:y:1964:i:2:p:327-340
    DOI: 10.1287/mnsc.11.2.327
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    Cited by:

    1. Igor Livshits & James C. Mac Gee & Michèle Tertilt, 2016. "The Democratization of Credit and the Rise in Consumer Bankruptcies," Review of Economic Studies, Oxford University Press, vol. 83(4), pages 1673-1710.
    2. Kavussanos, Manolis G. & Tsouknidis, Dimitris A., 2016. "Default risk drivers in shipping bank loans," Transportation Research Part E: Logistics and Transportation Review, Elsevier, vol. 94(C), pages 71-94.
    3. Andreas Hoegen & Dennis M. Steininger & Daniel Veit, 2018. "How do investors decide? An interdisciplinary review of decision-making in crowdfunding," Electronic Markets, Springer;IIM University of St. Gallen, vol. 28(3), pages 339-365, August.
    4. Christian Gourieroux & Joann Jasiak, 2015. "Introduction," Introductory Chapters, in: The Econometrics of Individual Risk: Credit, Insurance, and Marketing, Princeton University Press.
    5. Fabián Enrique Salazar Villano, 2013. "Cuantificación del riesgo de incumplimiento en créditos de libre inversión: un ejercicio econométrico para una entidad bancaria del municipio de Popayán, Colombia," Estudios Gerenciales, Universidad Icesi, December.

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