The advent of the economic crisis caused some core beliefs in traditional risk management to be tested. We had our very own stress test, not just of the portfolio but also of the tools used to manage that portfolio.
As our models came under stress, regulators changed the rules that govern business practices for many common personal financial products and services, and in turn started to ask more questions about the creation and governance of the modelling process.
We are all familiar with the observation that models tended to under-predict risk as the crisis unfolded. Ranking held up well, but the rating side of the models didn't do so well. All of these events rekindled interest in the relationship between the macro economy and credit risk.
While many factors can influence risk outcomes, a major contributor of late has been the state of the economy and predictions for its future state. Of course this isn't new, but the crisis has forced risk managers to think about the problem more explicitly than in the past.
This is a problem area that FICO has been thinking about for a while, as I recently discussed in American Banker, and it's one we are working on with clients across three continents.
So what's the solution? Creating a framework in which a lender can apply various assumptions about the future values of key economic variables, and then transform those inputs into an understanding of future default risk for any given score.
The technical challenge is separating the impact of the economy on the intercept and slope of the performance chart. Having solved that problem, we are now in a position to provide guidance to clients on how to model future risk and how that plays into their risk strategies.
When the crisis started, the challenge was to contain risk. By and large, this was done by simply shutting down originations, closing accounts and stopping credit line increases. As the economy improves, lenders will need a smarter approach when it comes to relaxing credit policy. That requires thinking through the impact of the macro economy as they make those decisions, and not returning to pre-crisis business as usual.