Question

finance discussion: discuss the relative merits between credit risk modeling and qualitative analysis (human judgment). What is the danger of relying too much on models? How important is it to have a balance?

Answer 1

Before diving into the relative merits of Credit Risk Modeling and Qualitative Analysis, let us first glance at what these terms are:

Credit Risk Modeling: It involves methods through which lenders get to know the possibility of repayment of their loan. There has been a growing need to evaluates quantitatively the potential risk in lending as there has been a surge in lending or banking activity due to high capital expenditure, meeting working capital requirements, and much more.

Qualitative Analysis: These involves analysis done with the help of judgement based on various factors such as relation with stakeholders, business cycles, expertise of the management team. At times it can also make the borrower unbiased due to brand recognition and credit reputation in the market.

Advantages/ Merits:

1. Both of the methods allow the users to forecast and predict the the potential risk factor involved in entering a transaction.

2. Even though credit risk is leverage on numbers while qualitative is more judgment based, They both can help in understanding the level of lending activity taking place at a present int of time.

3. Credit Risk Modeling is a more standardized form. It is more universally accepted as full proof method in prediction, forecast and measurement of risk element.

Danger in relying too much on Models

However relying too much on models can be limited if confined to themselves while evaluating a transaction.

1. Models is all about numbers. Numbers are absolute. However in reality, situations need personal judgement.

2. The process of modeling can be costlier and time consuming as well.

3. There are many ways of ascertaining through models but the companies must resort to one when evaluating a transaction.

4. Sudden shifts due to psychological factors cannot be answered by models but it can be tackled if the person is experienced and uses his judgement to make decisions.

5. By their very nature, Modeling can become too complicated for people. The degree of complication can rise with the increase calculations, factors that affect the loan repayment ability (external factors).

Importance of Balancing between Modeling and Qualitative Analysis

Credit Risk Modeling and Qualitative Analysis both go hand in hand. Modeling overcomes certain drawbacks of qualitative analysis like lack of measuring, communication errors due due to misleading qualitative statements and assumptions, finally comparison is more easier when data is quantified. While the model creates a structure and gives absolute numbers as output. Qualitative analysis provides reasoning to those factors which cannot be identified nor quantified like trends, fad, and even cultural shift. there should be a synergy in using both methods to find the potential lending risk in a transaction.