Modelling the credit risk for portfolios of consumer loans: Analogies with corporate loan models

The Internal Ratings Based (IRB) approach suggested in the New Basel Accord regulations (BIS 2005) uses a capital allocation formula derived from a Merton style structural model of the credit risk of portfolios of corporate loans. Yet this formula is being applied in the case of consumer loans as well as corporate loans. This has highlighted that although there are a number of well established credit risk models for portfolios of corporate loans which are widely used by financial organisations, there are no such established consumer credit risk models for portfolios of consumer loans. This is surprising given that modelling the credit risk of individual consumer loans,-credit scoring – has proved the underpinning that allowed the phenomenal expansion in consumer lending over the last fifty years. The need for models of the credit risk of portfolios of consumer loans is clear for capital adequacy provisions, where the Basel New Accord describes the regulatory capital needed, but banks themselves need similar models for economic capital provisioning. It is also needed to support the pricing estimates when such consumer loan portfolios are securitized. There appears to be a disconnect between the models of credit risk of portfolio of consumer loans needed for these more recent portfolio level decisions and the widely used credit scoring model of the credit risk of individual loans which have long been used for acceptance and operating decisions. So is it possible to develop new models for estimating the credit risk of portfolios on consumer loans? In fact it may be easier to get a modified or reinterpreted corporate credit risk model accepted by the industry than to develop completely new consumer loan credit models. In this paper we investigate possible approaches to consumer credit risk models , which build on the existing credit scoring knowledge but have parallels with the corporate models.