Earthquakes and Credit Risk – Prediction and Preparation

February 15, 2011 by Kelly Kent

I love a good analogy, and living in Southern California, lately I’ve been thinking a lot about earthquakes, and how lenders might want to start thinking like seismologists when considering the risk levels in their portfolios.

Currently, scientists that study earthquakes review mountains of data around fault movement, tidal forces, even animal behavior, all in an attempt to find a concrete predictor of ‘the big one’. Small tremors are inputs, but the focus is on predicting and preparing for the large shock and impact of large earthquakes. Credit risk modeling, conversely, seems to focus on predicting the tremors, (risk scores that predict the risk of individual default) and less so the large-shock risk to the portfolio.

So what are lenders doing to forecast ‘the big one’? 

Lenders are building sophisticated models that contemplate the likelihood of the big event – developing risk models and econometric models that look at loan repayment, house prices, unemployment rates – all in an attempt to be ahead of the credit version of ‘the big one’.  This type of model and perspective is at a nascent stage for many lenders, but like the issues facing the people of Southern California, preparing for the big-one is an essential part of every lender’s planning in today’s economy.