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Journal of Banking & Finance 21 (1998) 1721±1742

Credit risk measurement: Developments over the last 20 years
Edward I. Altman, Anthony Saunders
Salomon Brothers Center, Leonard Stern School of Business, New York University, 44 West 4th street, New York, NY 10012, USA

Abstractz This paper traces developments in the credit risk measurement literature over the last 20 years. The paper isessentially divided into two parts. In the ®rst part the evolution of the literature on the credit-risk measurement of individual loans and portfolios of loans is traced by way of reference to articles appearing in relevant issues of the Journal of Banking and Finance and other publications. In the second part, a new approach built around a mortality risk framework to measuring the risk andreturns on loans and bonds is presented. This model is shown to o€er some promise in analyzing the risk-return structures of portfolios of credit-risk exposed debt instruments. Ó 1998 Elsevier Science B.V. All rights reserved. JEL classi®cation: G21; G28 Keywords: Banking; Credit risk; Default

1. Introduction Credit risk measurement has evolved dramatically over the last 20 years in response to anumber of secular forces that have made its measurement more

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E.I. Altman, A. Saunders / Journal of Banking & Finance 21 (1998) 1721±1742

important than ever before.Among these forces have been: (i) a worldwide structural increase in the number of bankruptcies, (ii) a trend towards disintermediation by the highest quality and largest borrowers, (iii) more competitive margins on loans, (iv) a declining value of real assets (and thus collateral) in many markets and (v) a dramatic growth of o€-balance sheet instruments with inherent default risk exposure (see,e.g. McKinsey, 1993), including credit risk derivatives. In response to these forces academics and practitioners alike have responded by: (i) developing new and more sophisticated credit-scoring/early-warning systems, (ii) moved away from only analyzing the credit risk of individual loans and securities towards developing measures of credit concentration risk (such as the measurement of portfoliorisk of ®xed income securities), where the assessment of credit risk plays a central role (iii) developing new models to price credit risk (such as the ± risk adjusted return on capital models (RAROC)) and (iv) developing models to measure better the credit risk of o€-balance sheet instruments. In this paper we trace key developments in credit risk measurement over the past two decades and showhow many of these developments have been re¯ected in papers that have been published in the Journal of Banking and Finance over this period. In addition, we explore a new approach, and provide some empirical examples to measure the credit risk of risky debt portfolios (or credit concentration risk).

2. Credit risk measurement 2.1. Expert systems and subjective analysis It is probably fair to saythat 20 years ago most ®nancial institutions (FIs) relied virtually exclusively on subjective analysis or so-called banker ``expert'' systems to assess the credit risk on corporate loans. Essentially, bankers used information on various borrower characteristics ± such as borrower character (reputation), capital (leverage), capacity (volatility of earnings) and collateral, the so-called 4 ``Cs'' ofcredit, to reach a largely subjective judgement (i.e., that of an expert) as to whether or not to grant credit. In a recent paper, Sommerville and Ta‚er (1995) show that in the context of the Institutional Investor's rating of LDC indebtedness (based on bankers' subjective ratings), that: (a) bankers tend to be overly pessimistic about the credit risk of LDCs and (b) multivariate credit-scoring...
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