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On default definition in rating based models for small business

On default definition in rating based models for small business. S.-M. Lin, J. Ansell, G.Andreeva Credit Research Centre, The University of Edinburgh . Small business banking and financing: a global perspective Cagliairi, 25 th May 2007. Outline.

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On default definition in rating based models for small business

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  1. On default definition in rating based models for small business S.-M. Lin, J. Ansell, G.Andreeva Credit Research Centre, The University of Edinburgh Small business banking and financing: a global perspective Cagliairi, 25th May 2007

  2. Outline • Approaches to small business (SME) risk modelling • Data description and approach taken • Predictor variables and their transformation • Different definitions of default • Conclusions

  3. Small business risk • Small business risk shares the features of corporate and retail sectors • Banks that manage small-business-related exposures in a manner similar to retail exposures may apply the less capital requiring retail IRB treatment to such exposures, provided that the total exposure of a bank to an individual SME is less than € 1 Million.

  4. Possible modelling approaches • Corporate models • Merton-type structural models • Reduced-form models • Accounting – based approach • Retail (credit scoring) models

  5. Previous research • There is evidence that small companies experience problems in obtaining credit • Research shows that adoption of credit scoring techniques increases lending to small businesses • Credit scoring has relatively recently been applied to small business lending

  6. Data description • A sample of 445 UK SME from ‘Datastream’ • Oil & Gas, Basic Materials, Industrials, Consumer Goods, Healthcare, Consumer Services, Utilities, Telecommunications and Technology sectors • Annual turnover less than € 50 Million (Basel II definition) • Financial statements available for at least 3 years

  7. Different levels of financial health • ‘Dead’ insolvent companies • Stock-based distress • Insolvency Ratio = Shareholders Funds/ Total Assets = (Total Assets – Total Liabilities)/ Total Assets = 1 – Total Liabilities/ Total Assets • Cash flow-based distress • Interest Coverage = EBITAD/Interest Payable

  8. Levels of Financial Health

  9. Modelling details • Logistic regression • SMEs performance determined at the end of 2004 • Financial ratios from 2001 used as predictors

  10. Financial ratios • Profitability Ratios • Liquidity Ratios • Assets Utilization Ratios • Structure Ratios (Leverage) • Growth Rate Ratios • Cash Flow Related Ratios • Activity (Efficiency) • Employees Efficiency Ratios • Financial Scale

  11. Example of coarse-classification (Cash Ratio)

  12. Different definitions of default • Indeterminate groups are deleted from modelling, Group 1 is modelled as ‘Bad ‘ against Group 4 – ‘Good’; • Leaving all 4 groups in the analysis, with Group 4 defined as ‘Good’, and all other categories considered as ‘Bad’; • Taking Groups 1 and 2 as ‘Bad’ and modelling it against Group 4 as ‘Good’; • Opposing Group 3 (Bad) to Group 4 (Good) with the first two groups removed from the analysis.

  13. Composition of models with different definitions of default

  14. Composition of models with different definitions of default

  15. Conclusions • Default definition has a notable effect on the composition of the models • Most frequent variables are Cash Flow Related, Growth and Employees Efficiency ratios • All default definitions produced prediction better than a random selection • The choice of a particular definition would depend on the prioritisation of objectives

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