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Financial Innovation, Did it really help!

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Bob Litan of Brookings Institution has come out with a very provocative paper   “ In Defence of Much, But Not all Financial Innovation.” Therein he discusses “good vs bad” that has happened with financial innovations.

Kevin Drum at Motherjones has summarized the paper beautifully for all of us who don’t want to give time to understand the details of paper, and intricacies of the argument.

Financial Innovation, Source

Written by SK

March 8, 2010 at 4:00 pm

Aligning Scores

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Past few days, IITs have been in news again. HRD minister Kapil Sibal wants to give weightage to class twelfth performance also for selection.  He wants minimum marks to be eighty percent to qualify for the test.  While this proposal has been topic of hot discussion, I kept thinking about the execution of this proposal from statistical perspective.

The burning question, we all will agree, is that not two board examination is similar in terms of  strictness in awarding marks. While, it’s easier, I mean relatively easier, to get 90% in CBSE and ICSE , it’s next to impossible to get similar marks in a few state boards, like Bihar Intermediate examination.

Now, if we want the screening rule to be unbiased, we need to account for the reality that 80% in one board examination is not 80% in another board examination. This can be done by creating a unbiased methodology to  project all the scores on same axis – that is by aligning the scores of different board examination.

Before getting into the details of approaches to accommodate the bias, let us list down few business scenarios where we might have to do similar task.

Competitor Analysis:

a) An auto finance company gets number of request for refinance of auto loans. In this situation, the company would have data of interest rate charged by previous financier. It would have complete application data and bureau data for the customer. Interest rate charged is function of application data and internally developed risk score based on bureau data.  Now if an auto finance company is able to align its internal risk score with competitors risk score, it certainly has an edge over competitor. The detail will be clear from the paper linked below.

b) A similar problem for insurance company:  Please have a look at this patented method for aligning two scores. It can potentially help company to align the premium it will charge with competitor’s premium. Unfortunately, like all the patent filing document, it’s not very easy to get hold of methodology at one reading. Allow me to digress for a while; but it would be really helpful if law enforces patentee to file an easy- to- understand document along with the usual patent filing. It’s understandable why patentees constructs the claim the way they do, it’s necessary to prove infringement.

There are various examples in competitor analysis domain where we would have to perform similar task. Other scenario could be,  lets say risk team has developed a risk scorecard that is one of the input for pricing. Earlier risk team used traditional FICO score, but in newer model they have used Nextgen score for internal risk scorecard. Pricing team applies rule on FICO score and Internal risk score. With new risk score, pricing team has to apply rule on Nextgen score and internal score, but they don’t have access to Nextgen score of previous customers to reprice them.

Having explained few examples where aligning score is of paramount importance, we have to solve the problem of aligning marks. The details would be there in next post.

Written by SK

October 20, 2009 at 7:05 pm

How to Reform the Credit Rating agencies

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Major credit rating agencies are severely criticized for beautifying the bad credits of financial institutions with AAA ratings that led to financial crisis. There has been lots of discussion on reform of CRAs. There was a round table organized by SEC to examine oversight of agencies. Recently, they met on September and came up with a paper with adopted rule and proposed rule. World bank maintains a page devoted to ideas on CRAs reform. There has been deluge of working papers identifying the loophole in earlier set up, and proposing remedial measures.

The major problem has been the obvious conflict of interest. CRAs are paid by institution who they have to rate, and to attract more businesses CRAs began assigning superior ratings to financial products and institution. A recent paper suggests that CRAs are more prone to inflate rating when there is a larger fraction of naive investors, and reputation risk of getting caught of CRAs is lower.

There has been suggestion like CRAs revenue source should be people who benefit from their service, that is investors. But, due to practical difficulty in implementing a model like this, the idea don’t have much supporter. The second idea that came to fore is, why shouldn’t we have number of small CRAs like equity research teams.  Now, we have only three CRAs, Moody’s, S&P and Fitch rating. The proposed suggestion relies on assumption that number of CRAs will make the market competitive, hence it will become efficient and honest. The concept was correct, but unfortunately it has not worked properly for equity research as well, and retail investors continue to be fed with misinformation.

Another idea is to have rotating raters. It says that every tenth rating  by a CRA would be subjected to back rating. The idea is good, but yet again it adds to complexity and there is a possibility of back rating agencies to be as lenient as first rating agency. Some are suggesting joint liability scheme where if one rating agency is sued and can’t pay investor restitution, then other rating agency should be forced to pick up the tab. They say it will force all three to raise their bar, but few doubt that it would have opposite effect, as rating agencies are getting insured for it’s bad performance.

We have to wait and watch that what are the measures SEC adopts to reform credit rating agencies.

Written by SK

October 9, 2009 at 3:50 pm

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