Credit Risk Management Practice Exam

Which technique is used to measure scorecard performance in credit risk assessments?

1. Return on investment ratio

2. Review of management decisions

3. Cumulative accuracy profile (CAP)

4. Break-even analysis

The correct answer is: Cumulative accuracy profile (CAP)

The cumulative accuracy profile (CAP) is a crucial technique used to measure the performance of scorecards in credit risk assessments. This method involves plotting the cumulative proportion of good and bad borrowers against the cumulative proportion of total borrowers as you move through the ranked list generated by the scorecard. The resulting curve allows analysts to visualize how well the scorecard differentiates between good and bad credit risks. A well-performing scorecard will have a steep slope, indicating that it successfully identifies high-risk borrowers significantly early in the ranking, while a less effective scorecard will show a flatter curve, suggesting that it fails to distinguish effectively between different levels of risk. This visual representation provides valuable insights into the predictive power of the scorecard, enabling institutions to make informed decisions about lending and risk management. Other techniques like return on investment ratio, review of management decisions, and break-even analysis focus on different aspects of financial performance and are not specifically designed for evaluating the predictive accuracy or performance of scorecards in the context of credit risk assessments.