Wednesday, October 10, 2012

Lending Club Loan Amount and Credit Grade: Bad-Loan Experience Index

This post is continuation of last two posts discussing bad loan experience (BLE) index according to Loan Purpose, Loan Length and Interest Rate. In this post, I will review the two loan parameters that I had previously analyzed using default rate: Loan Amount and Credit Grade.

As a refresher, the green color represents loan parameters that has BLE index less than 0.90 and light red color represents loan parameters that has BLE index greater than 1.10. The smaller the BLE index, the better the loan parameter is in reducing the credit risk.

BLE Index for Loan Amount

The first table below shows the calculated BLE index according to loan amount. The second table shows BLE index according to loan amount for years 2007 through 2012. While reviewing the table, we need to keep in mind that loans for amount greater than $25,000 were only started to be issued in 2011.

It appears from BLE index that loan amount on its own may not be so much relevant in reducing credit risk.  This observation is consistent with the findings of 1940 study in NBER publication. That study also found that the amount of loan is not shown to be significantly related to bad-loan experience. Logically, it makes sense because the borrowers' capacity to make payments on borrowed amount (loan amount in connection with income, debt to income ratio, and revolving credit balance) is more likely to be influential on credit risk instead of loan amount.

BLE Index for Credit Grade

I consider credit grade to be a composite parameter developed by Lending Club to rate loans based on the methodology described at Interest Rate and How We Set Them. I expect bad-loan experience to show not only the relationship of credit grade with risk but also effectiveness of Lending Club methodology in assigning credit grade. Now, as the BLE index in the first table below shows, Lending Club does one fine job with credit grade. The smaller the BLE index, the better the credit grade. Also, the second table shows that by 2010 the bad-loan experience is rising with the credit grade. It appears Lending Club has done great job adjusting credit grade with credit risk over the years.

BLE Index for Credit Sub Grade

The two tables below show the BLE index according to the credit sub grade. It is clear that while Lending Club has done good job assigning Credit Grade with credit risk, some more work need to be done to do the same at credit sub grade level.

In general, the Credit Grade A and B appear to have lowest BLE index, i.e. better credit risk profile.

Key Takeaways

  • The BLE index according to loan amount, on its own, is not a good indicator of credit risk. I expect to get better results when loan amount is analyzed in connection with borrowers' income, debt to income ratio and revolving credit balance (to be analyzed in future posts).
  • Lending Club has done good job assigning credit grade according to credit risk; however, more work is required at credit sub grade level.
  • Loans with credit grade A and B have lower risk profile according to BLE index. As discussed in previous post, for other credit grades, lender should consider advantage of eliminating X% of bad loans versus disadvantage of eliminating Y% of good loans.

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