CREDIT RISK ASSESSMENT AND THE OPPORTUNITY COSTS OF LOAN MISCLASSIFICATION

This paper investigates the opportunity costs of loan misclassificatio n in credit risk assessment, and develops a model that directly incorp orates the opportunity costs of loan misclassification into the risk a ssessment criteria. The performance of this model is assessed by compa ring the empirical results with the results of the legit credit scorin g model using data provided by the Farm Credit Corporation of Canada. Results indicate that if both the models make a Type I and Type II err or with a $1-million loan, the expected costs of error would be $600 a nd $6,500 legs, respectively, in the cost minimization model compared with the legit model. The expected lenders's profit for a $1-million l oan would be $17,000 more in cost minimization model compared with the legit model. The cost minimization model performed better than the le git model, both in prediction accuracy and also in reducing the costs associated with the errors in classification.