How do lenders determine your credit risk?

Credit risk management

Credit risk management is the main task of banks and other loan companies. Untimely partial or full non-repayment of a loan or a percentage is one of the main causes of losses of financial institutions.

Credit risk management consists of a number of steps. First, they determine the cost of borrowed funds, formulate principles for working with a credit portfolio, and outline the principle provisions of a credit policy. The next stage is monitoring and a thorough analysis of creditworthiness, as well as work with problem debtors. At the final stage, the analysis of the effectiveness of the work done is carried out.

Determination of credit risk

Credit risk determination is the maximum amount of loss that a bank (lender) commits over a specified time period with a pre-calculated probability factor. Among the common causes of loss is a decrease in the value of a credit portfolio, which occurs as a result of a complete or partial loss of financial solvency of a large number of borrowers.

The concept of a qualitative evaluation involves the collection of the most detailed information about borrowers. Then, on the basis of the data obtained, they analyse the financial stability of a potential client, the liquidity of collateral, business activity and other similar indicators.

If you do not have a credit history, or your credit score is bad, then a bank will determine your credit risk as “high” and may refuse to issue even a £1000 loan. In this case, it is best to contact a loan company and easily take a small loan for your needs. Loan companies respond to your request quickly and make a positive decision.

Credit risk methods

The essence of credit risk methods is their consistent use as stages of the lending process. At each stage, a specific group of employees of a loan company is tasked with minimizing potential credit risks. In this section, the set of sequential methods is considered as a risk management algorithm in the context of a specific loan:

  • Analysis of a creditworthiness of potential borrowers.
  • Credit evaluation and analysis.
  • Structuring a loan.
  • Credit arrangements.
  • Control over the issued loan and collateral.

Credit bank risk

Each loan issuing operation carries a credit risk. For this reason, a multi-level credit risk management system is aimed primarily at reducing the full or partial defaults on borrowed funds. The process takes place in several stages:

  • Determination of a credit score and a financial solvency level of a borrower.
  • Diversification of bank customers by groups, income level, etc.
  • Loan insurance.
  • Formation of reserve funds to cover losses.
  • Organization of a creditor company work, aimed at minimizing credit risks.

Borrower credit risk

The borrower’s interest rate credit risk arises more often than others. This is explained by the fact that the income of each individual client of a loan company is not tied to the size of the established interest rate on a loan.

If the interest rate rises, the amount of monthly payments often reaches critical amounts and accounts for most of a borrower’s income.

Equally dangerous are the currency risks associated with a sharp fall in the exchange rate of a domestic currency. There are frequent cases when, due to the high volatility of currency quotations, borrowers generally lose the opportunity to repay a loan taken earlier.

Credit risk causes

Among the main causes of a credit risk is the lender’s insecurity in the financial solvency and responsibility of a borrower. The event of default and failure to meet the deadline of the loan agreement is possible in the following cases:

  • A debtor is unable to generate the necessary cash flow. This happens due to an unfortunate situation, as well as for economic and political reasons.
  • A lender is not sure of the objectivity of assessing the value and liquidity of collateral.
  • The borrower’s business suffers losses due to common risks in the field of entrepreneurial activity.

Types of credit risk

The most common types of credit risks:

  • Geographic risks are associated with the issuance of loans in a particular region or country.
  • Political risks provoked by the unstable political situation in a state, a high level of corruption in government, reduce the solvency of borrowers.
  • Macroeconomic risks are associated with a decrease in the pace of development of a state economy, a drop in GDP, and a slowdown in the growth of certain sectors of the national economy.

There are also inflationary, branch, legislative and risks of changes in discount rates.

Credit risk reduction

The most common way to reduce credit risk is a limitation. Using a well-thought-out scheme, it is possible to significantly limit the size of estimated losses. The risk level of each loan varies depending on the type of collateral, the intended use of credit funds, and the disbursement period. With the help of limitation, it is possible to limit treasury risks. For example, the effect of the disbursement period is reflected not only on the loan but also on the liquidity of the loan company as a whole, if it is not tied to the period of certain liabilities. Limiting helps to solve the problems of diversification of collateral and borrowers.