Credit Scoring - Assignment Example

CREDIT SCORING Definition: Credit Scoring is a management technique used by banks to reduce credit risk. Credit risk is the risk that a borrower could default in fulfilling his financial obligation to service his debt on time. There can be a number of reasons why a borrower may not have made payments, but once a certain period of time has elapsed, the default becomes a non performing loan. The non-payment record will then become a part of the borrower’s credit history. Once it becomes part of the credit history or credit record, it is available to be used during the formulation of the borrower’s credit score. This has adverse effects on the financial institution such as insolvency and therefore banks employ the 5 C’s of Credit Scoring to evaluate whether or not a person should be entitled to a loan. The 5 C’s are based on the characteristics of the borrower and are explained in detail as follows. Character- The bank seeks basic information from the borrower such as his trustworthiness, integrity, work, reputation based on previous history with lenders, any defaults. Some of this information could be accessed easily through credit reports. A credit report is a report generated by the Credit Reference Bureau detailing information on a person’s credit history including identifying information, credit accounts and loans, bankruptcies, late payments and enquiries. Because credit history shall make up the biggest percentage of a borrower’s eventual credit score, it makes sense that he focuses his attention on that factor. This helps evaluate whether he is credit worthy. Capital- The borrower’s equity or net worth is checked in comparison to the amount he so wishes to borrow. If the capital invested is way below the amount borrowed, then that could raise red flags in his ability to repay the loan. Capacity- The borrower is gauged on his sufficiency of yielding positive cash flows during the loan repayment period and the amount is pre-calculated using different analysis criteria such as the Net Present Value, Profitability Index. If he passes this stage, he has to provide a credible plan on his willingness to repay his loan when it’s due. Conditions- Economic conditions dictate whether a loan should be granted to a borrower. For instance, in periods of economic recovery or boom, it is safe for a borrower to be granted a loan because chances of him defaulting are minimal. However, in the recession period, it’s most likely that the borrower will not be in a position to fully settle his obligations and therefore banks would be hesitant to grant a loan to the borrower in such times. Collateral- These are assets that act as a security for the loan. It acts as a back-up plan in that incase the borrower defaults in his repayment, the lender can always sell or acquire the assets to settle the obligation. If a borrower has collateral say land, building, machinery or any other valuable asset, then the banks can easily grant a loan as opposed to where the borrower has no collateral at all. Credit Scoring could be employed by commercial and retail banks in order to reduce the incidence of loan defaults. A loan default is when a borrower has not made payments in accordance with the terms agreed upon with the lender. Specifically, they can employ the following measures: Securitization- Simply put, this is repackaging of loans and selling them on the secondary market. It refers to the ability and practice of commercial and retail banks to tap into the bond market, commercial paper and equity market directly without the help of intermediaries. It could also refer to the process through which the existing liabilities created by bonds and commercial papers or the borrower himself are sold or removed from the balance sheet through funding by other investors. This reduces the incidence of loan defaults by commercial and retail banks. Credit Limit- Commercial and retail banks could minimize the incidence of loan defaults from their borrowers by easily setting up a credit limit. This is the maximum amount beyond which a bank is not allowed to lend to any borrower. A new customer’s credit limit should be fixed at a low level and only increased if his payment record subsequently warrants it. Commercial and retail banks could devise a credit rating system for new and existing borrowers based on their characteristics say whether the customer is a home owner, his age or occupation and points awarded according to those characteristics. The amount of credit to be offered will therefore depend on his credit score. This way, the banks will ensure that they only offer credit with reasonable amounts to potential credit worthy clients whose chances of default are low. Portfolio Diversification- Commercial and retail banks could “pool their risks” over different borrowers and deposits in different consumers, sizes, industries, local and international locations to increase predictability of default. While diversification is holding of two or more securities for purposes of reducing risk, portfolio can be defined as a combination of assets held by an investor, in this case the commercial and retail banks, instead of investing in say shares of a company alone, they can opt to invest in a portfolio [combination] of shares thereby managing risk through diversification. Credit scoring can assist commercial and retail banks in identifying opportunities to purchase a large mix of assets or instruments, services or practices thereby reducing credit risks enabling them to withstand potential defaults in future. Stress Testing- This focuses on credit risks in commercial and retail banks with particular emphasis being on a sharp increase in credit risk, rapid movement in interest rates, rapid depreciation of exchange rates or collapse in asset crisis. Credit scoring helps Stress testing reduce incidence of loan defaults by employing these three techniques; 1. Scenario analysis- In this case the banks conducts some scenario based on specific cases such as economic growth, volatility of interest rates and how these scenarios can affect the lending/borrowing rates affecting the earnings of the banks in future. 2. Value at risk method-This is a qualitative measure of the value of the banks visa vis the credit risk at hand. The earnings, capital liquidity or asset quality of the commercial and retail banks are tested against their risk of facing a certain contingency level. 3. Financial Ratios- These are prepared by commercial and retail banks and compared with industrial standards. This also includes trend analysis [over time] and cross-sectional analysis when compared with other financial lending institutions. Credit Information Sharing-Theoretical studies have demonstrated the importance of Credit Information Sharing in mitigating the effects of adverse selection, moral hazards and over lending insisting that information sharing lowers default rates for individual borrowers. Credit Information Sharing is a process where lenders and other credit providers submit information about their borrowers to a credit reference bureau so that it can be shared with other credit providers thereby enabling the lenders to know how borrowers repay their loans. Adverse selection occurs before a transaction is undertaken, where investors such as banks do not have adequate information to distinguish between good and bad borrowers. However, banks can consult Credit Reference Bureaus for individual borrowers and Credit Rating Agencies for firms who act as financial intermediaries to solve the problem of asymmetric information. Moral hazard refers to the problem after the transaction has occurred in that borrowers may not invest wisely thereby increasing default risks. This can be solved by monitoring the borrowers’ activities by having a representative of the lending institution as a board of director. Assessing Credit Worthiness- Credit control involves the initial recognition of potential credit borrowers and the continuing control of outstanding accounts. The main points to note are that; 1. New customers should give two good references, including one from a bank before being granted credit. 2. Credit Ratings must be checked through a Credit Rating Agency such as Standard and Poor’s or Moody’s. 3. For large value customers, a file should be maintained of any available financial information about the customer and the file reviewed regularly. Information should be available from an analysis of the company’s annual reports and accounts. 4. The department of Trade and Industry and the Export Credit Guarantee Department will both be able to advise on overseas companies. 5. Press comments may give information about what a company is currently doing as opposed to historical results in published accounts which only show what the company has done in the past. 6. Commercial and retail banks could send a member of staff to visit the company concerned to get a first-hand impression of the company and its prospectus. This would be advisable in the case of a prospective major customer. The effectiveness and robustness of credit scoring as a risk management technique can be critically evaluated as follows. Effective use of credit scoring can be defined as how well credit scoring is being used to achieve its primary objective, the objective being reduction of credit risk and minimal cases of defaults. Credit scoring is of significance importance because it determines who qualifies for a loan, at what interest rate and with what credit limits. Most importantly, if used effectively as a credit risk management technique, commercial and retail banks can benefit from the following; 1. Control risk selection- 2. Manage credit losses- 3. Evaluate new loan programs- 4. Ensure that existing credit criteria are sound and consistently applied- 5. Improve profitability- However, the use of credit scores has its own limitations, for example 1. Credit scores do not account for situational factors such as local economic conditions or business cycles peaks and troughs. 2. The application of portfolio theory has its own assumptions that may not be practical when diversifying risks; a. Identifying a market portfolio by commercial and retail banks could be a problem as this requires knowledge of risk and return of all risky investments and their corresponding correlation coefficients. b. Even if the market portfolio is identified, it would be expensive to consult because of the transaction cost. These transaction costs would be prohibitive in case of small investors such as retail and commercial banks. c. The composition of market portfolio will change over time. This could be as a result of a shift on risk free rate of return, the envelope curve and hence the efficient frontier. d. It is unrealistic to assume that investors can borrow at risk free rate individuals and companies are not risk free. They will therefore not be able to borrow at free risk rate as they will be charged a premium to reflect their higher level of risk. 3. When setting the credit limit, bad credit history of the applicant could be a limiting factor to the amount for which he is granted a loan. This disregards an assumption that bad credit history can actually be repaired by a borrower paying his bills on time, paying down his current debts, keeping his credit balance within his limits to avoid becoming over indebted, avoiding too many inquiries for new loans posted on his credit report which can give lenders the impression that he is desperate and risky, keeping personal and business finances separate. Adherence to such high standards when selecting who to grant credit would lock out potential applicants and in the long run reduce the profitability of the financial lending institution. In conclusion, it is evident that credit scoring plays an important role in selecting good risks in consumer lending as the benefits outweigh the costs by far and hence it is advisable that all financial lending institutions make good use of credit scoring before advancing a loan to any of their potential applicants. It’s also necessary that they seek information from reliable credit reports because credit history is important for future lending decisions. The longer the credit history, the more useful the credit report. For good payers, a detailed credit report becomes a good collateral to lenders. Read More