Credit Risk Assessment

Credit risk assessment evaluates a borrower's financial history and track record to determine their creditworthiness and ability to repay the borrowed amount. Through practical assessment, banks, financial institutions, and other organizations tend to manage their credit portfolio and mitigate and reduce potential losses.

The same applies to businesses when involved in trade and transactions. The assessment informs about the customers' reputation regarding credit and paying on time not just once but with a continued ability to do so. Suppose a customer or entity has a bad reputation and a default history. In that case, the borrower can decline to lend funds or offer trade credit to avoid potential loss.

Credit risk assessment is the process of evaluating the level of risk associated with lending to a borrower based on factors such as their historical credit performance, current financial situation, credibility, and willingness to fulfill repayment obligations. This assessment typically falls into two main categories: structural and operational credit risk assessment. Structural credit risk assessment involves analyzing the financial statements and risk factors of the borrowing entity, including weaknesses, to assess its capacity to repay debts. In simple terms, it is a comprehensive process that considers a wide range of factors to strike a balance between risk and return.

Every time an individual or an entity applies for a loan, this assessment can help the lenders conduct a thorough check on them based on their history, credit report, financial statements, income, repayment behavior, credit score, and market and industry trends, which assists the bank in avoiding costly defaults. Without a proper assessment, lenders may face considerable difficulties in serving their customers, which eventually sabotages their market reputation and customer service.

The process plays a significant role in the finance industry as it reduces the risk of default, determines interest rates, and, most importantly, increases the probability. Some of the key benefits that a lender enjoys by employing this assessment are the elimination of financial risks and failures and reduced costs of credit risk management with improved credit decision-making, efficiency, productivity, and better financial planning.

The following are the main components of this assessment -

• Creditworthiness - It is the primary step and the most critical component of this assessment procedure. It involves the evaluation of financial history, credit score, income, number of loans, and repayment behavior, all of which denote the capacity, willingness, and ability of a borrower.
• Industry and economic analysis - When a business or entity requests a loan, the market conditions, economic indicators, regulatory changes, and industry trends are analyzed to understand the potential risks and the companies' ability to generate income and avoid defaulting in tough times.
• Financial statement and stability - When entities are evaluated based on credit requirements, their balance sheet, cash flow, and income statements are examined to measure their actual and future financial health. It includes studying key ratios such as leverage, liquidity, debt, and coverage ratios.
• Collateral and security - Most of the loans sanctioned by banks and financial institutions are secured loans, and therefore, lenders request that an asset be secured as collateral. Now, it cannot be just an asset. Therefore, in this assessment, the nature, value, and vitality of the collateral are also gauged in case it is used to cover the losses if the borrower defaults.
• Risk scoring - This includes historical data, macroeconomic variables, borrower's market reputation, and other factors that help in setting the loan terms, pricing, interest rates, and so on, including the risk mitigation plan.
• Stress testing and management evaluation - This component is like a litmus test for credit portfolios and economic scenarios. It's a dynamic process that seeks vulnerabilities and evaluates the competency of the borrower's management team and their decision-making abilities. It's about preparing them to face challenges and navigate through ups and downs to meet financial obligations.
• Risk mitigation and regulatory compliance - This component specifically deals with setting appropriate loan rules, repayment schedules, and risk tolerance levels so that all the risk factors are checked and effective risk mitigation strategies can be implemented. It goes hand in hand with regulatory compliance. It involves industry standards, legal requirements, KYC rules, and legal structures.
• Ongoing monitoring - This refers to the timely monitoring of borrowers' financial health and growth to ensure they are in proper conditions, thus enabling proactive measures such as loan restructuring, collateral liquidation, and covenant enforcement.

Let's understand the concept with the help of some real-world and hypothetical examples.

Example #1

Suppose Joseph owns a small bottling plant. He is looking to expand his business in terms of manufacturing and distribution. For this, Joseph has looked at land and other machinery and equipment but needs more capital. He applies for a business loan. The bank manager reviews his application and sends it to the loan department, where a team of risk assessment officers goes through his entire history, records, type of business, amount requested, and market reputation of Joseph, including his different financial ratios such as debt service coverage ratio, credit rating, history and credit score that the credit bureau sources.

The entire process is initiated to understand that if the bank sanctions him the loan, is the level of risk associated with it. Finally, after verifying Joseph's creditworthiness along with his ability and willingness to repay the loan, the bank approves the loan. It is a simple example: in the real world, there are many aspects considered, many documents required, and it can take a reasonable amount of time.

Example #2

As per the news in September 2021, artificial intelligence is used to perform credit risk assessments. The US consumer debt was already beyond the $14 trillion threshold. Hence, AI was introduced in this process to boost the bottom line and avoid costly defaults, enhancing better credit risk screening.

The traditional portfolio analysis is no longer viable to understand the complex factors that impact credit risk. It is one of the core reasons why lenders are using a more holistic approach to assess borrowers' financial health. Doing so converts vast volumes of real-time customer behavioral financial data into valuable insights.

Understanding the main distinguishing factors between this concept is critical for evaluating a borrower's creditworthiness effectively.

• Credit risk assessment is a systematic process aimed at evaluating the creditworthiness of individuals or entities. In contrast, a credit score is a numerical representation indicating a borrower's credit reputation.
• Typically, credit risk assessments are conducted by bank managers, risk managers, and product heads. Conversely, credit scores are derived from credit reports maintained and provided by credit bureaus.
• A comprehensive credit risk assessment involves examining the borrower's credit history, credit report, and credit score. Therefore, a credit score forms a part of the overall assessment process.
• While credit risk assessment assesses the level of risk associated with lending to a specific individual or entity, a credit score primarily reflects an individual's credit history, guiding lenders in making further decisions.