Risk-Based Lending
Credit risk management is how lending institutions protect themselves from the ever-present risks of late payments and defaulted loans. Over the past few years, lending programs have shifted their focus to new opportunities and resources that can help boost their performance, lower their risk profile, and enhance their decision-making when serving their customers. Most financial institutions learned a harsh lesson in the downturn that happened in 2008 and have responded by expanding risk management to include more than simply checking an applicant’s credit.
Credit risk management is how lenders prevent non-payment and late payments on their loans. This applies to personal and business loans of all kinds. Credit checks are an obvious first step to managing risk, but many other factors must be considered. High inflation has increased the need for credit management protocols, and lenders need to have this in mind when looking at an applicant’s credit history and creditworthiness.
The 5 C’s of Credit Risk Management for Lenders
The 5 C’s will help you refocus data collection and oversight regarding loan performance. Sometimes, despite the best efforts of your underwriting team, customers who finance loans through you will default or struggle to pay; it’s just part of the process. As a financial institution, you must know the trends behind these difficult loans ad risky client profiles to prevent them from becoming the lion’s share of your portfolio.
Financial institutions commonly use the 5 C’s to determine if a borrower can handle the banking responsibility of the loan and payments associated with it. Even in the case of debt consolidation, borrowers need to be assessed based on their current level of income and their prior credit history. If a lender is only looking at a single factor, loans might be given to borrowers who cannot afford them comfortably — increasing their business’s exposed risks.
The five biggest factors to take into account when considering a loan applicant are:
Character
Considering the applicant’s credit history is a huge factor in mitigating risk when offering loans to customers. Character isn’t about whether or not the loan officer likes an applicant; it’s about the ability of the borrower to afford the loan they’re requesting. The credit file of each borrower will show their ability to manage and use credit wisely.
Some leniency can be given to borrowers who have re-established credit, and there are instances where a lender might be willing to grant a loan based on prior credit performance alone. These exceptions are uncommon but can sometimes be justified when looking at a borrower’s overall credit and financial history.
Capacity
The capacity to pay is a central part of assessing lending viability. If a borrower has many other debts, they might not be a good candidate for a new loan. The borrower’s debt-to-income ratio is the best way to measure their capacity to repay a loan.
Borrowers should not be granted loans that they cannot afford. If their other debts extend beyond the cash available each month after their expenses are paid, they will likely default. Considering capacity is necessary to prevent default and damage to the borrowers’ credit. Financial institutions need to be conscious in their decision-making process to consider what is best for themselves and what is in the interest of potential customers.
Capital
Capital refers to a borrower’s financial resources. This might be money they get each month from retirement, income from a job, or large assets like their home. This is a complicated consideration in some cases, such as when issuing loans for the self-employed. Income and assets can paint a picture of a person’s overall ability to pay, but this is not always the best indicator of creditworthiness.
The income that a borrower brings in each month can vary dramatically, or there could be considerations like unpaid child support or other debts that need to be considered when looking at income. The dollar amount coming into someone’s bank account does not always represent the cash they have on hand for loan repayment.
Collateral
The value of an asset held as collateral impacts what kind of loan you can offer a borrower. You should never extend credit beyond the value of the collateral for any collateral-secured loan. Lenders need to remember that the value of the collateral is the only way to get money back against the loan in the case of default. Loans over the value of the collateral result in significant unsecured risk, equal to the difference between the loan’s value and the collateral’s value.
Collateral value is impacted by depreciation and market shifts. Never assume that a piece of collateral is as valuable as the borrower claims; always have collateral independently appraised or use a valuation tool that provides consistent information about collateral value.
Conditions
When considering making a loan, you will need to consider the loan’s purpose, the loan amount, the interest rate, the repayment period, and any special terms determined through negotiation with the borrower. All of the information you gather during the first stages of the loan process come together to paint a picture of the borrower’s ability to manage credit properly and make payments on time. The loan’s conditions should consider everything you know about the borrower to account for and mitigate any potential risk. Credit risk management combines the 5 C’s to give banks and other lenders a holistic representation of potential customers.
How Can Data Collection Tools Help Improve Credit Risk Management
If you want to remove a significant portion of the human error from this process, the leveraging of analytics is becoming the standard of practice for monitoring and credit risk forecasting. Machine learning and artificial intelligence-based tools are revamping what credit risk management looks like in the era of big data. These tools can help deliver insights into the factors that lead to defaults and transaction risks, helping you assess lending trends within an evolving environment. This is a great way to remove risk factors for business and personal loans and ensure that every application is held fairly and consistently.
Improved data collection and analysis, combined with the 5 C’s, can help keep your default rate and portfolio risk low. Implementing a credit risk management system that builds on powerful analytics simultaneously improves the human component attached to lending.
The Best Credit Risk Management Tool
If you are ready to improve the credit risk management program that you have in place at your institution, GDS Link can help. We offer access to industry-leading data collection and risk identification tools that can help you make better lending decisions. The demand for improved credit risk management processes is growing by the day as global financial trends and factors become increasingly difficult to pinpoint. With the right finance monitoring tools, banks and other lenders can reduce credit risk and better overall portfolio performance.
Contact us today, and start using the best analytics tool you can access.
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