Extending credit inherently involves a degree of risk; repayment is never assured. Whomever extends credit (a business, bank, individual), a well-structured risk assessment will help minimize potential loss and support the fairness of loan approval decisions. Assessing borrower risk involves evaluating three key elements: the ability of a borrower to make payments, the willingness of the borrower to pay, and the amount of exposure the lender should be willing to place on a single borrower.
The following sections outline a practical framework for conducting a credit risk assessment that can be scaled up to accommodate a variety of uses.
1. Identify Repayment Capacity/Cash Flow
Ability to repay is a critical factor in determining risk. The primary question is whether the borrower has sufficient income to meet the proposed repayment obligation.
Assessing capacity will signal a need to review:
- Income streams which are stable and provide consistent payment history
- Debt-to-Income (DTI): How much of the borrower’s income is already being committed to debt service
- Cash flow timing: Does the borrower receive income prior to when bills are due?
Businesses should assess their ability to collect cash and identify seasonal fluctuations in addition to analyzing their profit.
2. Assess the Borrower’s Credit History/Past Payment Behavior
Historical payment behavior provides insight into how a borrower manages obligations over time. While no single credit report score provides the complete picture of the borrower’s credit history, patterns of past payment behavior are extremely relevant to assessing future risk.
Important credit history factors include:
- Payment history including all types of accounts (credit cards, mortgages, etc.)
- History of delinquent or defaulted payments and the recency of those payments
- How the borrower utilizes available credit and manages credit accounts
The purpose of reviewing historical data is to gain an understanding of the borrower’s behavior and not simply rely upon a credit score.
3. Assess Collateral, Loan Structure/Terms and Risk Controls
In situations where there is greater risk involved in making the loan, structuring the loan is equally important. With better loan structures, the potential impact of a loan default is reduced.
Some common controls include:
- Collateral: Assets that may be used to mitigate loss in the event of a borrower default
- Terms: Shorter loan terms provide less opportunity for the borrower’s circumstances to change
- Down Payments: A down payment demonstrates a borrower’s commitment and results in lower exposure for the lender
- Covenants/Conditions: Establish specific guidelines and/or criteria that will result in a review of the borrower’s performance in the event of a decline in performance.
Risk does not have to be solely “approve” or “deny.” Rather, it can be influenced by structuring the loan appropriately.
4. Determine Exposure Limits and Develop Ongoing Monitoring Systems
Sound lending practices include establishing limits. While even a strong borrower can experience unforeseen difficulties, monitoring allows for protection of both the lender and the borrower.
Establishing exposure limits includes:
- Setting credit limits based on the risk associated with the borrower and their repayment capacity
- Diversification (avoid concentration): Do not lend too heavily to one borrower or to a single industry
- Identifying and responding to early warning signs: Late payments, declining revenues, job loss, increasing debt, etc.
Implementing a continuous process instead of a singular decision provides for a more effective way of managing credit risk.
Conclusion
Borrower risk assessments require a methodical review of capacity, payment history, loan structure and exposure limits. Lenders who establish sound practices focus on assessing a borrower’s cash flow first, followed by utilizing the borrower’s credit history and established risk controls to frame the loan agreement. Ultimately, the most responsible lenders view credit as managed risk and therefore develop and utilize pricing strategies and structure loans accordingly, monitor the borrower’s performance, and maintain exposure within prudent limits to ensure long-term financial stability.