Credit Risk

Banks lose billions of dollars annually due to overdue loan payments. 

According to current analytical data, in the U.S. in the second quarter of 2023 alone, credit institutions have incurred $19 billion in losses – this amount has been written off as unrecoverable.

To reduce losses, credit organizations resort to assessing the risk of their credit portfolio and building an effective credit risk management strategy.

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What is credit risk?

Credit risk is the probability of financial losses of a credit organization as a result of a borrower's failure to meet its debt obligations.

In other words, this concept is related to the risk that the creditor will not be able to receive the amount of the loan and interest on it, which will lead to a decrease in the income of the financial company and the appearance of new costs – to collect the debt.

A lender cannot predict for sure which borrower will default on a loan. However, proper risk management can reduce the likelihood of credit default.

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The impact of credit risk on the decision on a loan application

The degree of credit risk directly affects the decision to approve a loan and the terms of the loan.

According to Bankrate, the number of loan application rejections is directly related to the degree of credit risk, as determined by the borrower's credit score.

Applicants with Exceptional credit scores (800–850 points) and low credit risk are rejected in only 29% of cases. Whereas borrowers with a high level of risk, as evidenced by a low credit score (300–579), are refused credit 2.5 times more often.

To reduce the level of credit risk, the lender may request additional guarantees of debt repayment from the borrower. For example, collateral or a guarantor may be a prerequisite for granting a loan.
Credit products for high-risk borrowers are not characterized by the most favorable terms. They may be offered higher interest rates, a large down payment or a short repayment period.

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Credit risk assessment

Traditional financial institutions use such indicators to measure credit risk.

1. The borrower's credit history. It includes the consumer's payment history on previous loans taken, types of credit products used, date credit accounts were opened, credit utilization ratio and other financial information.
2. A person's ability to pay. This indicator is primarily determined by the ratio of a person's total assets to liabilities.
Consider the financial stability of the person. That is individual ability to make payments on financial obligations in the long term. For example, the stability of the applicant's employment and income is considered.
3. The applicant's credit rating. This is a numerical expression of a person's creditworthiness, with the help of which the creditor assesses the likelihood of timely repayment of the debt.

One of the most popular credit rating models is FICO. It involves assigning borrowers a score between 300 and 850. Where 300 is the lowest credit score, which indicates a high risk and virtually zero probability of a loan being granted, and 800 is the maximum score, which indicates that the borrower is highly trustworthy.

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Limitations of traditional credit risk management

Traditional banking institutions consider only financial information about the borrower when assessing credit risk. This places some limitations on the method for several reasons:

• According to the World Bank data, 1.4 billion people in the world do not have access to banking services. Consequently, they have no credit history and rating on the basis of which the degree of credit risk can be objectively assessed.
• According to ExplodingTopics statistics, 46.6% of the world's working population is engaged in freelancing. That is, they work for themselves without having a confirmed source of income.

This does not allow the borrower's solvency to be analyzed when assessing credit risk.

Role of alternative data in credit risk management

The solution to the above problem for modern credit organizations lies in the use of alternative credit risk data – information about borrowers that goes far beyond the traditional credit history and rating.

This approach to risk management allows the lender to gain certain advantages:

• Expansion of the target audience. The credit organization has an opportunity to lend to categories of population without credit history and official employment.
  

• Optimization of risk management. The use of alternative data allows the digital credit scoring system to provide the lender with hundreds of data points about a potential borrower. This gives the lending organization a comprehensive view of the borrower's reliability.

• Effective fraud prevention. Modern scoring systems provide their clients with various tools for highly accurate verification of applicants. This makes it possible to recognize fraud at the stage of considering a loan application.

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What is the definition of credit quality risk? 

It is the risk that the borrower will default on the loan and cause a loss to the lender. 

The degree of credit risk directly affects the likelihood of granting a loan and the terms of lending. It can also be reduced by using alternative data for credit scoring.