Measuring credit risk is an essential component in consumer, commercial, and corporate lending. Risk mitigation, as it's sometimes called, can be difficult when reviewing high-finance institutions, but by having certain parameters and guidelines established, the process becomes easier.
How to Measure Credit Risk
Learn how consumer credit works. Consumer loans are made almost entirely based on credit scores (FICO) and income. If an individual borrower's FICO score is high enough (720+ nearly guarantees approval with supporting income) and the income supports the new loan, a lender nearly always grants a loan.
Learn the essentials of credit-risk management for bigger institutions. The first tenet is called Probability of Default. Credit Risk measurers (sometimes called Risk Managers (or RMs) look at a potential borrower's credit history. Based on similar and dissimilar loans in their credit history, RMs can accurately determine if and when a borrower will default on a loan -- sometimes to the exact month. Probability of Default helps lenders determine if they should make the loan and if so, when they should dump it or sell it off.
Learn what Exposure of Credit means. This principle is fairly simple. Basically, RMs look at a potential debt extension and its size, and determine the potential effects on the lending company if the debt becomes delinquent. This comes into play with very large business loans (in excess of 50 million). RMs must be quite careful to analyze the potential impact of the disintegration of a large debt -- if a company is not well-capitalized, a large default can spell trouble.
Learn what Estimated Rate of Recovery means. The concept outlined in step 3 and this step work in concert with one another. If, for example, an RM deems a large debt a poor credit risk based on its Exposure, the loan's Estimated Rate of Recovery may outweigh the risk of its Exposure. Essentially, the assets (liquid and non-liquid) must be reviewed carefully and thoroughly as potential collateral in case of default. If the value of such assets matches the value of the debt, credit may be extended.
It's important to remember that credit risk measurement is not an exact science and anomalies exist -- granting approval to a borrower is always a risky proposition. The goal of the lender is to most accurately determine how risky a transaction it is.
- It's important to remember that credit risk measurement is not an exact science and anomalies exist -- granting approval to a borrower is always a risky proposition. The goal of the lender is to most accurately determine how risky a transaction it is.
Based in Eugene, Ore., Duncan Jenkins has been writing finance-related articles since 2008. His specialties include personal finance advice, mortgage/equity loans and credit management. Jenkins obtained his bachelor's degree in English from Clark University.