Just How do Banks Measure Credit Risks Today?
Banks earn profit from the interest rates they charge on the loans they give out to debtors. But how do banks measure credit risks then?
When you are in dire need of cash, the first alternative that pops in your mind would be to go to the bank or another type of lending institution to take out a loan. This is the fastest possible way for you to get cash, on top of turning to your relatives for the needed funds, of course. Still, it is not too wise to mix financial matters with family because this can be a very touchy matter all on its own. Thus, it would be so much better to just go to the bank and take out a loan. However, not all loan applicants are approved. This is because banks have their own system of determining and computing their losses in case their debtors would choose to default their loans. This system is termed as credit risk measurement. More importantly, if you are planning to take out a loan, then it helps to know this system. So, how do banks measure credit risks?
In reality, this system varies from one bank to the next. Over the past few years, banks and even lending institutions have been developing model after model to improve their system in determining credit risks. After all, the fate of their business relies on the hands of these debtors, and should most of them choose to default, then the bank itself might end up going bankrupt. Another sad reality here is that there are just too many debtors who end up defaulting on their loans. Thus, it has become a must for bank regulators and the like to impose stricter rules and standards for their own system.
There are three factors to consider when banks are out to determine potential financial risks amongst the many debtors at hand. These are probability of default, exposure of credit, and estimated rate of recovery.
Probability of default, as the name suggests, pertains to the possibility that the debtor would fail to pay his loan during the period that has been arranged in the contract. In determining this, you also need to determine projected default rate – the computation for that particular year.
Exposure of credit, on the other hand, pertains to just how big the overall debt would be should the debtor choose to default his loan. You have to understand that on top of the amount loaned, there are interest rates to be computed as well. After all, it is through the interest accumulated that the bank would earn its profit. Thus, this has to be included in the computation.
Estimated rate of recovery pertains to that portion of the debt that can still be regained if ever the debtor chooses to default. This can be in the form of the freezing of the debtor’s assets so that the bank can still go after those. This could also be in the form of collateral.
Apart from these factors, banks also obtain the credit scores of their potential debtors. The debtor’s billing statements as well as income statements are evaluated so that an apt credit score can be determined.
So, how do banks measure credit risks? With all these factors, it is clear that the whole process can indeed be complicated. Better keep these factors in mind when you are considering taking out a loan with your bank.
