Evaluating credit risk is important for banks or any other business that extends credit to its customers. While some risk is inherent in all types of borrowing, businesses have a vested interest in trying to minimize that risk to acceptable levels. When making credit decisions based on the appropriate level of risk, losses due to non-payment of the debt can be controlled, and the business can remain profitable.
Judgment-Based
Judgment-based credit risk evaluation is a non-automated system for making credit decisions. The judgment-based evaluation is also called manual underwriting. A loan underwriter examines the credit application carefully, and he may verify the information that the applicant provides with other sources. The underwriter examines all the supporting documents that accompany the application for thoroughness and accuracy. He may consult different financial calculations, such as debt-to-income ratios, to determine whether the borrower is capable of paying the bill. In the end, the underwriter makes a loan decision based on his own judgment concerning the credit risks the transaction presents.
Scoring Models
Scoring-based credit risk evaluation is designed to make credit decisions more automatic and less subject to the judgment of an individual who might be biased. A uniform standard for credit evaluation allows consistency in assigning risk to different loans, and it indicates a likelihood of default on a loan. Scoring-based models use information found in retail credit reports to calculate a score according to a proprietary formula. The FICO score is the most common score-based model used to evaluate credit risk.
Business Credit Analysts
Some business credit transactions are less formal and involve a credit manager or analyst making credit decisions for purchases that a business wants to make. While these analysts may use a credit report or application to help with their credit decisions, their decisions may be based on an interview or discussion with the business owner or manager seeking credit. An analyst may consider customer behavior and buying habits, as well as how sensitive to pricing the customer is. Business credit analysts must watch accounts continuously for any signs of trouble that could increase the credit risk.
Other Considerations
Evaluating credit criteria for businesses or individuals allows credit grantors to institute risk-based pricing. If there is a higher risk involved with a transaction, the price of the credit must reflect this to offset potential losses. Scoring-based models also eliminate the possibility of a lender or business being accused of illegal credit discrimination, because the scoring-based model does not take into account criteria that it is illegal for a lender to consider.
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