Credit risk refers to the potential loss that a company will experience if a customer does not pay their bill. Companies need to anticipate that some of their customers will default on the credit that has been extended to them. There are a variety of techniques companies can use to manage their credit risk.
Credit Decision Making
Companies generally do not grant credit to every customer who requests it. They decide which customers are riskier than others and extend credit to those customers who are less risky. The company identifies risky customers by analyzing the customer's credit report, which details other credit accounts the customer has open and their payment history. A history of late payments indicates that the customer is more likely to continue paying bills late. The company also verifies employment history and the customer’s current income to determine the customer’s ability to make the payments. After reviewing the credit report and verifying employment, the company decides whether or not to extend credit to the customer.
Lenders and creditors manage their portfolios using objective criteria rather than subjective criteria. A customer requesting credit can appear to be credit worthy and responsible when meeting with the lender or creditor and later miss payments. Using objective criteria requires the lender or creditor to look at the customer’s actions rather than her appearance. The use of objective criteria also helps the company determine the terms of the loan. A higher risk customer pays a premium interest rate for the opportunity to borrow money or receive credit. The higher interest rate charged for riskier customers mitigates the loss incurred when a borrower defaults.
Loss forecasting involves identifying borrower characteristics and using these characteristics to identify potential credit risks. These characteristics include past delinquency rates, charge-offs and income level. Early use of loss forecasting lacked accuracy and more sophisticated methods have evolved. These include seasonal indexing and vintage curve techniques to identify the level of risk with a particular borrower. Seasonal indexing looks at the risk levels of borrowers at various times throughout the year. Vintage cure techniques graph the delinquency rates of credit extended through different time periods.