Credit Risk Analysis 2021: Understanding The 5C’s With Data Science
Introduction
What do you mean by credit risk analysis?
Credit risk refers to the uncertainty faced by an organization while lending money to an individual, business, or organization. Credit risk analysis is defined as a detailed review, and inspection done by the lending organization regarding the borrower about their financial background, modes of earning, and the capability to repay the borrowed credit. This gives the lending enterprises a fair idea regarding the credit-paying capabilities of the borrower. In simple terms, credit risk refers to the potential for loss due to the failure of a borrower to make a payment when it is due. The risk is mainly for the lender and it can include complete or partial loss of principal amount, loss of interest, and disruption of cash flow.
Financially exclusive organizations like investment banks, commercial banks, private equity funds, asset management companies, venture capital funds, and insurance companies are the ones that are actively involved in credit risk analysis in order to be able to work with a profit in the market.
- Understanding Credit Risk
- What is the purpose of credit risk analysis?
- What does it take to pursue a career in Credit Risk Analysis?
1) Understanding Credit Risk
Credit risk in layman’s words means the average loss that can be expected out of the transaction from the lender’s end when a borrower is unable to meet the debt commitments. This will majorly disrupt the cash flow into a lending organization.
Types of Credit Risk
- Credit default risk – This occurs in two situations. One when a borrower is unable to pay the entire borrowed sum. Second when his payment is due over 90 days from the actual date of loan repayment.
- Concentration risk – Occurs when the borrower’s area of interest and earning is not diversified.
- Country risk – Occurs when a country bans foreign currency payment obligations
These are the three kinds of credit risks that a leading organization might face. Therefore it is of the utmost importance to have a detailed credit risk analysis of the borrower in order to make an accurate judgment. This judgment or the credit risk analysis of a borrower is made with what is known as the “5 Cs of Credit”. All the aspects of data about the borrower are accumulated, stored, and analyzed here before approving the borrowing sum. The “5 Cs of Credit” are as follows:
- Character – This refers to the creditworthiness of the borrower based on their previous records and repayment history.
- Capacity – The repayment capacity of the borrower is determined by his income, profession, and other probable wealth they might possess.
- Collateral – Here, a borrower needs to pledge an asset as a guarantee in order to be able to receive the desired amount of loan. The amount of loan given out is also determined by the value of the collateral.
- Capital – This refers to the overall wealth that the borrower possesses.
- Conditions – This is the final step of the transaction where specifications of the transaction like the amount leaded, rate of interest, monthly repayment amount, etc is calculated based on the above factors for the borrower.
All the above factors are considered while conducting the detailed credit risk analysis of a potential borrower. The requested credit amount is granted only after it is established that he fulfills all the necessary criteria to be eligible for the particular amount of money requested.
2) What is the purpose of credit risk analysis?
The purpose of credit risk analysis is to determine the creditworthiness of the borrower based on his financial background and repayment history and capacity. It means to determine the eligibility of the person to receive the amount of money he is requesting without causing any kind of complete or partial loss to the lending organization.
Having a credit risk analysis done provides lenders with a complete profile of the customer and an insight that enables them to anticipate customer behavior. By employing various analytics techniques, lenders can save their time, money, and resources to target the right customers and monitor or anticipate the risk involved for a more profitable business.
In recent times the number of people, organizations, and enterprises looking out for credit has increased exponentially. This has resulted in data analytics becoming an integral part of credit risk analysis. Seasoned professionals with expertise in innovative methodologies, capable of deriving the necessary analysis from a tsunami of data are always in demand in the market.
The new methods mainly involve collecting various data of the potential customer and conducting a high-frequency review of the same. It involves analyzing the customer lifestyle and behavioral data to effectively predict the risk level, which is missing in the traditional way of analysis. With analytics techniques, organizations can analyze the risk level for those customers with little to no credit history. This analysis is usually done by a Credit Risk Analyst who works for banks or other companies that are involved in the money lending business. Their major responsibility is to evaluate loan applications and determine who is likely to pay their loans back or access whether it’s a good investment or not.
3) What does it take to pursue a career in Credit Risk Analysis?
The prerequisite for a Credit Analyst involves a good understanding of statistics and the finances involved. An experienced Credit Analyst can work for prestigious financial institutions or can also work independently. Those who are working independently can consult a bank or an organization involved in crediting money. They can also work with the organization to improve customer acquisition. A Credit Analyst can work within varied sectors like Consumer & Retail, Gaming, Healthcare, Insurance, Finance, Media & Telecom, Natural Resources, Banks, Broker and Asset Managers etc. It gives them an opportunity to interact with senior management while enabling them to also do independent research towards the overall assessment.
From the smallest firm to the biggest company, everyone wants to assess their borrowers before issuing a loan. Hence there are immense opportunities in this profession. A person with the right attitude and capabilities can reach great heights and this can be a most enriching career option for those wanting to pursue a career in finance.
Conclusion
Data analytics has begun to make inroads in the field of Credit Risk Analysis. We are seeing companies or organizations using the data at hand along with various resources and programs, to better analyze the risk of their borrowers. Often lenders will employ their own models to assess the customers according to the risk involved and then apply appropriate strategies. An organization might sometimes conduct its own analysis or at times might hire a third-party organization to conduct the process. Either way, conducting a thorough and proper credit risk analysis is of the utmost importance for lending organizations.
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