Credit risk management is a cornerstone of any financial institution’s operation. Central to this task are two key techniques: credit scoring and risk assessment. A blend of data analysis, financial intuition, and predictive modelling, these methods help banks decide who to lend to, how much, and under what terms. But what exactly are these techniques? And how are they applied in the real world?
Understanding credit scoring techniques
Credit scoring techniques are data-driven algorithms that quantify the risk of lending to a particular borrower. They weigh factors like credit history, current debt, payment behaviour, and more to calculate a score reflecting the borrower’s creditworthiness.
Credit scoring techniques help lenders determine the creditworthiness of borrowers. On the other hand, risk assessment techniques are used to evaluate the likelihood of default and the potential loss resulting from a loan.
The key differences between credit scoring and risk assessment are the following:
- Scope of evaluation: Credit scoring focuses solely on a borrower’s credit history, while risk assessment considers a broader range of financial factors.
- Methodology: Credit scoring relies on standardised algorithms to assign numerical values to borrowers, while risk assessment can involve more subjective factors, such as the borrower’s character, that are not easily quantified.
- Purpose: Credit scoring predicts the likelihood of default, while risk assessment determines loan terms.
In general, credit scoring is a faster and more efficient method, but risk assessment provides a more comprehensive and accurate evaluation of a borrower’s creditworthiness. Lenders often use both approaches to make informed lending decisions and to bolster their credit risk management strategies.
Credit scoring system in Australia
The credit scoring system in Australia uses a numerical score calculated based on information in a credit report.
There are three main credit reporting agencies in Australia:
- Equifax
- Experian
- illion
Each of these agencies uses its own credit scoring mode, but they all use similar factors to calculate credit score. The factors most commonly used to calculate credit score in Australia include the following:
- Payment history: Lenders look for a history of making payments on time when determining credit score. This is the most important factor.
- Amount of debt: Lenders want to see that the individual isn’t overextended. A high debt-to-income ratio can lower credit score.
- Length of credit history: Lenders want to see that the borrower has a long history of managing credit responsibly.
- New credit inquiries: Lenders may be concerned if an individual has made a lot of credit inquiries in a short period. This could indicate that they’re looking for more credit than they can afford.
- Public records: Lenders will also consider any public records on a credit report, such as bankruptcies or defaults.
Credit score is typically between 0 and 1200. A higher score means you’re a lower-risk borrower and are more likely to be approved for credit. A lower score means you’re a higher-risk borrower and may have difficulty getting approved for credit.
Credit ratings in Australia are as follows:
Equifax:
| Excellent | 853–1200 |
| Very good | 735–852 |
| Good | 661–734 |
| Average | 460–660 |
| Below average | 0–459 |
Experian:
| Excellent | 800–1000 |
| Very good | 700–799 |
| Good | 625–699 |
| Fair | 550–624 |
| Below average | 0–549 |
illion:
| Excellent | 800–1000 |
| Great | 700–799 |
| Good | 500–699 |
| Room for improvement | 300–499 |
| Low | 1–299 |
Businesses also have distinct credit scores, representing their financial health. Banks, online lenders, and other financial institutions use these scores to gauge the risk of lending to a particular business. Factors influencing a business credit score include:
- Registered defaults: Instances of defaults on financial obligations are scrutinised.
- Duration of business operation: The duration of a business’s operation signals stability and resilience.
- Director information: The background and history of business directors provide insights into the company’s leadership and management practices.
It’s essential to note that while credit scores play a significant role in lending decisions, they aren’t the sole determinants. For businesses, lenders might also consider factors like cash flow, profit and loss statements, and balance sheets. Some online lenders even offer services to check business credit scores for free, ensuring businesses understand their financial standing before applying for loans.
Risk assessment models
Credit risk assessment models provide essential insights beyond traditional credit scores. Some of them are the following:
- What-if analysis. What-if analysis involves analysing the potential impact of different scenarios on a project or business process. For example, a lender may use what-if analysis to evaluate the possible effect of an economic downturn, changes in interest rates, or a borrower’s loss of income on their ability to repay a loan. This analysis can help financial institutions better understand and manage their credit risk exposure.
Fault tree analysis (FTA). FTA is used in engineering and other industries, but its principles can also be applied to financial systems to analyse potential risks or failures. For example, a bank might use FTA to identify the potential causes of a loan default.
The FTA would start with the event of the loan default and work its way down to the underlying causes, such as the borrower’s financial situation, the collateral securing the loan, or the terms of the loan. By identifying the potential causes of an event, FTA can help organisations take steps to prevent or mitigate the event from occurring.
- Failure mode event analysis (FMEA). FMEA analyses the potential failure modes of a system and their effects. In credit risk assessment, FMEA can be used to evaluate various ways in which a borrower might default on a loan and the potential consequences of such a default. Understanding these failure modes can help financial institutions develop strategies to minimise credit risk and improve their risk management processes
- Hazard and operability analysis (HAZOP). This technique analyses the potential hazards associated with a system and its operability. In credit risk assessment, HAZOP can be used to pinpoint possible risks related to a borrower’s financial situation, such as high levels of debt or a lack of financial stability. By identifying these risks early, banks can take steps to address them proactively.
- Incident BowTie. The Incident BowTie model is a risk management tool used in various industries. In finance, it’s used to analyse the causes and consequences of a credit incident. Understanding these causes and consequences can help banks manage their credit risk better, leading to more informed decision-making.
These are all widely used techniques that can help financial institutions better understand and manage their credit risk exposure. By analysing potential scenarios, identifying potential failure modes, and pinpointing possible risks, banks can take proactive steps to minimise credit risk and improve their risk management processes.
Conclusion
Credit risk management is crucial to the operations of financial institutions, with credit scoring and risk assessment being central techniques. While credit scoring offers a quick data-driven snapshot of a borrower’s creditworthiness, risk assessment provides a deeper, more comprehensive analysis of potential loan defaults and their implications.
Australia’s credit scoring system, with its three main reporting agencies, offers a structured way to gauge creditworthiness, while advanced risk assessment models like What-if analysis and FTA provide insights beyond traditional scores. Together, these tools empower banks to make informed lending decisions, ensuring a robust credit risk management strategy.
