Assessing the creditworthiness

Risk assessment and management have become extremely essential nowadays. The assessment of the borrower’s risk first of all means the assessment of his/her creditworthiness.

There are three types of the assessment of creditworthiness:

a)The analysis of the borrower’s financial state on the basis of financial indicators,
b)The analysis of the borrower’s cash flow,
c)The analysis of the business.

The above three are interconnected with each other. For example, if the analysis of the business enables to evaluate the borrower’s creditworthiness at the time of the contract signing on the basis of one credit transaction and the cash flow stemming out of it, the system of financial indicators predicts the risks taking into account the total amount of debt and the overall credit history of the borrower. The analysis of the borrower’s cash flow not only estimates the borrower’s creditworthiness, but also shows the possible limits for new credits, as well as the flaws of the company management.

The risk level in general, and the credit risk level in particular may be estimated as

a)High,
b)Moderate, and
c)Low.

High credit risk means that all the credit investments in the borrower might become lost.

The borrower is considered to have moderate credit risk if the bank might loose only half of the main amount of the credit, and the risk is in acceptable limits.

Low credit risk is rather insignificant, which allows the bank to gain stable profit.

Although all banks experience internal and external, as well as balance and off-balance risks, each bank also experiences other risks specific to that particular bank and based on the bank’s main operational aspects.

The borrower’s creditworthiness is his/her ability to fulfill taken financial obligations on time and in full.

It is essential to distinguish between creditworthiness and ability to take credit. The latter is an indicator based on which the financial organization makes the decision to whether or not extend credit.

In the world banking practice the following are the criteria for creditworthiness:

• The character reference of the customer,
• The ability to take credit,
• The ability to earn money to repay his/her financial obligations,
• The capital of the customer,The ability to earn money to repay his/her financial obligations,
• The securisation of the credit,
• The terms of the credit,
• Monitoring.

The character reference of the customer – This part includes the overall financial reputation and the credit history of the customer, the executive staff reputation, level of responsibility, a comprehensive understanding of the credit purpose, certain level of professionalism, ability to follow certain credit transaction policies established by the bank.

The ability to earn money to repay his/her financial obligations – This part shows the efficiency of the borrower’s overall operations, his/her ability to earn money while operating and paying back financial obligations.

The capital of the customer – This is the adequacy of the customer’s capital and the degree of its participation in the credit transaction.

The securisation of the credit – the total sum of the customer’s total asstes and a definite secondary source of the loan repayment (mortgage, guarantee, insurance). In case the borrower becomes bankrupt, the ratio between the assets and liabilities is important for the repayment of the credit, while the quality of the secondary source assures the repayment of the credit in due time frame. The above mentioned types of guaranty are especially important for the bank in case of the borrower’s inability to repay his/her credit obligations, which means that the customer may have current liquidity problems.

The terms by which the credit transaction is carried out include the current and projected economic conditions of the country, some political factors, etc. These terms determine the bank’s external risk level and taking into account the borrower’s cash flows, liquidity, capital adequacy and management level.

Monitoring is the process of overseeing the borrower according to standards established by the bank.

Based on the above mentioned criteria the analysis of the customer’s creditworthiness includes certain assessment methods:

• Evaluation of business risk,
• Evaluation of the management,
• Evaluation of the customer’s financial stability based on financial indicators,
• Evaluation of cash flows,
• Collection of information on the customer,
• Monitoring of the customer’s activities.

Establishing the credit limit of a physical entity

The credit limit of a physical entity is established on the basis of the ratio between the total sum of the credit requested and the income of the borrower, as well as his/her financial state, real estate property, family status, and credit history.

In many European countries (especially in France) the evaluation of individual’s credit limit is given in the form of credit scoring.

The steps to decide whether or not the credit is expedient comprises three sections:

• Information about the credit,
• Information about the customer,
• Information about the financial status of the customer.

The first section includes information about the bank employee that has approved the credit. Here the customer credit case number, as well as the borrower’s place of work, type of the credit extended, repayment type, interest, the approval and repayment dates, opinion on the necessity to insure and other information are indicated.

The second section contains information about the customer’s profession, annual income, yearly expenses, work experience, etc.

The third section comprises information about the financial status of the customer, such as liabilities in balance sheets, ratio of expenses and income, etc.

On the basis of all the above information it is possible to make the decision of whether or not to extend credit.

In the United States the physical entity’s creditworthiness is evaluated on the basis of his/her credit history. The bank uses the information provided in the credit application (his/her name, address, place of living, Social Security Number). Based on the information the bank then collects information about all the defaults and credit delinquencies in other banks, credit card issuing organizations, if any. The bank is especially interested in the amounts of late payments and defaults, the number of days the payment was delayed, the types of overdue payments, etc. All the above forms the credit history of the entity.

Apart from the credit history, the banks in the USA also take into account such indicators, as the correlation between the debt and the income, the stability of the income; the period of time worked and lived at one place, the volume of his/her capital, etc.