Retail credit classification by individuals and SMEs

Classification by segments

Segment-based classification is an approach that classifies bank’s customers into different tiers in order to be able to categorize customers by requirements and demands. The nature of credit facilities will differ by customer segment. If a bank understands the actual credit needs of each segment, it has a better chance to avoid the ‘adverse selection’ of customers. The purpose of this approach is to have the right credit for the right customer segment. It also provides detailed features of the type of borrower that enables the bank to design and offer the right facility to the right customer that meet customer needs and desires. Such an approach helps the banker to draw an image grouping people by characteristics.

An example of segmentation is doctors, students, fishers and so on.

Classification by purpose

The purpose of the credit facility is a vital element in the credit approval process. We divide purpose into two categories: a specified purpose and an unspecified purpose.

The specified purpose credit is one credit where the bank knows for a fact the actual purpose of and utilization of the credit. One example of a specified purpose credit is a mortgage loan, the purpose of which is to buy a house. The purpose of an auto loan is to buy an automobile.  

 Unspecified purpose credits are those where the bank may be advised of the purpose of the credit but does not know the real utilization or the real purpose of the credit granted to the customer. Some examples of unspecified credit include a personal loan, credit card, and overdraft facility. The amount of risk evaluation in the case of unspecified credit would be more difficult and hence riskier than a specified purpose credit where the bank is able to verify the purpose and may get a collateral.

Classification by Duration

Duration – whether short, medium or long-term – is one of the most important elements affecting the credit assessment of a customer. This is obvious. The shorter the duration the less risky the credit, as the variation of the elements affecting the credit would be limited. Unlike short duration credits, a greater burden attaches to long-duration credits as variations are more likely to happen. An example of the effect of duration on credit assessment is the rate of interest, which has a greater chance of changing over a longer duration.

We will discuss later the effects of change of interest rate on risk, and how changes in the interest rate would have a great impact on the credit risk. The variability of interest rates resulting in a rate fall may cause customers to exercise their put option and request to pay back the full amount of the loan far ahead of maturity through a “buyout” with another bank that offers them a lower interest rate that matches the rate change in the market. Therefore, an interest rate drop would cause losses for the bank due to losing a targeted profit.

Another factor relating to loan duration is that when loan durations are long the bank is exposed to greater chances that the value of the collateral could decline from the value at the outset of the loan.  We then have to deal with the chances that the market price of the loan’s collateral may change.

Classification by Collateral

Credit is classified as secured credit or unsecured credit.  Secured credit is credit secured by collateral, which is an asset or property that is offered to the bank by the borrower to secure his or her credit. Credit classification means the class or code that represents an obligor or borrower credit. Such collateral could be a deposit under lien (i.e., a deposit blocked or frozen in the bank’s favour until final settlement of the credit), mortgage of real estate, cars, or shares and bonds. We may classify the credit based on the type and nature of the collateral. A bank can offer loans against time deposits, real estate, vehicles, or against quoted securities like shares and bonds, among others.

Classification by Companies

The employer of the applicant for the credit is one of the vital parts of the approval process. A bank classifies companies based on number of staff, capital or net worth, business turnover, and number of years in business.