The aggregate types and levels of risk a bank is willing to assume within its risk capacity are determined by its strategic objectives and business plan. Each bank will have a different strategy and policy with regard to credit risk based on the bank appetite and the bank’s approach to risk acceptance and risk tolerance. ‘No risk, no gain’ is a very well-known expression in banking, meaning that banks do not achieve satisfactory results unless they accept a calculated risk challenge. What is a calculated risk? It means to study and thoroughly analyze business details in relation to risk.
The investigation part is a vital part of the Retail Credit process cycle in obtaining a consolidated credit report from the Credit Bureau. Such reports as are available through credit bureaus represent the customer’s credit history and their credit performance. They also show the bad debts or other negative information on the customer, providing a consolidated view of how consumers meet their credit obligations, including accounts held by other lenders. Consolidated reports could also go wider to show how prompt the customer is with paying other creditors such as rent or utility bills for the telephone, electricity, water, gas, and so on.
The modern concept of credit scoring was developed by FICO (Fair Isaac & Company), which issued the FICO-SCORE in 1989. Before credit scoring, customers could conceal their credit information, which resulted in information asymmetry and furthermore into adverse selection by the lenders, leading to many cases of bad debts. Customers were able to move freely from one bank/lender to another, repeating the same bad experience. The reason was the lack of knowledge sharing as there were no techniques for sharing credit information between banks and financial institutions. There were cases that a customer could full different branches of the bank.
Credit scoring is a technique that financial institutions use to build judgmental models to assess and control credit risk. There are two sides to this picture. First, there is external information about the credit of the applicant that banks obtain through the credit bureau showing five main elements of the creditworthiness of the applicant. According to the FICO score system that dominates the majority of the credit bureaus throughout the world, the report shows weighted scores such as the applicant’s payment history, the amount owed, the length of the credit history, the new credit and the credit mix. Second, there are in-house score cards that are a combined weighted score for each and every feature and data of the applicant of the credit such as age, assets, the amount of monthly income and so on. Each element (and the score may reach to 20 or more elements) is given a certain weighted score. The total score represents the credit status of the applicant and determines if credit will be granted or not. The decision regarding the amount and duration of the credit are based on the level of the score.
A combination of the two types of the external score and the internal in-house score are the bases of the decision making while approving the credit. Further full details of the credit score will be shown in Retail Credit Risk Management II.