Question

Identify some risk factors that would indicate to a lender that a potential borrower may be a high risk. (Detail borrowing risk factors).

Answer 1

Major risk factors for a lender to the borrower is Credit risk / Default Risk. It is an investor's risk that borrower will not pay interest and principal when they come due. The quantification of credit risk is the process of assigning measurable and comparable numbers to the likelihood of default risk and the concept is a major frontier in modern finance. The factors that affect credit risk ranges from borrower-specific criteria to market wide considerations. The idea is that liabilities can be objectively valued and predicted to help protect the lender against financial loss.

Several major variables are considered when evaluating credit risk; the financial health of the borrower; the severity of the consequences of a default ( for the borrower and the lender ) ; the size of the credit extension; historical trends in default rates ; an a variety of macroeconomic considerations, such as economic growth and interest rates.

• Different factors are used to quantify credit risk , and three are considered to have the strongest relationship; probability of default, loss given default and exposure as default.
• Probability of default measures the likelihood that a borrower will be unable to make payments in a timely manner
• Loss given default looks at the size of the loans, any collateral used for the loan and the legal ability to pursue the defaulted funds if the borrower goes bankrupt.
• Exposure at default looks at the total risk of default a lender faces at any given time.

Among all possible factors, three are consistently identified as having stronger correlative relationship to credit risk, probablity of default, loss given default and exposure at default.

• Probability of Default - Expresse the likelihood the borrower will not maintain the financial capability to make scheduled debt payments.
• Loss Given Default - It seems like a straightforward concept, but there is actually no universally accepted method of calculating Loss Given Default. Several factors can influence it including any collateral on the loan and the legal ability to pursue the defaulted funds through bankruptcy proceedings.
• Exposure at Default - It is an assessment of the total loss exposure a lender is exposed to any point in the time. Even though it is almost always used in referance to a financial institution, the total exposure is an important concept for any individual or entity with extended credit.

There are mainly five C's used by lenders inorder to determine the level of risk;

• Character - The borrower's history of how they pay their bills
• Capacity - The quantitative measure of whether the borroweer has sufficient income to pay its debt.
• Capital - Also known as equity. Generally the higher the equity contribution the lower the risk to the bank.
• Collateral - An alternative source of repayment if cash flow cannot be relied upon to pay the debt.
• Conditions - Also known as capital structure. This refers to both the return built into the investment as well as conditions placed on the accomodation to ensure the Bank is repaid.