Any business that depends on a credit model needs to have a solid understanding of the credit risk involved before they begin lending — and those risks will vary between industries, business models and economic pressures. After all, each credit risk assessment is as unique as the company using it. But, if that’s the case and each business has to establish their own risk model, where do you even begin? To help you get started, we’ve put together everything you need to know about credit risk models.
Risk Models: What Are They and How Do They Measure Risk?
Let’s begin with the basics: in the simplest terms, risk models help financial executives in B2B organizations determine the probability of default of a potential borrower. In other words, credit risk models help to predict the financial outcome of a given request by assessing the likelihood and scale of risk involved and lenders rely on the validation provided by risk models to make quality lending decisions.
Credit risk assessments take into consideration distinct risk factors and assign a score to a customer based on quantitative and qualitative data. All of this information is compiled from and analyzed by considering each company’s distinct business model and setup because each business’s history and foundation are as unique as the product or service they offer.
For example, a food supplier may base their credit decision on the end customer’s credit score paired with personal collateral or a personal guarantee, while a supplier in the HVAC or capital goods industry might extend credit and set terms solely based on a financial analysis of the borrower.
In order to create a credit risk model tailored to your business, it’s important to identify specific risk factors and explore how they each can affect the probability for repayment. As previously mentioned, credit risk factors vary greatly from industry to industry and are weighed differently across companies, in different economic climates, according to societal events and more.
That means that coming up with the perfect credit risk assessments for your business is a largely individual task with each risk model as unique as the company it represents. But that doesn’t mean that you are completely alone in creating your own risk evaluation process. The five Cs of credit evaluation are used as a guide in comprehensively evaluating a customer — and they can help you tailor a risk model to your company.
What Are the Five Cs of Credit Evaluation?
Lenders employ a basic framework known as the "five Cs of credit," which consists of five factors to evaluate potential borrowers' creditworthiness. This model uses Character, Capacity, Capital, Conditions and Collateral to evaluate a potential borrower comprehensively. The five Cs method of analyzing a borrower’s solvency incorporates both qualitative and quantitative measures, resulting in a robust snapshot of credit/liquidity risk for the customer.
- Character: reflected by the applicant’s credit history
- Capacity: reflection of a company’s repayment trajectory
- Capital: the amount of money on hand or liquid assets
- Conditions: current economic circumstances relevant to the larger credit market
- Collateral: an asset that can back or act as a security guarantee, when necessary
Of course, it is essential to understand that there is not one single indicator or predictor of credit risk that would paint a comprehensive probability of default every single time. There is no silver-bullet solution in this situation. Incorporating each of these factors into a larger credit risk model offers a greater guarantee of comprehensiveness when analyzing your customer, but only you can determine the weight each of these factors has on a borrower’s creditworthiness.
Risk is Subjective, So How Do I Know I’m Making a Quality Credit Decision?
While the “five Cs” model will certainly provide structure to your credit evaluations, it will not serve as a flawless, thorough assessment of every possible liability risk. It can’t — there are simply too many intricate factors that interplay and interact for any risk evaluation to be 100% accurate 100% of the time.
The most important thing to remember when assessing credit is that risk is inherently subjective and abstract. There is not one right way — or one wrong way — to assess exposure because what could be a risk to one person, company or business model may be acceptable to another. It’s all entirely up to individual judgment to determine what defines risk to you, your company and your goals.
Credit risk is personal and exclusive to each company and borrower, so you must create your own definition of risk specific to your unique processing needs. For example, while a food supplier might consider a lack of references or personal collateral to be a risk, a construction contractor may consider the project being worked on and determine it an acceptable risk.
Ultimately, there are infinite approaches to assessing credit and it’s up to you to find the unique evaluation formula that works for you and your business.
How Bectran Can Help
Once you’ve created the ideal credit risk assessment for your business, Bectran can streamline the process by automating the intake and assessment to help you manage current and potential risk exposures. Our models cover the full spectrum of credit risk, seamlessly assigning a score based on the risk evaluation index you provide to every piece of information on a customer. In addition, we offer model customization scorecards, capturing every detail of the customer’s borrowing and repayment trajectory.
If your needs include custom risk modeling measures, Bectran can work with your organization to design, develop and deliver custom solutions to support your credit risk analysis, crafting a risk model perfectly tailored to your company’s needs.
The views expressed on this blog are those of the author and do not necessarily reflect the views of Bectran. This blog may contain links to content on third-party sites. By providing such links, Bectran does not adopt, guarantee, approve or endorse the information, views or products available on such sites.
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