Credit risk assessment: photo by freepik
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Accurate Credit Scoring: A Crucial Step in Lending

Read Time: 5 mins

Before giving out that loan, have you accurately determined whether the borrower deserves the funds? Accurate credit scoring means ensuring a borrower is dependable and trustworthy.

 

What Does That Mean?

 

Picture yourself as a credit officer at a bank, responsible for determining whether an individual’s loan request should be approved. Naturally, you want to ensure you make decisions that won’t haunt you later. That entails lending to only people who will meet their loan obligations on time, while avoiding those who may struggle to pay it back. That’s accurate credit scoring.

 

Accurate credit scoring is like having a powerful tool that enables you to predict the likelihood of a borrower repaying their loan. You must be able to analyze important factors, such as income, credit history, and employment status, etc.

 

Now, suppose you have two individuals applying for a loan—Sarah and John. Sarah has an impressive credit record and a higher income. On the other hand, John is not good at paying back and has a lower income. Given these details, you will likely assign a higher score to Sarah, suggesting she has a greater chance of making timely repayments, while John may receive a lower score, indicating a greater likelihood of default.

 

Ideally, you will have effectively safeguarded your bank’s funds while promoting responsible borrowing choices.

 

Failure to Accurately Assess Creditworthiness Results in Non-Performing Loans (NPLs)

 

—loans where borrowers don’t pay on time or miss payments.

 

While the main reason for your financial institution’s existence is lending, you must do so with careful consideration of the associated risks. If you fail to assess credit risk properly, you will likely lend to people who may not pay back.

 

The result? — bad loans.

 

What Are Bad Loans?

 

Bad loans consist of non-performing loans (NPLs), past-due loans, and defaulted loans. Past-due loans refer to instances where borrowers have missed their scheduled payments but are still within a designated grace period. NPLs, however, are loans that have not been paid for an extended period and are classified as a greater risk for default.

 

Defaulted loans arise when the borrower fails to fulfill their repayment obligations altogether. It’s comparable to that one friend who always pledges to return your money but never follows through. We all have that one friend, don’t we?

 

Non-Performing Loans and How They’re Classified

 

You can think of NPLs as loans that have strayed from following the standard protocol. Typically, a loan must have gone without payment for a set time frame, usually 90 days or more, for you to label it as an NPL. In simpler terms, it is when the borrower chooses to relinquish their role as the leading player in the game of repaying debt.

 

Current Status of NPLs and their Impact on Lending

 

Now that you understand what NPLs are, what’s the current state of non-performing loans and their impact on Lending?

 

In the first 8 months of 2023, the Central Bank of Kenya reported that loan defaults rose to Ksh 611.4 billion. This figure is a barometer for the health of financial institutions in the country, indicating a significant increase in loan defaults in 2023 alone. That means there’s a substantial volume of loans that borrowers have been unable to repay.

Nation epaper

For your financial institution, this figure indicates that borrowers are not repaying as expected. This situation poses several risks for your institution overall—financial losses, reduced profitability, impaired liquidity, etc.

 

Now, You Might be Wondering, What Causes High NPLs?

 

The sudden appearance of NPLs cannot be explained by a single, straightforward reason. It involves a complex interplay of multiple factors, both within and outside the banking system. Economic downturns and uncertainty in the job market make it even challenging for borrowers to fulfill their loan obligations. On top of that, internal issues, such as careless lending practices, or inadequate risk assessment methods, can also contribute to the issue.

 

Just in February this year, a shift in the regulatory standards seems to have added fuel to the fire. The Central Bank of Kenya (CBK) revealed a new lending rate of 13%, up from 12.5%.  This decision by the Monetary Policy Committee (MPC) signals significant changes in the borrowing environment.

 

So, What Causes High NPLs?

 

When talking about the soaring NPL levels, you cannot ignore the looming presence of 3 major factors:

  1. Economic Slowness: This not only poses difficulties for your institution but also makes it tougher for your customers to manage their finances. As a result, the number of NPLs can skyrocket, with borrowers struggling to pay off their debts. It’s a daunting and confusing task that is likely to result in wrong turns.
  2. Potential Credit Risks: Your financial institution faces greater risk when dealing with borrowers who have a poor credit track record or a history of missed payments. These individuals may have limited options for obtaining credit. Moreover, they may be subject to higher interest rates to offset the possibility of default.
  3. Lack of Proper Risk Management: Financial institutions that do not properly assess the risk while lending may end up approving loans for borrowers who have a higher likelihood of default. Without properly examining a borrower’s creditworthiness and ability to repay, you may unknowingly increase your institution’s vulnerability to problematic loans.

 

In an ideal scenario, the increase in NPLs is often accompanied by high-risk rates. This is because a considerable portion of loans within your institution’s portfolio turning non-performing can harm its financial well-being and stability.

 

Financial Consequences of High NPLs

 

The accumulation of NPLs can spell disaster for your financial institution. High NPLs make it difficult for you to provide loans to individuals and businesses. This in turn drives up the cost of credit for all.

 

It’s comparable to having a friend who consistently expects you to cover their expenses. Eventually, it begins to strain your pockets.

 

Three Questions Emerge

 

  1. Are you accurately assessing the creditworthiness of your borrowers?
  2. Are you setting realistic repayment terms that align with your borrowers’ financial capacity?
  3. Are you monitoring the performance of your loan portfolio closely and taking timely action to address any signs of distress?

 

Well, as a credit risk officer, you can’t risk your institution drowning in debt.

 

Loan recovery is a process, one where you must ensure that borrowers repay the money they borrowed. It’s like trying to extract that last drop of toothpaste from the tube – every bit counts!

 

So, What Should You be Paying Attention to?

 

Think about the following elements of accurate credit scoring:

  1. Income stability
  2. Employment track record
  3. Spending habits
  4. Repayment history
  5. Rate of default
  6. Security/collateral
  7. Loan amount

etc

 

Such indicators can provide insight into borrowers’ financial management skills and ability to repay their loans.

 

Prioritize Your Collections Efforts: Minimize Losses

 

You can proactively avert the escalation of NPLs and maximize your recovery endeavors. Essentially, you can utilize effective credit scoring systems like the NLS Credit Management System. This tool is fundamental in accurate credit scoring, which entails performing immediate risk evaluation and automatic decision-making.

 

That means, you’ll grant loans to only qualified candidates, significantly reducing the likelihood of defaults and troublesome non-performing loans.

 

So, protect your financial institution’s financial health. Keep your lending activity running smoothly.

 

Request a Demo today to experience the effectiveness of this tool.

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