What are the issues banks consider and evaluate for assessing credit risk? The decision whether to grant a loan or other banking facilities for industrial or financial investment (as well as for consumption or other aims) depends mainly on the perceived risk of the credit, i.e. the probability that the borrower might not respect the contract with the bank. The borrower could not be able or not be willing to pay back the money, in full or in part, thus leading to a bank loss.
First of all, the banks consider the personal and institutional creditworthiness of borrower, which is the main issue. Secondly, they will examine the characteristics of the proposed operation, and they will probably fine-tune them in order to meet bank desired risk level for that borrower.
In this essay we won’t talk about the first point (how banks assess the creditworthiness of borrower), since there is plenty of literature about it. We just remember that banks consider, among other factors, the current and prospect patrimonialisation and profitability, the borrower's history, as well as its industrial sector and how the borrower is positioned in it. Instead, we will propose a general synoptic scheme about the other issues to be considered in the perspective of the bank.
We can distinguish three "risk drivers" (from the less to the most important):
These drivers apply to both cash credits and non-cash credits (e.g. commercial and financial bonds, issued by a bank on client's request).
We will now describe the content of the three drivers.
We can classify the range of the lending operations according to which control banks have over the amount granted and to their "auto-cashing" attitude. Now, we proceed from the most to the less risky operation.
Needless to say, other elements can balance the degree of risk as function of operation but one should remember that usually banks will require higher margins on more risky operations.
In the ordinary credit facilities, bank commitment is very low. It means that a bank can call its money back at a moment’s notice (usually at two days notice). The credit facilities described in the former paragraph are usually granted as "day-to-day loan".
However, large companies are sometimes granted by "committed" facilities: the technical structure of the operations is usually very similar, but the bank commits itself, for a defined period, to keep the amounts at the disposal of the client without the possibility of calling back the credit line. This "service" is rewarded by a commitment fee, paid on the amount granted and not drawn at the date.
In long-term loans and mortgage loans the bank is highly committed: it can call its money back only when the borrower doesn’t pay at least two or more installments. For this reason, banks usually ask collateral (real-estate mortgage).
Finally, we should remember that bank commitment and duration has an effect not only on risk, but also on costs. Banks should fulfil some ratios provided by Central Banks. And long – term (as well as risky) facilities absorb more capital, which is the "limited resource" for banks.
What happens when a company can’t pay back its facilities and interests?
The bank should consider the so-called second barrier (the first barrier is the long-term profit and cash flow): guarantees and collaterals.
According to their effect to risk, how can we classify them? We will now explain the four groups of guarantees and collaterals, from the most to the least risky.
In this essay, we shortly illustrated a general scheme about the way banks tackle with credit risk. The purpose was not to exhaust the issue, but to provide a comprehensive scheme that considers together all the "risk drivers". By order of importance, we remember that banks usually evaluate first of all the creditworthiness of borrower, then, if necessary, guarantees and collaterals, then the type of commitment and, finally, the requested operations.
To understand the effects that bank credit has on the whole economy, see this paper - A new approach to business fluctuations: heterogeneous interacting agents, scaling laws and financial fragility.