Assessing Credit Risk: The Five-Step Risk Management Process

In the world of finance, prioritizing risk management is crucial. The evaluation of risk involves identifying potential hazards, how likely they are to happen, and how you can best prevent them.

When lenders are evaluating the risk associated with credit, the ultimate goal is to see how likely it is that the consumer will repay a loan. Alternative data tools can help determine and reduce risk by looking at a customer’s payment instruments, trends, and behaviors.

The Five Steps of Risk Management

There are five main steps involved in the risk management process.

1. Identify the Applicant

   The first step to a proper risk management process is collecting all the necessary information to determine the characteristics of the applicant. When you are assessing sources for traditional credit information you will need to collect their personally identifiable information (“PII”). Alternative credit information may require something other than PII, for example, banking, payroll, or even tax information.

2. Analyze the Risk

   Next, you need to evaluate their ability to repay it. Their good intentions to repay might be there, but if they are unemployed with no job prospects, have a negative balance in their bank account, then they may not be a viable prospect for your service. While you are evaluating approvals based on the applicant’s willingness to pay it back and their intentions, you’re most likely lending based on their ability to pay it back.

3. Evaluate the Risk

   Evaluating credit can be complex. Most financial institutions and fintech’s use data science, build credit models, and incorporate AI and ML to automate the evaluation of credit risk. Whatever the method, variables from the credit data have been weighted for their contribution to the desired outcome and predictive strength.

4. Implement Your Findings & Conditions

   Once you evaluated the risk, it’s time to determine the conditions of the loan. These conditions will include the interest rate and the life of the loan. The purpose of this step is to build an extra layer of security and accountability into the loan. You need to cover all the potential weak spots to decrease the risk of the loan.

5. Review & Monitor Your Assessment

   Lastly, the final step is to continuously assess your customer’s risk. Just because their credit was good when they applied, does not mean their credit will remain the same. A customer’s credit needs to be monitored and reviewed on a regular basis. Often the monitoring and review process will help you find customers that may be eligible for additional financial services.

Key Factors to Keep in Mind

There are a few additional factors you should also consider.

Probability To Default

When calculating loan terms, the most important factor lenders should prioritize is assessing the borrower’s probability to default. This measure gauges how probable it is that the borrower may struggle to repay the loan. The evaluation involves reviewing the details in a credit report, and identifying key factors that are indicative of a default occurring.

Debt To Income Ratio

Another important calculation is the borrower’s debt to income ratio. Once they have collected a substantial amount of debt, their credit risk skyrockets. By spreading their finances too thin, they demonstrate that they are a high-risk borrower.

Ultimately, consider what aligns with your company’s best interests. It’s wise to evaluate the level of risk you’re comfortable taking on. Also, determine the extent of interest rate reductions and down payment amount you’re open to offering low-risk clients. Establishing clear parameters in your risk management approach makes it easier to assess individual cases.

Assessing Credit Risk with ValidiFI

ValidiFI’s vCredit score helps determine whether a consumer can, will or if they even have the ability to pay back their loan or other financial obligation. Leveraging bank account and payment insights, vCredit looks at a consumer’s banking activities and behaviors, account length and history, velocity, and transaction history to help identify fraud, risk, and creditworthiness.

If you need assistance putting together an effectiverisk management process, ValidiFI can help. We can help lenders determine the best risk strategy. Contact us today to learn more or set up a data study.