APPROACHES TO CREDIT RISK MEASUREMENT: INTRINSIC RISK
There are three basic approaches to credit risk measurement at individual loan intrinsic level that are used for various types of loans such as commercial loans, project and infrastructure finance, consumer and retail loans. They are: * Expert Systems * Credit Rating * Credit Scoring Expert Systems: In an expert system, the decision to lend is taken by the lending officer who is expected to possess expert knowledge of assessing the credit worthiness of the customer. Accordingly the success or failure very much depends on the expertise, judgment and the ability to consider relevant factors in the decision to lend. One of the most common expert systems is the five “C’s” of credit. The five C’s are as under (Saunders, 1999): 1. Character: Measure of reputation of the firm, its willingness to repay and the repayment history. 2. Capital: The adequacy of equity capital of the owners so that the owner’s interest remains in the business. Higher the equity capital, better the creditworthiness. 3. Capacity: The ability to repay is measured by the expected volatility in the sources of funds intended to be used by the borrower for the repayment of loan along with interest. Higher the volatility of this source, higher the risk and vice versa. 4. Collateral: Availability of collateral is important for mitigating credit risk. Higher the value of the collateral, lower would be the risk and vice versa. 5. Cycle or (economic) Conditions: The state of the business cycle is an important element in determining credit risk exposure. Some industries are highly dependent on the economic condition while the others are less dependent or independent. Higher the dependence, higher the risk as during recessionary period of the economy, the cyclic industries would suffer and vice versa.