As a commercial lender, you take on risk every time you issue a loan. The borrower may never pay you back—at least not in full. Maybe they go out of business or the debt turns out to be too high for them.
But that doesn’t mean you can’t mitigate the risk. There are many things lenders can do to protect themselves against financial loss. The key is to quantify the risks through measurable metrics.
In this article, we’ll go over what those metrics are and how they help you de-risk the lending process.
Credit Risk Factors
First, let’s go over the main factors that impact credit risk:
- Probability of default (POD)—This is the chance that the borrower won’t pay back the loan. You can gauge POD by the borrower’s debt-to-income (DTI) ratio and their credit score.
- Loss given default (LGD)—This is the amount the lender stands to lose given a default. In many cases, it’s equal to the size of the loan. But you can offset your LGD by having the borrower put up some collateral.
- Exposure at default (EAD)—This is similar to LGD but also includes potential increases in overall exposure to loss. For example, if you offer a credit line, future withdrawals can increase your financial exposure.
The 5 C’s of Credit
Now that you know what makes up credit risk, let’s go over the top 5 ways you can minimize it. Lenders refer to these strategies as the 5 C’s of credit:
1. Credit history
Check the borrower’s credit history. Essentially, this means taking a look at how they’ve managed their past debts and bills. This will be a good indicator of how they will handle your loan.
The easiest way to check credit history is to run a credit report and check the borrower’s credit score. The Fair Isaac Corporation (FICO) rates borrowers on a scale from 300 to 850 based on past performance, length of credit, missed payments, and more.
Verify the borrower’s capacity to pay off the loan. Here, you need to take a close look at their profit and loss statements (P&Ls) as well as their debt-to-income (DTI) ratio.
If the business is only breaking even or it already has too much debt relative to the revenue it brings in, you should reconsider offering the loan.
Assess the borrower’s capital. Capital, aka equity, is the total amount of assets that a borrower has that can be used toward repaying a loan. This includes savings, investments, real estate, and other assets. The more capital they have, the lower the lender risk.
Require some collateral. Collateral is an asset that the borrower surrenders in the event of a default. This is how you “secure” the loan instead of leaving it “unsecured.” Make sure to properly assess the value of the collateral as well so you know how much it’s worth.
Set loan conditions. This means designing a loan structure that specifies the interest rate, fees, and other requirements. For example, you may outline expenses for which the loan may not be used—like other debts or real estate. You may include contingencies for economic and environmental factors as well.
If the borrower meets your standards for all 5 C’s, then they’re probably a safe investment. Just don’t overleverage yourself by issuing too many loans at a time.
And remember to plan for the worst. Have a backup plan in case the borrower does not repay the loan. Then closely monitor their business and incentivize good financial management. If you can do all of that, you’re in a good financial position to make a sizable return.