Default risk is a type of risk that accompanies all debt obligations. Default risk represents the uncertainty associated with repayments from borrowers. In case these risks realize, lenders can suffer a substantial amount of losses. Therefore, they need to protect against such occurrences. Usually, lenders check the borrower's creditworthiness to decide on providing the loan.
What is a Credit Rating?
A credit rating is a quantification of an individual or company's creditworthiness. Lenders may use creditworthiness to evaluate the default risk of a particular borrower. Most lenders require borrowers to have a history of past credit transactions, based on which they can calculate their credit rating. Usually, credit ratings apply to both individuals and organizations.
Credit ratings mostly come from credit rating agencies. Therefore, the credit rating signifies the agency's opinion of the borrower's creditworthiness. Despite its many uses, a credit rating that comes from these agencies can have some limitations. For example, they may not address a particular issue that lenders want to consider.
What is Internal Credit Rating System?
An internal credit rating system describes a borrower’s creditworthiness for a particular sector or industry. Usually, this system bases the calculation on the assessment criteria for the sector or industry in question. Through an internal rating system, lenders can manage and control their credit risks by grouping and managing borrowers’ creditworthiness and quality of credit transactions.
Internal credit rating systems analyze a borrower's ability to repay a loan based on their financial condition. These may include factors, such as determining their cash flows, profitability, debt profile, industry and operational background, liquidity, etc. For most banks, an internal credit rating system is a crucial part of their credit risk management process.
In the past, lenders managed their credit risks by evaluating a borrower’s creditworthiness only. Due to several financial crises, however, they realized the system was ineffective in preventing losses. Therefore, more lenders started adopting internal credit rating systems. It made the process of decision-making simpler while also minimizing loss occurrences.
What are the advantages of using the Internal Credit Rating System?
Using an internal credit rating system can have several advantages for lenders. Firstly, it allows for a more efficient decision-making process while minimizing the administrative burden. It also considers various factors and combines them into a single measure, making it easier to understand. An internal credit rating system can also help lenders develop credit management strategies, such as establishing lending rates.
More importantly, an internal credit rating system allows lenders to get more specific information about borrowers. It allows lenders to customize the process of evaluating a borrower's creditworthiness according to their requirements. Overall, an internal credit rating system can provide lenders with a basis for a consistent, comprehensive, and objective credit management process.
What are the uses of the Internal Credit Rating System?
Internal credit rating systems have several use cases for lenders. Firstly, they can help lenders establish credit limits based on rating grades. By setting rating grades, lenders can also determine which loans will need active monitoring. This way, they can avoid any unexpected circumstances in the future. Similarly, an internal credit system can help in establishing a PD for each grade. They can then use this to quantify the credit risk and in other further calculations.
Conclusion
Credit rating is a term used to describe a borrower’s creditworthiness in quantitative form. Lenders may use an internal credit rating system when making decisions. With this system, they can analyze a borrower’s ability to repay based on their financial situation. Similarly, they can use it to describe a borrower’s creditworthiness for a specific sector and establish rating grades for borrowers.
Originally Published Here: Internal Credit Rating System
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