In the world of finance, risk management is of the utmost importance. Assessing risk is the process where you identify what hazards can occur, 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.
Identify the Applicant
The first step to proper risk management 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.
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.
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.
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.
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.
Keep These Factors in Mind
There are a few additional factors you should also consider.
Probability To Default
When calculating the conditions of the loan, the most important factor lenders need to take into consideration is the borrower’s probability to default. The probability to default is how likely it is that the borrower will not be able to pay the loan back. This calculation helps lenders assess the information contained in a credit report and which pieces of the information are most predictive 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. They are proving they are a high-risk borrower because they are spreading their finances too thin.
In the end, you need to do what is best for your company. It is a good idea to determine how much of a risk you are willing to make. It is also worthwhile to decide how much of a break on interest and down payment you’re going to give low-risk clients. Once you have a baseline and maximum associated with risk management, it will be much easier to assess individual cases.
Assessing Credit Risk with ValidiFI
ValidiFI’s Payment Instrument Risk Score (“PI Risk Score”) helps determine risk by assessing a consumer’s payment instrument including the use of bank accounts. The PI Risk Score is able to determine whether a consumer can, will or if they even have the ability to pay back their loan or other financial obligation. Leveraging live bank and payment data, the PI Risk Score looks at a consumer’s banking activities and behaviors, account length and history, new account creation velocity, and transaction history to help identify fraud, risk, and creditworthiness.
If you need assistance with risk management when it comes to assessing credit risks for your company, ValidiFI can help. We help lenders determine the best strategy for their business. Call us today at 844-562 6678 to set up a consultation and go step-by-step through the risk assessment process.