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Reasons for financial intermediators
Aggregation of amounts
Maturity matching
Credit risk assessment
Credit risk management
Credit risk diversification
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Aggregation of amounts
Depositors generally place much smaller amounts in their accounts than the loan amounts sought by borrowers.
Economies of scale can be achieved, particularly in the retail sector, by aggregating those smaller amounts into parcel sizes of loans sought by borrowers.
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Maturity matching
Depositors generally do not have the same investment horizons as borrowers, a role exists for a party of sufficient standing (intermediary - bank) to link liabilities and assets so that their maturity dates can be matched.
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Credit risk assessment
The granting of any loan involves assessing and accepting the credit risk of the borrower, i.e., the risk that the borrower will meet the loan repayments and interest as they fall due.
Rather than collecting information about each individual borrower, depositors prefer to leave such assessments to credit providers who specialise in making such assessments.
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Credit risk management
Once a loan is approved and drawn, the credit risk associated with that loan can be reduced through active monitoring of the accounts and performance of the borrower.
Credit providers undertaking this specialised role can achieve economies of scale.
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Credit Risk Diversification
Credit risk can be mitigated or reduced by spreading exposure over several borrowers, rather than ‘placing all the eggs in one basket’.
By investing in a spread of loans, credit providers offer their depositors, the benefits of their credit risk diversification.
(Analysis, management and diversification of credit risk are the most important functions of successful credit portfolio management)
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5 C's
Character
Capital
Capacity
Conditions
Collateral
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Capital
Appraisal of the borrower’s position and performance through examination of balance sheets, financial statements, bank statements, etc. For consumer customers this is their cash or equity contribution.
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Capacity
Analysis of the borrower’s repayment capacity through verification of income from pay slips, taxation returns, group certificates, assessment of fixed expenses, etc.
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Character
Appraisal of the borrower’s integrity and assessing the borrower’s willingness to repay through examination of past loan statements, credit reports, etc.
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Conditions
Analysis of key external and internal factors that may affect the borrower’s future performance, by gaining an understanding of market, economic and other conditions.
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Collateral
Appraisal of the security available to support the borrowing
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Credit Evaluation Systems
Judgemental
Automated (Credit Scoring)
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Judgemental Credit Analysis
Relies on the credit officer’s experience and insight when evaluating a borrower’s capacity and willingness to repay.
Similar to the evaluation of a business credit for a small to medium size business.
The credit officer must also assess the borrower’s character, use of the funds, and the primary and any secondary sources of repayment.
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