Ebook Bank Lending Policy, Credit Scoring and the Survival of Loans
Consumer credit has come to play an increasingly important role as an instrument in the financial planning of households. When current income falls below a house-old’s permanent level and assets are either not available or not accessible for dissaving, credit is a means to maintain consumption at a level that is consistent with permanent income. People expecting a permanent increase in their income but lacking any assets, like students, have a desire to maintain consumption at a higher level than their current income allows. Borrowing can assist them in doing that. Those who accumulate funds in a pension scheme but are unable to get access to them when they experience a temporary drop in current income can also increase their welfare by bridging the temporary fall in income with a loan.
The quantitative importance of consumer credit may be illustrated by the fact that total lending, excluding residential loans, by banks and finance companies to Swedish households amounted to SEK 310 bn. (199 bn.), or SEK 34,779 per capita (22,494), by the end of 2001 (1996). That is equivalent to 13.7 (10.9) percent of Swedish GNP or 28.1 (22.3) percent of total private consumption. Viewed from the perspective of financial institutions, household credit also constitutes a significant part of their activities, making up 34.3 (36) percent of total lending to the public. If one includes residential loans, that are often granted by separate subsidiaries, in total lending, this figure drops to 15.5 (12.8) percent. When looking at the risk involved in these loans instead of their volume, their importance is even greater, however. Current BIS rules stipulate an 8 percent capital requirement on consumer credit compared to, for example, 4 percent on residential loans.
From these numbers, it may be clear that a lending institution’s decision to grant a loan or not and its choice for a specific loan size can greatly affect house-holds’ ability to smooth consumption over time, and thereby even households’ welfare. At a more aggregate level, consumer credit makes up a significant part of financial institutions’ assets and the effects of any loan losses on lending capacity will be passed through to other sectors of the economy that rely on borrowing from the financial sector. For this reason, the properties and efficiency of banks’ credit granting process are of interest not merely because the factors determining the optimal size of financial contracts can be examined. At least as important are the implications these contracts have for the welfare of households and the stability of financial markets.
The starting point of every loan is the application. When lending institutions receive an application for a loan, the process by which it is evaluated and its degree of sophistication can vary greatly. Most continue to use rather naïve, subjective evaluation procedures. This could be a non-formalized analysis of an applicant’s personal characteristics or ’scoring with integer numbers’ on these characteristics. Some banks, however, use a statistical ’credit scoring’ model to separate loan applicants that are expected to pay back their debts from those who are likely to fall into arrears or go bankrupt.
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