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What is Credit? The Best Definition

Tags: credit risk

CreditWhat Does Credit Mean?

The word ‘credit’ simply means, ‘buy now, pay later’, whether the purchase is for short-term consumption, durable goods and other assets that provide users with valuable services, or productive enterprises. The word ‘credit’ comes from the old Latin word ‘credo’, which means, ‘trust in’, or ‘rely on’. If you lend something to somebody, then you have to have trust in him or her to honour the obligation. Many people today view access to Credit as a right, but it comes with its own obligations.

Borrowers must pay the price of (i) creating the impression of trust; (ii) repaying according to the agreed terms; and (iii) paying a Risk premium for the possibility they might not repay. This gives rise to concepts like: creditworthiness—borrowers’ willingness and ability to repay; and credit risk—the potential financial impact of any real or perceived change in borrowers’ creditworthiness.

Creditworthiness is often mistakenly viewed like a personal attribute like height, weight, or eye colour, as something that can be directly measured. Indeed, application, behavioural, and bureau risk scores are sometimes mistakenly believed to be creditworthiness measures, but almost all of them ignore the loss severity and profitability elements. A person of higher than average risk may nonetheless be creditworthy at the right price. You may not be creditworthy to one lender, but just adjust the risk/return dynamic— increase the interest rate, lower the amount, shorten the term, etc.—and presto!

As regards credit risk, and any other situation involving trust (which includes all economic activities involving contracts or liabilities), the contracting parties must be aware of the possibility that things may not be as they seem. Where trust is low, lenders will increase their charges to cover the risks. Trust can however, be enhanced through collateral, other security, or more information. In ages past, credit was often only extended against collateral, but the cost of realizing its value is high. The modern information age allows lenders to enhance trust, by using data about borrowers’ financial and other circumstances, whether at time of application or ongoing thereafter.

Just as credit is a human construct, and a commodity with no physical form other than documentary evidence, so too is the information upon which it is based. The two are not only similar, but heavily intertwined, to the extent that lenders’ activities extend far beyond lending money, to managing and transacting in the information needed to manage the risks. This leads to concepts like information goods and information economies, and a variety of others used in economics and law:

In sales situations, it is the buyers that are most at risk of adverse selection, because sellers are more familiar with the item being sold. In contrast, in credit and insurance markets, the sellers are most at risk, because their customers have better knowledge of their own personal circumstances. Likewise, for moral hazard, just as people may engage in riskier behaviour when they know that they are insured, so too may borrowers become less financially responsible, once they have funds in hand.

All of these informational aspects are particularly pertinent for banks, which have huge investments in information, and rely upon it for a competitive advantage. The better the information, the greater the rent that can be achieved. This will, of course, also be dependent upon:

(i) methods used to interrogate the data; and

(ii) actions taken based upon the knowledge that is gained. Indeed, the situation can be compared to other conflict situations where intelligence gathering is critical, like military intelligence and business intelligence.

In like fashion, ‘credit intelligence’ can be used to describe the gathering, interpretation, and delivery of information to support credit decisions, where the information relates to borrowers, either individually or collectively. Many lenders refer to it as ‘customer insights’, if only because it is more politically palatable, but this plays down the lender/borrower conflict, and focuses on the positive-sum game.


This post first appeared on Best Payday Loan Companies | Top Cash Advance Lenders Online, please read the originial post: here

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What is Credit? The Best Definition


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