Controlling Credit Exposure
The key action to control credit exposure starts with evaluating the borrower’s ability in repaying the debt. Basically, lenders have a lot of ways to limit and control credit exposure. The epitome could be imposing a $300 credit limit on a college student with no credit history. It could work until the person has a proven track record of making on-time payments. In this scheme, the card company could reduce credit exposure by lowering high-risk borrowers.
The bank may also have FICO customers. FICO is Fair Isaac Corporation where the account data could be measured based on its creditworthiness. The examples are from payment history, level of indebtedness, types of credit used, credit history length, and the new credit accounts. When customer income is more than 800 FICO score, the credit card offers a $100.000 limit. In this scenario, the company nurtures business partnership with a wealthy client. The above two ways are actually not the only way to control credit exposure.
A more complex method is credit default swaps.
In order to limit credit exposure by having credit default swaps, the bank must purchase credit default swaps. This is actually an investment. Analysts often call this way an effective investment, because the bank can transfer the credit risk to a third party. The swap seller will receive premium payments from the swap buyer. But first, they must agree to the risk of the debt. The buyer will receive interest payment as a form of compensation from the swap seller. It includes returning premiums if the defaults happen.
Credit default swaps had the biggest role during the 2008 financial crisis. At that time business faced subprime mortgage. Subprime mortgage normally issued to borrowers with low credit ratings. A prime conventional mortgage does not get the offer because the lender viewed the greater-than-average risk defaulting on the loan. Seller misjudged the risk of the assumed debt when issuing swaps on the subprime mortgage.
