Benefits of credit ratings to banks
Last week, I shared that since the majority of people depend on banks when they want to borrow, it is important to understand the concept of credit rating.
Whenever you apply for a loan from a bank, your credit rating is checked. Banks and financial institutions are using credit rating agencies to check your credit rating.
A credit rating agency is an organization that evaluates the creditworthiness of an individual or company who wishes to borrow money or apply for a line of credit in the bank.
Also, I shared the definition of credit rating which is an assessment of a borrower that determines whether the borrower will be able to pay the loan per the loan agreement. The agency’s ratings are used by banks to determine the risk premium to be charged on loans.
A poor credit rating shows that the loan has a higher risk premium, and this prompts an increase in the interest charged to individuals and entities with a low credit rating.
In Tanzania, we have only two credit rating agencies which I believe are too few to serve more than 50+ commercial banks that we currently have.
To improve the performance of the banking sector, stimulating economic development, addressing the problem of information asymmetries, and to reduce the cost of lending through low lending rates, Bank of Tanzania (BoT) needs to do more to create a friendly environment that will attract more credit rating agencies.
There are many benefits to having effective credit rating agencies for banks, consumers and the state of the country’s economy.
Last week I shared one benefit, which is that credit ratings enable banks to save time and effort in analysing the financial strength of a borrower hence helping the banks to make good lending decisions. This week, I will share additional benefits of effective credit ratings for banks and consumers.
• Efficiency in credit markets – Credit rating agencies improve efficiency and transparency in the credit market by helping to reduce the knowledge gap between borrowers and lenders (banks).
The knowledge gap I am referring to is the borrower’s creditworthiness. Although the lender may be able to correctly characterize potential borrowers most of the time, there is still a chance of misjudging the borrower or internal staff colluding with the borrower to issue unwarranted loans, so by combining credit ratings and the bank’s own analysis, the bank can determine more accurately the creditworthiness of the borrower.
Usage of multiple approaches (internal analysis and credit bureau agencies), will enable the bank to be more confident about their lending decisions hence the banks will be able to set up loan interest rates that truly reflect the riskiness of the borrower. And this should ensure superior allocation of the limited credit which results in more net profits for the banks.
• Determination of interest rate – Every bank offers a loan at a particular range of interest rate based on the market’s conditions and subject to changes in line with money market conditions.
One of the major factors that determine the rate of interest on a loan is the credit history of a borrower which is obtained through a credit rating report. The higher the credit rating of a borrower, the lower the loan’s interest rate for the borrower.
The interest rate on the loan is very important to the borrower since it has a big impact on the cost the borrower is paying for borrowing the money (loan). A lower interest rate on a loan is easier to repay than a higher interest rate because there is less interest added on top of the loan amount.
To summarise, the past two weeks I shared that banks and financial institutions are using credit rating agencies to check the credit ratings of loan applicants to determine their creditworthiness.
With credit rating, the bank gets an idea about the creditworthiness of an individual or company (borrower) and the risk factor attached to them, hence enabling a bank to make a better lending decision.
Also, we have seen other benefits of having effective credit rating agencies for both the banks (financial institutions) and consumers.
Kelvin Mkwawa is a Seasoned Banker
Email address: [email protected]
