Credit Evaluation by Commercial Banks

The commercial banking practice has undergone a huge change within the past few years. This is despite the fact that commercial banking, as we know it, is still quite recent. However, it cannot be denied that the lending business of commercial banks is under attack from fintech companies. Fintech companies have brought in a more modern and data-driven approach to making commercial loans.

As a result, commercial banks all over the world have also been forced to evaluate their practices. In this article, we will have a closer look at how commercial banks have changed their credit evaluation approach over the ages.

What is Credit Evaluation?

Whenever a commercial bank makes a loan to a business, it must have sufficient reason to believe that the loan will be paid back within a certain time frame. In some cases, the borrowers are able to provide collateral. Hence, the banks can be assured of their repayment.

In other cases, where providing collateral is not feasible, banks want to evaluate the creditworthiness of their borrowers. In short, they want to gauge the ability of the borrower to be able to repay the loan based on their current financials.

Up until the past few years, commercial banks had a very stringent and standardized process for credit evaluation. However, with the passage of time and with an increase in the competition from fintech companies, this criterion has undergone a change.

A comparison between the old and the new approach used by commercial banks has been given below:

Old Approach:

The old approach followed by commercial banks to evaluate the credit of a prospective borrower was quite restrictive. This is because of the fact that banks would consider only data that came from very legitimate sources. Commercial banks were not making any effort of their own to find out more data. The details have been mentioned below:

1. Based on Credit Rating Agency: Commercial banks would rely on data from credit rating agencies and other reputed organizations only. However, if a corporation had started business recently or did not have enough scale, the credit rating agencies would not have their data. As such, it became impossible for a vast majority of corporations to borrow money from the banks. The few corporations which could meet the very high standards set by the bank had tremendous bargaining power. As a result, these corporations would drive down interest rates to extremely low levels.

2. Emphasis on Past Reports: Commercial banks placed a lot of emphasis on past reports such as the past cash flow data or the past tax returns. Banks were not willing to understand that the cash flow position of start-ups can change drastically from year to year. Hence, evaluating their credit based on past year’s tax returns may not be the most feasible approach. This does not apply to only start-ups but to all companies which fall in the small and medium enterprises category.

3. Missed Opportunities: Over the years, commercial banks realized that they are losing a lot of business because of their stringent measures. This became apparent when start-up fintech companies started to compete with them by using modern and advanced mechanisms of credit evaluation. It was time for commercial banks to adopt or perish!

New Approach:

Commercial banks realized that having a new approach to evaluating the credit of corporate customers is necessary. The changes made by commercial banks have been highlighted below:

1. Focus on Informal Data Collection: Over the years, commercial banks realized that they have many ways of collecting and analyzing data based on which they can make loans. For instance, commercial banks provide payables and receivables-related services to many corporations. Hence, they have access to invaluable data about the payables and receivables-related situation of these companies. If this data is analyzed correctly, it can be used to make a more accurate guess of the creditworthiness of the organization and make a loan accordingly.

   Also, since a lot of businesses conduct their business online portals and other public marketplaces, banks have started utilizing the data available from such marketplaces in order to make more informed decisions about the creditworthiness of a business.

2. Focus on Different Parameters: Commercial banks earlier were obsessed with certain parameters such as consistency of cash flow, solvency, etc. This is because internet businesses were new and commercial banks did not have the data required to evaluate them.

   Now, commercial banks have started collecting data about the various parameters related to internet businesses, the evaluate credit based on a much broader perspective and more realistic data points.

3. Faster Turnaround Times: The earlier process of credit evaluation used to be manual and time-consuming. It was much more common for businesses around the world to wait for commercial banks to take their time while assessing the loan application.

   The modern world has become hypercompetitive. Hence, if commercial banks are not able to evaluate the applications quickly, corporations usually take the funding from somewhere else. The end result is that the credit evaluation process of a commercial bank has become automated and less human-intensive. This has been done to increase the turnaround time and reduce the element of human subjectivity.

The bottom line is that commercial banking has undergone a huge change related to credit evaluation. They have started using big data techniques to be able to make better loans and have also automated the process in order to make it faster.

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