YOU as the Banker – The 5Cs of Credit

I am sure most of you jumped for joy when your car or housing loan got approved by the banks but have you ever wondered the kind of criteria banks apply to assess the creditworthiness of borrowers?

In my previous article, I suggested that individual lenders can emulate banks by employing techniques of credit analysis, such as the 5Cs of credit, before investing in a borrower. (Nope, this is different from the 5Cs that most Singaporeans know of – Cash, Car, Credit Card, Condominium and Club Membership.)

1) Character

This “C” asks: Who are you? What’s your background? Can I trust you to pay me back?

For instance, when applying for any credit facility, banks check your background in terms of education level (which provide expectation of earnings), employment records (to gauge whether you were able to find someone else to pay your bills) and credit history (whether you have been responsible to meet your past and present liabilities).

In peer-to-peer lending, “character” assessment can be similarly applied. Credit information about a company’s history of default or delinquency, litigation and bankruptcy trace can be examined. The value-add that most p2p websites derive for prospective lenders is to collate and organize (but not analyze) such information from various 3rd party independent sources.

2) Capacity

This “C” is most concerned with: Are you able to pay me back?

Banks require details of your current income and yearly tax assessment to determine your credit limit and estimate your likelihood of paying them back. Also, they look at your payment history to see if you might be encountering any difficulties to meet outstanding liabilities.

In peer-to-peer lending, the same technique can be applied by scrutinizing the financials of a company. From the financials, one can examine if the cash flow generated from the business is adequate to service the monthly interests and repay the principal. One can also look at its current indebtedness to ascertain if it is already near its limits. And of course, see if the company is facing any challenges from its payment history (whether they are current with their payments or not).

3) Capital

No bank will fund 100% for any business venture, even for asset backed loans such as mortgages. Any investor will need to see your own skin in the game. To illustrate with home loans, 1st time buyers will first have to put in 20% equity (down payment) before they can even approach any bank for financing.

All things being the same, I would have better comfort investing in a company that is capitalized with shareholder funds of S$100,000 versus a S$1 shell company.

4) Conditions

Banks will be looking at the overall macroeconomic conditions, and also specific conditions pertaining to each borrower. Some of the questions banks will be asking are:

    • What is the outlook of the economy? Projections on GDP growth? Will there be a recession or economic contraction?
    • Which sectors are vulnerable? What are the current and expected default rates? What are expectations on future interest rates?
    • What is the borrower’s plan? Why do they need the loan?

There are numerous macro reports that a p2p lender can review on the general economic outlook. Sectoral insights can also be

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gleaned from reading equity research reports of comparable businesses, and also by combining one’s own professional experience in particular industries. Many p2p sites have forums that allow lenders to interact and exchange insights with each another.

Similarly, the p2p lender can also examine the purpose of the loan. Is the loan going to be used for productive activities such as investment in the business, refinancing at lower interest rate or expansion of business? If it’s for working capital, is the company acquiring the loan at reasonable cost?

5) Collateral

Notice the gulf of difference between rates on home loans (~ 1.25% p.a.) and credit card loans (~ 24% p.a.)? Loan rates are much lower for car or housing loans as they are “secured” by the car or the house. In the event the borrower defaults on his loan, the bank will simply repossess the collateral, sell it off and recoup its principal. For that reason, banks consider secured loans as less risky, though charging 24% p.a. for unsecured loans is unjustifiably avaricious!

As you can see, the 5Cs of credit framework isn’t that complicated. The good news is that the evaluation of the 5Cs can now be more readily accessed by combining technology and wisdom of the crowd, as other p2p sites have demonstrated.

With peer-to-peer lending, anyone can be a banker!